CFA CFA Level 1 Considering risk premium in Forward Pricing

Considering risk premium in Forward Pricing

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    • Avatar of vaibhavgupta177vaibhavgupta177
        • CFA Level 2

        While synthetically replicating forward contract to determine the forward price, why do we assume that the opportunity cost of our spot outflows would be the risk free rate of return, when very clearly the forward contract carries a counterparty default risk?

        I am detailing my thought process here. Suppose we are trying to replicate a forward contract on Commodity A which has no cost of carry, no cash income and no convenience yield. Now, to replicate the long position in the forward contract, let’s assume that the commodity is bought in the spot market and held for the tenure which is same as the term of maturity of the Forward. Since, both the transactions leave me in virtually the same position at the time of maturity of the contract, they should ideally cost the same. So, the cost of purchasing A in the spot market and holding it for the tenure of maturity should be Spot Price plus the opportunity cost of funds we had to shell out to purchase A in the spot. Now, my issue here is that I am having a hard time convincing myself that my opportunity cost would be the risk free rate of return. Ideally, I should be compensated at a rate which takes into account the systematic risk which is inherent in A. To this a counter argument would be that the entire exercise is for determining forward price.Since, the person taking the position in the forward contract does not want to be exposed to this systematic risk, his/her opportunity cost can best be assumed to be the risk free rate of return. Now, this makes sense to me. However, this leads me the main problem I’m facing. The person taking position in the forward contract is clearly exposing himself to counterparty risk which every forward carries. So, shouldn’t his opportunity cost include a premium for this risk he is undertaking and therefore, forward price include this risk premium?

        *Sorry for the long post*

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