Equity forwards are contracts where a price is agreed today for a future transaction in the underlying stock or index. One of the most important considerations when trading equity forwards is the forward price. When calculating the fair value of equity forwards or futures, we start with the following formula. The fair forward value is essentially the spot price plus the financing cost required to hold the position, minus the dividends expected to be paid over the forward period. This can be rearranged into a more compact form as shown here. Spot price multiplied by one plus I ties by days divided by basis close parentheses minus dividends. Where I is the interest rate, days is the number of days until the end of the forward period, and basis is the assumed number of days in a year. Please note that this version of the formula only applies to forward periods up to one year as it uses simple interest.

There is an alternative version of this formula, which incorporates the dividend yield instead of the absolute dividend amount where you would've spot price times by one plus I minus the dividend yield close parenthesis, where the dividend yield is the expected annual dividend expressed as a percentage of the stock's current price.

While this approach is not incorrect, using expected dividend payments rather than the yield can be clearer as dividend payments are more stable, while the dividend yields will fluctuate as the spot price of the share changes adding unnecessary complexity.

However, this then gives us a different challenge forecasting what the dividend payments will be over the forward period. Only dividends with ex-div dates between the transaction and the four dates are relevant here. The ex-div date is the cutoff after which those buying shares in the secondary market will not be entitled to receive the upcoming dividend. This means only dividends paid before this date affects the forward price. To be more precise, the future value of these dividends, the dividend amount compounded to the forward date, only those should be used used in this forward price formula.

This ensures that the timing of each dividend's impact on the forward value is accurately reflected.

However, dividends are declared at the discretion of a company's board and may only be confirmed shortly before they are actually paid. Even companies with historically consistent dividends may increase, decrease, or suspend their dividends in the future. This unpredictability complicates forecasts, especially for longer term contracts.

Returning to the equity forward price formula, here are some useful rules of thumb for understanding spot and forward price relationships. If the interest rate is higher than the dividend yield, the forward trades at a premium to spot. If interest rates are lower than the dividend yield, the forward trades at a discount to spot, and when interest rates and dividend yields match the spot and forward prices are identical. These principles illustrates that the forward price does not predict future price movements, but is instead based on the balance between financing costs and asset yields.

However, it's important to know that the formula is based on a no arbitrage assumption, the ideal of a frictionless market. In reality, transaction costs differences between borrowing and lending rates, and other frictions mean that actual prices may stray from the theoretical fair value.

Additionally, different participants face different funding costs, so their views of the fair price can vary slightly.

Nonetheless, many market participants calculate the fair value to assess whether the forward is under or overvalued. Significant discrepancies might prompt them to act. For instance, if a forward appears undervalued compared to its fair value, arbitrages might buy the forward and sell the spot assets expecting to profit as the prices converge. Conversely, an overpriced forward could prompt selling the forward and buying the spot assets.

So while the generic formula seems simple, pricing in real markets is often more nuanced.