Let's have a look at some of the inherent risks of using derivatives. Starting with market risk, it's crucial to understand that moving from a direct cash purchase of a security to using a derivative position such as a forward contract changes not only the settlement date and potentially the price, but also the profile of risk exposure.

Let's have a look at what this means in relation to equity forward contracts. We're going to have a look at how the fair forward price of a 12 month forward contract may fluctuate with changes in the underlying price determinants. This movement represents market risk to a trader since it captures the cost of offsetting the initial contract. We're going to start by assuming we have an initial position for an equity forward contract, which has an underlying asset with a spot price of 100, where 12 month interest rates are 5% and there is an anticipated 12 month dividend payout of 6. To calculate the fair forward price of this forward contract, it's necessary to add on the cost of carry being 5% of the 100, giving us 5, and deduct the benefits of carry that being the dividends of 6. This will result in a fair forward price of 99.

Let's now think what would happen if the spot price experienced an increase of 1. The fair forward price would correspondingly increase to 100.05 since the 5% interest rate would now be applied to the new underlying asset spot price of 101, translating to an increased cost of carry, totaling 5.05. Given that the dividend payout remains at 6, the forward price will increase by 1.05, 1 being the increase in the underlying asset and the 0.05 from the increase cost of carry. This illustrates the fundamental principle that all else equal an increase in the spot price will typically result in an elevated forward price. Now let's move on to interest rates. Imagine a scenario where interest rates increase by a full percentage point to 6% while the spot price remains stable. With this rise, the fair forward price also increases because the rate for borrowing or investing is now at 6% when applied to the spot price of 100, we see the borrowing cost increase to 6, which precisely offsets the dividend benefit resulting in a fair forward price of 100. Hopefully, the takeaway here is clear. With an increase in interest rates and assuming all else is held constant, the fair forward price will also increase. Moving on to dividends, let's consider an increase here and let's suppose the expectation for total dividends over the forward period grows to 7. Here the interest component stays at 5, but the forward buyer will miss out on 7 worth of dividends. Consequently, the fair forward price decreases to 98.

There's also one final factor we haven't considered yet, time itself. Since both the interest and dividends are contingent upon the time until the forward's maturity, the passage of time also affects the fair forward price. Let's look at what this means for the forward. If we assume that the spot price hasn't changed, but we're evaluating the forward three months into the future, it has now turned into a nine month forward contract. For simplicity's sake, let's assume that interest rates are still at 5% on an annualized basis, and let's assume that dividends are paid out evenly each quarter. That's $1.50 per quarter. Ignoring a time value of money for simplicity. As such three months down the road, the dividend value to be received over the remaining life of the forward reduces to 4.50. Since one installment has already been paid out in this scenario, the fair forward price will now be 99.25 because the 5% interest rate now needs to be de annualized to just nine months, giving an interest cost of 3.75, that's the 100 times 5% multiplied by nine months divided by 12 months, which needs to be added onto the spot price with the dividends outstanding at 4.5 to be subtracted. What this shows us is that as the forward date nears, the forward and spot price begin to converge over these three months, the forward price has moved from 99 to 99.25 closer to the spot price of 100. This is because the net cost of carry diminish with a shorter timeframe to maturity. However, it's important to note that this convergence is not a given in all scenarios. This is due to a number of factors including the discrete timing of dividends, fluctuating interest rates, and changes to other market conditions.