Let's go a bit further with our understanding of forward pricing with a formula that captures the essence of our intuitive deductions. So far, the formula displayed is the cornerstone of forward pricing, that the fair forward price is the sum of the spot price and the net cost of carry. This net cost of carry is the cumulative effect of the cost of carry, minus the benefits of carry that we've previously discussed. It's vital to recognize that the fair forward price is not a speculative prediction of where prices might be in the future. Rather, it is rooted in the tangible costs and benefits associated with owning or carrying an asset over time. Hence the term cost of carry. You might wonder, do forward prices consistently align with the theoretical fair value, and if they do, what mechanism ensures that they don't stray from this fair value over time? The answer lies in a foundational concept of financial markets, the no arbitrage principle, also known as the law of one price.

This principle states that in an ideal market, free of friction, meaning no transaction costs, taxes, or trading restrictions, identical financial instruments or assets should carry a uniform price if prices diverge, arbitrage opportunities arise, allowing traders to buy low and sell high in different markets to secure a risk-free profit. Now, how does this relate to forwards? Imagine a scenario where we've determined that the fair forward price should be 105, but the market quotes us at 102.

The right move here would be to buy the forward at this undervalued rate. Yet this alone isn't arbitrage. As we're now exposed to the assets future price fluctuations to construct a risk-free arbitrage, we will need to take the opposite position in the spot market and short sell the underlying asset in the spot market for 100. We could then invest the proceeds at a 5% interest rate. After 12 months, our investment would mature and would receive 105, which we can use to fulfill the obligations of the forward contract paying 102 to buy the underlying asset. This leaves us with a guaranteed profit of 3.

We don't need to own any underlying asset to begin with, and the short position in the underlying asset would be settled by delivering the underlying asset that we would've receive from the settlement of our forward contract market. Participants would continue to exploit this until forward prices rise and spot prices fall to a point where the arbitrage opportunity disappears.

This principle is universally applicable across all asset classes, but the specific components of the cost of carry differ. For equities, we consider funding costs and dividends as price influencing factors. For bonds, the funding costs are again relevant, but instead of dividends, we adjust for coupon payments. Currency forwards also entail funding costs, but here the underlying asset, another currency can accrue interest as well. Commodities present a unique case where funding costs remain a factor, but we must also account for physical storage, insurance and transportation costs. And since commodities typically don't yield dividends or interest, there is no offsetting benefit to reduce the cost of carry.