Let's have a think about where the forward price comes from. Imagine stepping into the shoes of a market maker tasked with setting a 12 month forward price for an asset. The challenge before us is to determine what constitutes a fair price for this commitment to buy or sell in the future. This fair price is the sweet spot, the mid-market rate that balances the needs and expectations of both buyer and seller. Here's the data we have to work with. The asset's current spot price sits at 100. A collective of analysts have set their sights on a 12 month target price of 107. Your personal forecast leads you to believe that the assets value will be 109 in a year's time. However, your client is more optimistic and expects the price to be 115. Meanwhile, the 12 month interest rates are 5%, and to simplify matters, let's assume that the asset distributes no dividends or other yields.

Now, let's unravel this. A forward contract is in essence, a spot transaction With delayed settlement to arrive at a fair forward price, we must account for the economic impact of postponing the settlement.

Consider the seller's position first. Agreeing to the forward contract rather than trading in the spot market, means foregoing immediate payment for a year, which with interest rates at 5%, translates to a 5% opportunity cost. They won't receive the cash for one year, so won't be able to earn interest of 5% on it for that year either. This suggests the forward price ought to include a 5% uplift from the spot price. Dividends are outta the equation here, as our asset is non wielding.

From the buyer's vantage point, the delayed payment yields a financial advantage, a saving equivalent to the interest that could be earned on the purchase price over the next 12 months, since they won't have paid out any cash yet. As a result, the buyer too should be amenable to a forward price. That's 5% above the spot price. Taking both perspectives into account, both could be agreeable to afford price of 105.

Another way to look at this is if we step into the market maker's, shoes are agreeing to deliver the underlying asset in the future, so to hedge the cost of that asset, the market maker could consider buying the asset today at the current spot price. This would lock in the cost, but requires capital cash that might need to be borrowed at the prevailing interest rate of 5% for a year. After a year, this loan would be offset by the proceeds of the forward contract. For the trader to agree to this trade, they'd want to be compensated for all of the costs of setting up the trade, that being the 100 purchase price and the 5% interest on the loan to purchase the underlying asset, Indicating a fair forward price of $105, which could be used to repay the money borrowed in the initial loan and the cost of capital.

Now, let's think about dividends. If our asset were to yield a total of $6 in dividend over the 12 month period, the dynamic shift, the seller would face the same 5% opportunity cost, effectively losing out of $5 of interest. However, they'd offset this with $6 of dividend income. This interplay would result in a net benefit of $1 to the seller, which means the buyer should pay less, more precisely $99 for the forward contract, or in other words, setting the forward price at 99.