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Vocabulary3 min read

The forward is NOT the market's prediction

It's the cost of replication — borrow cash, buy the asset, carry it to maturity. No views involved.

The most common mistake about forwards: assuming they reflect what the market thinks the spot will be in the future. They don't. The forward is forced by no-arbitrage — it's an accounting identity, not a forecast.

The replication argument

Suppose you want to own a stock in 1 year. Two ways to lock that in today:

  1. Buy now, hold for a year. You pay €100 today (spot), borrow that €100 at the risk-free rate, hold the stock, and collect any dividends along the way. In 1 year you own the stock and you owe the loan back with interest.
  2. Lock in the price today via a forward contract. You agree today on a price F to be paid in 1 year for delivery of the stock. No money changes hands now.

Both paths give you the same outcome (own the stock in 1Y). So they must cost the same — otherwise you'd arbitrage:

F = spot + financing cost − dividends collected

For a stock with no dividends, F = spot × (1 + r × T) — slightly above spot. With dividends, F = spot × e^((r − q) × T). With repo income or storage costs on commodities, you add or subtract those. Each term comes from a real cost or benefit of holding the asset between now and maturity.

Where the arbitrage comes from

Suppose the market quotes F = €110 on a stock with spot €100, no dividends, r = 5%. Fair forward = €105. The €110 forward is too high. Trade:

  1. Sell the forward at €110.
  2. Borrow €100 at 5% for 1 year.
  3. Buy the stock today at €100.
  4. In 1 year: deliver the stock (collect €110 from the forward), repay the loan (€105). Risk-free profit: €5.

Arbitrageurs would do this until the forward drops back to €105. The forward price isn't a forecast — it's the price at which this particular arbitrage closes.

Why this matters for derivatives

Every option pricing model uses the forward, not the spot or any "expected future price". The Black-Scholes formula uses the forward implicitly through the (r − q) drift. The reason it works at all is because the cost of replication (= forward) is the only quantity everyone in the market has to agree on, regardless of personal views.

Two investors with completely opposite forecasts on the underlying still agree on the option price, because they both agree on the cost of replication. That's the magic of risk-neutral pricing — it sidesteps the impossibility of consensus on forecasts.

Try itOpen the Vanilla pricer. Set spot=100, r=5%, q=0%, T=1Y. Notice the forward the model implies (~€105). Then change r to 10% — the forward jumps to ~€110. The forward moves onlybecause the cost of borrowing changed, not because anyone's view changed.Go deeper · ProSee "Stock XYZ's 6-month forward trades at a 5% discount to spot — why?" and "Why does μ disappear from option pricing?" in the Coach Q&A.