How can a contract be worth something when it costs nothing to enter?
Buy a share for $100 and $100 leaves your account. Enter a forward on 1,000 bushels of wheat at $6.00 and nothing leaves your account at all. You have not bought anything. You have signed an agreement.
This is the conceptual hinge of the whole domain, and it is worth slowing down for.
Why a forward is worth zero on day one
A forward is struck at the fair forward price — the price at which neither side would pay the other to swap places. If October wheat is fairly priced at $6.00, then agreeing to buy at $6.00 gives you no advantage and no disadvantage. The contract's value to each side is zero. That is exactly why no money changes hands.
And why it stops being zero immediately
A month later, the forward price for the same October delivery is $6.40. Your contract says you may buy at $6.00. Someone entering fresh today must pay $6.40. You hold something better than what the market currently offers, by $0.40 per bushel.
Put a number on it. You can enter an offsetting forward selling 1,000 bushels for October at $6.40. Whatever wheat does after that, you buy at $6.00 and sell at $6.40:
($6.40 − $6.00) × 1,000 = $400, locked in.
So your original contract is now worth about $400 to you — and exactly −$400 to the person on the other side, who is obliged to sell you at $6.00 what they could otherwise sell for $6.40. (Strictly, discount the $400 back from October — over the remaining term, not the month already elapsed; at ordinary rates that trims it by a few dollars, so we round it away.)
Value from zero cost. A contract that cost nothing now carries a real, computable, transferable value that swings with the underlying.
Options are the exception that proves the rule
An option does cost money on day one — the premium. The reason follows straight from the argument above: an option's payoff is asymmetric. One side may walk away and the other may not. That is plainly not a fair swap at zero, so the side receiving the privilege pays for it. Symmetric contracts start at zero; asymmetric ones start at a price. You now know why, before meeting a single option formula.
The consequence that runs through the rest of the course
Because a zero-cost contract accumulates value, the amount one party owes the other can build up over time, in either direction. On the wheat forward, that debt reached $400 in a month with no cash exchanged and no way to be sure it will be paid in October. Two problems fall out of that single fact, and they are the subject of Unit 3:
- Counterparty risk. The $400 only exists if the other side is still solvent in October.
- Leverage. You control the price behaviour of 1,000 bushels — $6,000 of wheat — having committed nothing. Small capital, full exposure. That is not a trick; it is arithmetic, and it cuts symmetrically. The same structure that produced $400 would have produced −$400 on a $0.40 fall, and there is no floor at zero: a large enough adverse move creates an obligation larger than anything you put in.
Exchanges solved both problems with the same tool — a daily cash settlement called margin — and that is the next unit.
Try it now
- A year of one liquid share is below. Measure any one-month stretch of it and write down the price at each end.
- Treat the first of those two prices as a forward struck at that level for 1,000 shares. The contract's value on the second date is (new price − struck price) × 1,000, from the long side's perspective. Compute it.
- Now compute the same number for a 10% fall instead. Compare the size of that obligation with the zero dollars required to enter. Write the ratio down — you have just measured leverage before it was formally defined.