Hello everyone, When pricing forward contracts - how do you decide on how to construct the two portfolios? Is there a rule of thumb? Many thanks!
There isn't a unique pair of portfolios that can be used, but here's how I would tackle the problem: Portfolio 1 should contain the derivative in question, and the asset class required to exercise it. (For the forward on a simple asset (ie one without income or charges) that would be enough cash at expiry to purchase one unit of the underlying.) Portfolio 1 then needs to be evaluated at the expiry date. (For this forward that would be one unit of the underlying asset.) Portfolio 2 then needs to be constructed to match the value of Portfolio 1 at expiry. This is where we might need to be a little creative. (For this forward we could simply hold one unit of the asset). Hope that helps.
