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Preferences over Probability Distributions

In: Forecasting and Hedging in the Foreign Exchange Markets

Author

Listed:
  • Christian Ullrich

    (BMW AG)

Abstract

A forward contract is an agreement between two parties to buy/sell an asset at a certain future time for a certain price. One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. A forward contract therefore has a symmetric distribution of rights and obligations.payoff from a long position in a forward contract on one unit of an asset is (12.1) $$F_T = \omega _T - f_{0,T}$$ where f 0,T is the price in t = 0 for a forward contract with maturity T, and ωT is the spot price of the asset at maturity of the contract. Long positions enable hedgers to protect themselves against price increases in the currency. Conversely, the payoff from a short position in a forward contract on one unit of an asset is (12.2) $$F_T = f_{0,T} - \omega _T$$ Short positions protect hedgers against price decreases. The fact that the payoffs resulting from long and short positions in forward contracts can be symmetrically positive or negative is illustrated in Fig. 12.1 [200]. The gain, when the value of the underlying asset moves in one direction, is equal to the loss, when the value of the asset moves by the same amount in the opposite direction. Since it costs nothing to enter into a forward contract, the payoff from the contract is also the firm’s total gain or total loss from the contract.

Suggested Citation

  • Christian Ullrich, 2009. "Preferences over Probability Distributions," Lecture Notes in Economics and Mathematical Systems, in: Forecasting and Hedging in the Foreign Exchange Markets, chapter 12, pages 117-131, Springer.
    • Handle: RePEc:spr:lnechp:978-3-642-00495-7_12
    DOI: 10.1007/978-3-642-00495-7_12
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