What happens to the total payoff at an oil price of 80 when a forward contract is sold at 60?
Understand the Problem
The question is asking about the implications of selling a forward contract at a price of 60 when the oil price rises to 80. This involves understanding how forward contracts work and calculating the total payoff based on the difference between the forward price and the market price.
Answer
The total payoff is $20 per unit as the selling price exceeds the forward contract price by $20.
When the forward contract is sold at $60 and the market price is $80, the total payoff is $20 gain per unit of oil in the contract. This is because the contract locks in the $60 price, and at expiration, when selling at $80, the seller gains the difference.
Answer for screen readers
When the forward contract is sold at $60 and the market price is $80, the total payoff is $20 gain per unit of oil in the contract. This is because the contract locks in the $60 price, and at expiration, when selling at $80, the seller gains the difference.
More Information
In a forward contract, you agree to sell or buy an asset at a predetermined price, irrespective of the current market price at the contract's expiration. Here, the market price of oil ($80) is higher than the contracted price ($60), leading to a profit.
Tips
A common mistake is ignoring the contract price and considering only the market price, or ignoring the difference in prices when calculating the payoff.
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