Forward Pricing

Written By:
Adiste Mae

Forward pricing is a policy developed by the Securities and Exchange Commission (SEC) as a way to manage shareholder dilution and more efficient mutual fund operations.

Net Asset Value, which gives you the forward price, is calculated by computing the total market value of investments held by the fund minus fund liabilities and expenses.

Forward pricing only applies to open-ended mutual funds which are not traded with real-time pricing.

Intermediates, which include financial advisors, brokers, or brokerage platforms, sell open-end mutual funds to investors.

Rule 22(c)(1) of the Investment Advisors Act of 1940 requires that mutual funds be transacted at their forward price.

These mutual funds are priced once per day once the market is closed and this closing price is called the Net Asset Value (NAV).

What is the forward pricing rule?

The forward pricing rule is taken directly from the Securities and Exchange Commission Investment Advisors Act of 1940 as follows:

“Rule 22c-1 under the Investment Company Act, the “forward pricing” rule, requires funds, their principal underwriters, and dealers to sell and redeem fund shares at a price based on the current net asset value (“NAV”) next computed after receipt of an order to buy or redeem.² The rule also requires that funds calculate their NAV at least once a day.³ Today, most funds calculate NAV when the major U.S. stock exchanges close at 4:00 p.m. Eastern Time.^4“

The forward pricing rule requires investment companies to price their mutual fund shares at the net asset value (NAV) of the next market close.

For example, let’s say you buy $300 worth of a mutual fund first thing in the morning.

The net asset value (NAV) was $30 per share the previous night which means that your transaction from the present morning will not happen at the NAV price of $30.

Mutual fund NAV is recalculated each day after the market has closed for the day and this is called the forward price.

Let’s say that at the end of the present day, the NAV is recalculated and the forward price becomes $20 instead of $30.

This means that your $300 worth of mutual funds will give you 15 shares (15 shares x $20/share = $300).

What is the forward price formula & How is forward price calculated?

To calculate the forward price, the following formula is used (the formula assumes zero dividends):

F = S₀ x e^rT

To understand the elements of the formula, let’s define each component as follows:

• F = the forward price
  
• S₀ = The underlying asset’s current spot price
• e = Mathematical irrational constant approximated by 2.7183
• r = The risk-free rate that applies to the life of the forward contract
• T = Delivery date in years

Forward Pricing Example

To help you makes some sense of this, let’s look at an example.

Jeff is looking at an investment asset that he wants to enter into a forward contract with.

The asset is currently trading at a current spot price of $1,000 and the risk free rate in Jeff’s location is 4%.

Let’s plug this information into the formula to find the forward price for this asset:

F = S₀ x e^rT

F = $1,000 x e^{(0.04 x 1)}

F = $1,040.81

What is the difference between forward price and delivery price?

When we are talking about forward pricing, delivery price and forward price are one in the same when the contract begins.

However, the forward price eventually fluctuates, but the delivery price always remains the same.

Delivery price is defined as the price that is agreed upon to deliver a commodity.

It is the price at which a party agrees to supply the underlying goods and at which the counterparty agrees to approve the delivery.