The market making of forward contracts with premature delivery provision

Abstract

Money center banks offer a specialized foreign exchange contract which allows the customers the option of settling the contract by delivery prior to the pre-specified expiration date, thereby reducing risk exposure to the fluctuations of foreign exchanges. The banks price the contract in a way which implies that the option available to the customers has no value. The purpose of this paper is to model this contract and to produce numerical values for its price under several sets of assumptions. In the absence of empirical data on market prices the numerical results can only be simulated. It is shown that banks tend to mis-price this contract. Analysis of the contract has implications to the pricing of prepayable mortgages, callable bonds and Mark to marking of futures contracts. © 1990.