Forwards and futures Flashcards
List key characteristics of a forward deal
A buyer (long) agrees to buy certain asset from a seller (short) at certain date (expiration) at predetermined price. No money changes hands at the start, although the parties might require some collateral in order to decrease the default risk
What is the cash settlement?
Payment of difference in price of the underlying asset instead of the delivery. Used when delivery is impractical (e.g. when the underlying asset is an index)
Bid and ask
Bid - price at which the dealer is willing to buy, ask - to sell
Forwards and dividends
Forwards do not usually pay any dividends paid by the underlying stocks. However, dividends might be taken into account in calculation of rate of return on indexes (e.g. S&P 500 total return)
Specifics of forwards on bonds
1) Forward must mature before the underlying bond
2) Forward must take into account credit risk of the bond as well as covenants and other specifics
Explain mechanics of FRA
1) Long in a FRA is a borrower, so she will benefit from an increase in interest rate
2) Payoff on FRA occurs at its termination and equals the PV of interest saving / loss
3) Forward are calculated from spot rates by the chain rule: (1 + rate(A+frw)) = (1 + rate(A))*(1 + rate(frw))
Explain FRA notation (A x B) and the formula for FRA payoff
FRA expires in A months and deposit starts.
In B months deposit terminates, so underlying rate is (B-A) LIBOR
Payoff equals interest saving discounted at the actual rate: interest saving = (Actual - FRA)*(B-A)/360
Forward pricing
V_f(t) = S(t) - F_price / (1 + r)^(T - t)
Under the assumption that no money changes hands at the start we got F_price = S(0)*(1 + r)^T
Effect of dividends and coupons
Dividends are decreasing value of a forward as they benefit holder of the underlying equity
V_f(t) = S(t) - PV_did(t) - F_price / (1 + r)^(T - t)
When forwards and futures trade started?
In mid XIX century in Japan and USA related to agricultural trade. In 1848 Chicago Board of Trade was established - first futures exchange
List key differences between forwards and futures
1) Futures are standardized and exchange determines all the characteristics but price, therefore forwards allow for more flexibility
2) There is a secondary market for futures, so one can sell futures in order to terminate exposure. In case of forwards the only way to end the exposure is to originate a counter-forward
3) Futures are marking to market, so P&L occur every day, not only at expiration as with forwards
4) Futures are usually collateralized (initial margin) in order to reduce the credit risk, forwards are usually not
What price of a forward refers to and how it is expressed?
It refers to the forward price of the underlying assets!
1) T-bill - annualized discount from the face value
2) Coupon bonds - YtM
3) FRA - annualized LIBOR rate
4) Currency - FX rate
Pricing of currency forwards
1) Annualized at a 365-days year!
2) V(t) = Spot/(1 + foreign_rate)^(T-t) - Frwd/(1 + domestic)^(T-t)
What determines price difference between futures and forwards?
Correlation between price of the underlying asset and interest rates:
Asset up -> positive mark-to-market -> reinvestment profits up
Asset down -> negative mark-to-market -> need for borrowing, but it is cheaper
Explain backwardation and contango
Backwardation - futures price is below the spot; it occurs when there are benefits of holding the asset (e.g. dividends, coupons, etc) or when there is a premium for taking asset price risk (called “normal backwardation”)
Contango - future price is above the spot; it occurs when there are costs of holding the asset (e.g. storage costs for commodities)
