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Flashcards in forwards and swaps basics Deck (47):

A forward contract is

a non-standardised and
privately negotiated contract
between two parties
to trade a specified asset
on a set date in the future
at a specified price.
These days it may be centrally cleared through a Central Clearing Party (CCP).


A swap is a

contract between two parties
under which
they agree to exchange a series of payments
according to a prearranged formula.
As with forwards,
although swaps may be
these days they are often centrally cleared through a CCP.


Swaps, like forwards, are deals arranged

with banks as the main market makers
in an “over-the-counter” market.


The two most common types of swaps are:

1. interest rate swaps–
⁃ whereby two different sets of interest payments are swapped 

2. currency swaps –
⁃ payments in two different currencies are swapped. §


Other derivative products

provide returns
linked to
a wide variety of underlying assets.


Guaranteed equity products (GEPs) offer

a return linked to
an equity index,
but with
a minimum guaranteed return,
often of zero.


a particular GEP might offer

a return equal to
the increase in the value of the FTSE 100 index
over a 5-year period,
together with a guarantee to
return your initial investment
should the index fall
over the 5-year period.


Structured notes are

non-standard securities
that are structured so as to
meet the particular
risk and return requirements
of investors.
often contain
embedded options and/or
provide payments that
vary in some pre-specified way.


Examples of structured notes include:

  bonds that include an option
⁃ for the lender to
⁃ extend or reduce the term of the bond
⁃ in accordance with pre-specified terms 

  bonds whose coupon payments
⁃ vary in line with a property index or an exchange rate index.
⁃ The former enables the purchaser to
⁃ gain some indirect exposure to property,
⁃ whilst the latter might be used for
⁃ hedging currency risk,
⁃ without any direct derivative exposure –
⁃ which may not be permitted for the investor in question. 

  bonds whose coupon payments are
⁃ denominated in a different currency to
⁃ the capital payments.


A forward contract is

an agreement between two parties
to trade an asset at
a certain future time
for a certain price.
normally traded in the over-the-counter market (OTC).


Although a forward contract is OTC,

once the parties have agreed the contract it is
often migrated to a Central Clearing Party (CCP),
means that margin payments are
collected from both parties
in a similar way to that
used for a (standardised) futures contract.


Party positions

The party that agrees to buy the underlying asset is said to
assume a long position and
the party that agrees to sell the asset
assumes a short position.


Forward exchange rates

can be used by investors to
hedge foreign currency risk.
Most large banks have a
“forward desk” within their foreign exchange trading room
that is devoted to the trading of forward contracts.


List the fundamental differences between forward contracts and futures contracts.

Futures contract
highly marketable
minimal counterparty credit risk
delivery price determined openly by buyers and sellers in the marketplace
index futures readily available
can be closed out prior to maturity and most are!

Un-margined) forward contract
normally over-the-counter or OTC
counterparty credit risk
delivery price negotiated privately between buyer and writer
contracts normally based on specified underlying security
difficult to close out and so usually settled at maturity


Example of Forward currency agreement:

UK company knows
that it will have to pay $1m
to one of its US suppliers in two months’ time.
It faces the exchange rate risk
that the pound might weaken against the dollar.
could hedge by entering a long forward contract to buy $1m in two months’ time.

This would effectively guarantee the exchange rate and
remove the exchange rate risk.

if the US Dollar weakens then no gain will be made either!


Rates for forward currency deals are based on :

spot rates
but with an adjustment for
the difference in interest rates between the two currencies.


Example of rate for forward currency deal

  The current £/$ spot rate is £1 = $1.50. 

  One year £ spot interest rate is 7% pa and one year $ spot interest rate is 4% pa. 

A bank should quote a one-year forward based on a £/$ rate of: 
1.501.04  1.4579 11.07 

This fall reflects the expected decline in the value of Sterling against the Dollar indicated by the lower Dollar spot interest rate.
(The expected depreciation of Sterling offsets the higher interest rate paid in Sterling,
so that the expected return is the same in both currencies. ) 


Using forwards to hedge

If you are expecting proceeds from a foreign currency investment you may want to
sell the foreign currency forward.
By doing this
you remove the possibility that
a depreciation of the foreign currency
will reduce the domestic currency value of the expected proceeds.
You can lock in to a rate agreed today.


Costs of Forward Lock-in

1   remove the possibility that an appreciation of the foreign currency
⁃ will increase the domestic currency value of the expected proceeds 

2  the bid/offer spread on forward deals is
⁃ normally a little more than the spread on spot market transactions, so there is a small additional cost for using forwards. 


The forward price, K, is set in such a way that

the value of the contract at time 0 is equal to zero.

So, at the outset of the contract, the
expected present value of the profit to both the buyer and the seller of the forward contract
can be considered to be approximately zero.

In addition, neither the buyer nor the seller of the forward contract
hands over any payment or premium to the other party.


The forward price is also known as

the delivery price.


if the market price of the security increases, then

the buyer of the forward will benefit.


both parties are

obliged to trade


List the main factors that will influence the agreed delivery price of a froward:

The agreed delivery price will reflect:
1   the current share price 

2   the current risk-free rate over the period to maturity 

3   the dividends that the share is expected to pay between now and maturity 

4   the term to maturity.


payoff diagrams are typically drawn ignoring:

1.  any taxes and transactions costs payable 

2–  any income payable by the underlying asset and
3 any margin payments 

4 –  the effect of discounting on the value of the cashflows exchanged.


Futures contracts are

agreements between two parties
to trade an asset
at a certain future time for a certain price.
differ in that they are
normally traded on an exchange.


The exchange specifies

certain standard features of the contract and
provides a mechanism whereby both parties have
a guarantee
that the contract will be honoured.


Another difference from forward contracts is

that often the actual date of delivery is
not specified.
contract is generally referred to
by the month of delivery and
the exchange specifies
the period during the month
in which delivery must be made
which, for commodities in particular, can often be the entire month.


Where delivery is not a specific date and time,

the holder of the short position has
the right to choose the actual delivery date.
the holder of the short position is the party obliged to sell (deliver) the underlying asset.


can draw payoff diagrams for futures

that are similar to those for forwards.


the theoretical forward price F0 is given by:

F =Se^(r-q)T

  S0 isthecurrentshareprice 

  r is the risk-free force of interest 

  q is the constant and continuous force of dividends 

  T is the term to maturity


What are the typical standard features specified by the exchange in a financial futures contract?

1  underlying financial security or index 

2  specific delivery date and time or period during which delivery must take place 

3  trading hours 

4  unit of trading (eg £10 per index point) 

5  form of quotation (eg pence per share) 

6  minimum price movement (tick size) 

7  method of calculating the EDSP (exchange delivery settlement price) ie
⁃ the monetary value that can be paid at delivery
⁃ rather than providing physical delivery of the underlying asset.


Options are traded on

exchanges and
the over-the-counter market.


Traded options, like futures, are

contracts specified by an exchange that are
standardised and


As traded option contracts are fully standardised

all that buyers and sellers need to negotiate
is the premium for the contract.
Note that this standardisation extends to the exercise price.
(This is different to futures where there is no premium,
and it is the strike price that is negotiated. )


An over-the-counter (OTC) derivative is one that is

not traded on a recognised exchange.
the expression over-the-counter can be used to
describe any security dealings
outside of a recognised exchange.


Most OTC derivatives are sold by

investment banks and
may be European or American in nature.


Traded options are available on

individual equities and
also financial futures contracts,
as well as commodities,
foreign currencies,
short-term interest rates and
stock market indices.


What are the differences between a traded call option and an OTC put option?

Traded call option
  right to buy 

  traded on an exchange 

  standardised 

  can easily close out 

  limited credit risk 

  price quoted in market 

OTC put option
 right to sell

 purchased from an investment bank
 can be “tailor-made”

 would need to negotiate terms to end contract
 possibly material counterparty credit risk

 valuation more subjective
apply equally to a discussion of
the difference between futures and (un-margined) forwards.


option premium is quoted and calculated in:

the marketplace and
can be estimated
using pricing formulae
such as Black Scholes.


most options traded on exchanges are

American options,
⁃ regardless of the location of the exchange 

  large number of other more complex options available beyond the standard or “vanilla” options

⁃ a series of pre-specified strike dates or
⁃ in which the payoff depends on the average share price over the period to expiry (
-and not just the share price at the expiry date). 


the payoff for an investor who purchases a call option and exercises the option can be expressed as:

ST - K - O

where: K is the exercise (strike) price
ST is the price of the underlying stock at expiry (maturity)
O is the price of the call option – the option premium

assumes that the option is actually exercised.


payoff for an investor who sells (or writes) a call option can be expressed as:

O- S +K
This is because the writer receives cashflows of O and K and
effectively pays out ST
(by handing over the share worth ST ).

assumes that the option is actually exercised.


The payoff for an investor who purchases a put option can be expressed as:



The payoff for an investor who writes a put option can be expressed as:



A straddle is a

speculative options strategy where
both put and call options are purchased simultaneously
with the same strike price and date.


option payoff diagrams ignore:

1  taxes 

2  transactions costs 

3  any income payable by the underlying asset in the period between now and the strike date 

4  any margin payments 

5  discounting – ie the fact that the premium is paid/received at the outset, whereas the remainder of the profit or loss arises at the strike date, typically several months later.