D. Describe the characteristics of equity forward contracts on zero-coupon and coupon bonds Flashcards
D. Describe the characteristics of equity forward contracts on zero-coupon and coupon bonds
- Different types of equity forward contracts
- Stock forward contracts would include going long or short on a stock. The forward market is OTC – over the counter, thus it has credit risk and liquidity risk.
• Zero Coupon Bonds pay no interest and pay principal back on the maturity date. Therefore, there is only one payment and it occurs on the expiration date.
This is just like any other typical forward contract.
• Forward Price(t) = Spot price*Ert
• Coupon Bond forward contract – Forward price is the spot price minus the
payments received during the bond’s life.
- Forward Price(t) = [spot price-PV(payments)]*Ert
- Where PV is the present value of the coupon payments.
- One payment at end of bond’s life, credit risk OTC.
Default free Zero-Coupon bonds, U.S. T-Bills
*Serve as proxy for risk free rate
“T-bills are typically sold at a discount from par value and the price is quoted in terms of the discount rate” the contract specifies a future purchase prior to maturity at some price.
If purchased + held to maturity then will pay FV.
Discount price, (days/360)
FV
discount (% of par price)
par price procedure, interest is deducted from FV in advance, ‘discount interest’: $-%(price) = sale price, ….but pays FV$ at maturity.
T-Bill trades quote the discount rate, not the price.
Characteristics of equity forward contracts (a contract calling for the purchase of an individual stock, a stock portfolio, or a stock index at a later date)
On individual stocks: Lock in a price at some time. Client loses on opportunity cost if price exceeds contract. Wins if price dips below contract.
On portfolios: Enter a fwd contract to lock in the sales prices. FWD on each stock, or FWD on entire portfolio.
On indices: Hedge via fwd’s to reduce systematic risk.
Effect of Dividends: May effect forward contracts, especially on ‘total return’ contracts, but usually dividends aren’t included.
