Forward contracts Flashcards
Define: Forward market
contract between a buyer and a seller
that obliges the seller to deliver and the buyer to accept delivery of an agreed quantity and quality of an asset at a specified price (determined now)
on a stipulated date in the future.
Define: Spot market (cash market)
A contract between a buyer and seller @ time T+0
for delivery of a security by the seller to the buyer
and payment by the buyer to the seller to complete settlement of the contract at the earliest time T+0 or T+ (few days)
What is the difference between the spot market and forward market?
Biggest difference is the time of settlement
Why use a forward instead of a spot deal?
The spot price might change dramatically on a daily basis.
The chance that the spot price will prevail is uncertain.
A forward deal removes spot price uncertainty.
List: Advantages of the Forward Market
- Flexible delivery dates
- Flexible size of contracts
- Payment can be
determined in advance
List: Disadvantages of the Forward Market
- Integrity – risk of non-performance
- Locked-in – no exposure reverse
- Physical delivery is mandatory (No cash settlement alternative)
- Quality may vary
- Higher transaction cost
- Exposure to default risk
List: Markets under the forward market
- Debt market
- Equity market
- Foreign exchange market
- Commodities market
Define: Debt market
The sale of a debt instrument on a pre-specified future date at a pre-specified rate of interest with further details on:
* the debt instrument/s and amount of
instruments deliverable
* due date of the debt instruments and
forwards date (contract due date)
* rate of interest on the debt instrument to be
delivered.
List: The markets under the debt market
- Interest rate contract
- Repurchase agreement
- Forward Rate Agreement (FRA)
Define: Repurchase agreement
Contractual transaction where an existing security is
sold at market value (usually lower) at an agreed rate of interest coupled with an agreement to repurchase the security on a specified or non-specified date.
Why can the repurchase agreement be regarded as a derivative (money market instrument)?
- Derived from money or bond market instruments
- The value is derived from another part of the money market (interest rate
on it, the price of money)
Define: Forward Rate Agreement (FRA)
An FRA enables the user to hedge against
unfavourable interest rate movements by fixing a rate on a notional amount, usually same size and term of exposure that starts sometime in the future.
Define: Equity market (cash market)
A contract between a buyer and seller @ time T+0
for delivery of a security by the seller to the buyer
and payment by the buyer to the seller to complete settlement of the contract at the earliest time T+0 or T+ (few days)
List and define: The market under Equity market
Outright market - The sale of equity at some date in the future at a price agreed at the time of structuring the deal
Define: Foreign exchange market
Transaction that takes place on a date in the future
other than the spot settlement date (T+2), but
* The price and amount agreed upon on the deal
date (T+0).
