forwards and swaps basics

Question 1

A forward contract is

Answer 1

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).

Question 2

A swap is a

Answer 2

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 
non-standardised, 
these days they are often centrally cleared through a CCP.

Question 3

Swaps, like forwards, are deals arranged

Answer 3

with banks as the main market makers

in an “over-the-counter” market.

Question 4

The two most common types of swaps are:

Answer 4

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

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

Question 5

Other derivative products

Answer 5

provide returns
linked to
a wide variety of underlying assets.

Question 6

Guaranteed equity products (GEPs) offer

Answer 6

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

Question 7

a particular GEP might offer

Answer 7

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.

Question 8

Structured notes are

Answer 8

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.

Question 9

Examples of structured notes include:

Answer 9

 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.

Question 10

A forward contract is

Answer 10

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).

Question 11

Although a forward contract is OTC,

Answer 11

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.

Question 12

Party positions

Answer 12

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.

Question 13

Forward exchange rates

Answer 13

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.

Question 14

List the fundamental differences between forward contracts and futures contracts.

Answer 14

Futures contract
exchange-traded 
standardised 
highly marketable 
liquid
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
tailored
non-marketable
illiquid
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

Question 15

Example of Forward currency agreement:

Answer 15

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!

Question 16

Rates for forward currency deals are based on :

Answer 16

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

Question 17

Example of rate for forward currency deal

Answer 17

 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. ) 


Question 18

Using forwards to hedge

Answer 18

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.

Question 19

Costs of Forward Lock-in

Answer 19

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. 


Question 20

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

Answer 20

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.

Question 21

The forward price is also known as

Answer 21

the delivery price.

Question 22

if the market price of the security increases, then

Answer 22

the buyer of the forward will benefit.

Question 23

both parties are

Answer 23

obliged to trade

Question 24

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

Answer 24

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.

Question 25

payoff diagrams are typically drawn ignoring:

Answer 25

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.

Question 26

Futures contracts are

Answer 26

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.

Question 27

The exchange specifies

Answer 27

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

Question 28

Another difference from forward contracts is

Answer 28

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.

Question 29

Where delivery is not a specific date and time,

Answer 29

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.

Question 30

can draw payoff diagrams for futures

Answer 30

that are similar to those for forwards.

Question 31

the theoretical forward price F0 is given by:

Answer 31

F =Se^(r-q)T

where:
 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

Question 32

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

Answer 32

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.

Question 33

Options are traded on

Answer 33

exchanges and

the over-the-counter market.

Question 34

Traded options, like futures, are

Answer 34

contracts specified by an exchange that are
standardised and
marketable.

Question 35

As traded option contracts are fully standardised

Answer 35

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. )

Question 36

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

Answer 36

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

Question 37

Most OTC derivatives are sold by

Answer 37

investment banks and

may be European or American in nature.

Question 38

Traded options are available on

Answer 38

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

Question 39

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

Answer 39

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.

Question 40

option premium is quoted and calculated in:

Answer 40

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

Question 41

most options traded on exchanges are

Answer 41

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). 


Question 42

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

Answer 42

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.

Question 43

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

Answer 43

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.

Question 44

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

Answer 44

K-S-O

Question 45

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

Answer 45

O-K+S

Question 46

A straddle is a

Answer 46

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

Question 47

option payoff diagrams ignore:

Answer 47

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.