I_SS17_R61_Forward_Markets_and_Contracts Flashcards
Forward contract is an agreement
between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset or other derivative, at a future date at a price established at the start of the contract.
A forward contract hedge
locks in a price
At start of forward contract
no money changes hands
Two ways of handling a forward on expiry
delivery or cash settlement
Cash-settled forward contracts are sometimes called
NDFs: nondeliverable forwards. Mainly in regards to foreign exchange forwards
Forward contracts are subject to
default regardless of whether it is for delivery or cash settlement
Forward contracts are generally structured so that in the event of a default
only the party owing the greater amount can default
Forward contract nearly always constructed so that participants
will hold on to their positions until the contract expires
Dealers in forwards engage in transactions with
end users and other dealers
Interest rate forwards are called
forward rate agreements (FRAs)
Equity forward is a contract calling for the purchase of
an individual stock, a stock portfolio or a stock index at a later date
Equity forward contracts typically do not pay
dividends paid by the component stocks. Exceptions are equity forwards based on total return indices
Bond forward contracts can be based on
an individual bond, specific bond portfolio or a bond index
A forward contract on a bond must expire
prior to the bond’s maturity date
A forward contract on a bond, unlike an equity, carries the
risk of default
T-bills are typically sold at a
discount from par value and the price is quoted in terms of the discount rate. 180-day T-bill selling at a 4% discount has a price per $1 par of $1 - (0.04)(180/360) = $0.98. 360 is the convention for the discount
A T-bill is traded by quoting the
discount rate, not the price.
Price of 90-day T-bill selling in 60 days trading at a 4.2% discount
$1 - 0.042(90/360) = $0.9895
U.S. Treasury bonds are typically quoted
without the interest that has accrued since the last coupon date
Eurodollar is
dollar deposited outside the United States
LIBOR
London Interbank Offer Rate. Commonly used in derivative contracts
LIBOR is the rate at which
London banks lend dollars to other London banks
LIBOR is considered the best representative rate on a dollar borrowed by a
private, nongovernmental, high-quality borrower
If LIBOR loan is for $10 million for 30 days at 5.25% in 30 days will owe
$10,000,000 (1 + 0.0525(30/360)) = $10,043,750
Day convention in Eurodollar market is to prorate the quoted interest rate over
360 days as in the case of the Treasury bill market
Eurosterling
trades in Tokyo
Euroyen
trades in London
Euribor trades in
Frankfurt and is more widely used than EuroLIBOR which is compiled in London
FRAs are contracts in which the underlying is neither a
bond nor a Eurodollar or Euribor deposit but simply an interest payment made in dollars
A user who is long a FRA when rates rise
will benefit. The dealer is short the rate and will benefit if rates decrease
3x9 FRA means
Contract expires in 3 months at which point the underlying rate is for 9-3=6 month (180-day) LIBOR
1x3 FRA means
Contract expires in 1 month at which point the underlying rate is based on 3-1=2 month (60-day) LIBOR
12x18 FRA means
Contract expires in 12 months at which point the underlying rate is based on 18-12=6 month (180-day) LIBOR
Most commonly traded Eurodollar rates
30-day, 60-day, 90-day and 180-day LIBOR
Non-standard FRAs are called
off the run
Which market is bigger: FRA or swaps?
FRA market is large but not as large as the swaps market
A swap is a special combination of
Forward rate agreements (FRAs)
Common FRA notations
Present value of a 180-day LIBOR Eurodollar time deposit for 6% on $10,000,000 paid in 180-days
Amount received from dealer on 90-day FRA for 5.5% based on 180-day LIBOR which ends up being 6% at the expiration in 90 days
General FRA payoff formula
