Intro and Summary Flashcards
Intro
“In the reading on derivative markets and instruments, we gave a general overview of global derivative markets. We identified those markets as forward markets, futures markets, options markets, and swap markets. The following series of readings focuses individually on those markets. We begin with forward markets.
First recall our definition of a forward contract: A 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. Therefore, it is a commitment by two parties to engage in a transaction at a later date with the price set in advance. The buyer is often called the “long and the seller is often called the short.1 Although any two parties can agree on such a contract, in this book we are interested only in forward contracts that involve large corporations, financial institutions, nonprofit organizations, or governments.
Recalling an example from the reading on derivative markets and instruments, a pension fund manager, anticipating the receipt of cash at a future date, might enter into a commitment to purchase a stock portfolio at a later date at a price agreed on today. By doing so, the manager’s position is unaffected by any changes in the value of the stock portfolio between today and the date of the actual investment in the stock portfolio. In this sense, the manager is hedged against an increase in stock prices until the cash is received and invested. The disadvantage of such a transaction is that the manager is also hedged against any decreases in stock prices. If stock prices fall between the time the commitment is established and the time the cash is received, the manager will regret having entered into the forward contract because the stock could have been acquired at a lower price. But that is the nature of a forward contract hedge: It locks in a price.
An important feature of a forward contract is that neither party pays any money at the start. The parties might require some collateral to minimize the risk of default, but for most of this reading, we shall ignore this point. So keep in mind this very important aspect of forward contracts: No money changes hands at the start.”
General Global Derivative Markets
Forwards, Futures, Options, Swaps
Focus on forward markets!
“A forward contract is an agreement to buy a sellers underlying asset or other derivative, at a future date at a PRICE established at the start of the contract (price≠cash. FWD contract, no money changes hands at start!).”
A commitment (contract) to engage in a transaction at a later date with the price set in advance.
Forward Contract: Buy (long) tomorrow at a price set;sold (short) today.
Long tomorrow at todays price (lock in a price)
Delivery and Settlement
Delivery and Settlement, fwd contract expires (two possible obligation settlements)
Delivery: Long $$–> Short, Short underlying asset –> Long
Cash Settlement: Long and short to pay the net cash value of the position on the delivery date. Basically, pays net to settle the contract. Contract at 90 but 91? Short pays +1 to settle 90.
Default Risk
Only the party owing the greater amount can default. Long not obligated to make payment unless short makes delivery.
Termination
re-enter the market and create a new forward contract expiring at the same time as the original forward contract, taking the position of the seller instead.
Long original asset, short a new asset
Long to buy, short to deliver (assuming the prices either are net or +net)
However, long has no obligation to buy and short may not deliver cash (credit risk). If long doesn’t buy, she’s required to buy.
Long agrees to…
…buy the asset at the expiration date at the price agreed on at the start”
Summary
“■ The holder of a long forward contract (the “long”) is obligated to take delivery of the underlying asset and pay the forward price at expiration. The holder of a short forward contract (the “short”) is obligated to deliver the underlying asset and accept payment of the forward price at expiration.”
At expiration, a forward contract can be terminated by having the short make delivery of the underlying asset to the long or having the long and short exchange the equivalent cash value. If the asset is worth more (less) than the forward price, the short (long) pays the long (short) the cash difference between the market price or rate and the price or rate agreed on in the contract.
A party can terminate a forward contract prior to expiration by entering into an opposite transaction with the same or a different counterparty. It is possible to leave both the original and new transactions in place, thereby leaving both transactions subject to credit risk, or to have the two transactions cancel each other. In the latter case, the party owing the greater amount pays the market value to the other party, resulting in the elimination of the remaining credit risk. This elimination can be achieved, however, only if the counterparty to the second transaction is the same counterparty as in the first.
A dealer is a financial institution that makes a market in forward contracts and other derivatives. A dealer stands ready to take either side of a transaction. An end user is a party that comes to a dealer needing a transaction, usually for the purpose of managing a particular risk.
Equity forward contracts can be written on individual stocks, specific stock portfolios, or stock indices. Equity forward contract prices and values must take into account the fact that the underlying stock, portfolio, or index could pay dividends.
Forward contracts on bonds can be based on zero-coupon bonds or on coupon bonds, as well as portfolios or indices based on zero-coupon bonds or coupon bonds. Zero-coupon bonds pay their return by discounting the face value, often using a 360-day year assumption. Forward contracts on bonds must expire before the bond’s maturity. In addition, a forward contract on a bond can be affected by special features of bonds, such as callability and convertibility.
Eurodollar time deposits are dollar loans made by one bank to another. Although the term “Eurodollars” refers to dollar-denominated loans, similar loans exist in other currencies. Eurodollar deposits accrue interest by adding it on to the principal, using a 360-day year assumption. The primary Eurodollar rate is called LIBOR.
LIBOR stands for London Interbank Offer Rate, the rate at which London banks are willing to lend to other London banks. Euribor is the rate on a euro time deposit, a loan made by banks to other banks in Frankfurt in which the cur- rency is the euro.
An FRA is a forward contract in which one party, the long, agrees to pay a fixed interest payment at a future date and receive an interest payment at a rate to be determined at expiration. FRAs are described by a special notation. For exam- ple, a 3 × 6 FRA expires in three months; the underlying is a Eurodollar deposit that begins in three months and ends three months later, or six months from now.”
“The payment of an FRA at expiration is based on the net difference between the underlying rate and the agreed-upon rate, adjusted by the notional princi- pal and the number of days in the instrument on which the underlying rate is based. The payoff is also discounted, however, to reflect the fact that the under- lying rate on which the instrument is based assumes that payment will occur at a later date.
A currency forward contract is a commitment for one party, the long, to buy a currency at a fixed price from the other party, the short, at a specific date. The contract can be settled by actual delivery, or the two parties can choose to settle in cash on the expiration day.”
