Lesson 14: Forwards

Question 1

How a forward works

Answer 1

Example: 6-month forward contract on XYZ specifies that at the end of 6 months, the buyer of the contract will buy a share of XYZ for $40
+ forward price: $40
+ expiration date: 6 months from today
+ spot price: current price of underlying asset
+ at expiry, the obligation of the seller may be satisfied by physical delivery of the asset, or the seller paying the buyer the excess of the stock price at expiry over the forward price -> cash settlement

Question 2

Forward premium

Answer 2

is the ratio of the forward price to the stock price

Question 3

Compare forward price to expected price of the stock

Answer 3

The forward price < the expected price of the stock

Question 4

Synthetic long forward

Answer 4

• To create a synthetic long forward, one buys a stock and borrows the price of the stock
  + Borrowing the price of the stock can be done = selling a zero-coupon bond whose price is the price of the stock and which matures at expiry of the forward

Question 5

A market-maker who deals with forwards will

Answer 5

offset the forward with a synthetic forward
+ if he longs (shorts) the forward, he shorts (longs) the synthetic forward

Question 6

Cah-and-carry

Answer 6

• is the latter set of transactions: buying the stock, selling a bond, and selling a forward
• is risk free
• if profit is made on this combination -> this arbitrage is called a cash-and-carry arbitrage

Question 7

Reverse cash-and-carry

Answer 7

set of transactions : sells the stock, buys a bond, and buys a forward

Question 8

Create synthetic zero-coupon bond

Answer 8

= buying a nondividend paying stock and shorting a forward on the stock