CHAPTER
ForwarD MARKETS AND CONTRACTS
LEARNING OUTCOMES
After completing this chapter, you will beable todo the following:
' Discuss the diferences between the positions held by the long and short parties
to a forward contact.
1 Describe the procedures for seling a forward contract at expiration.
1 Discuss how a purty toa forward contract can terminate a position prior to
expiration and how credit sk is affected by the way in which a position is
‘erminared.
1 Explain the diference between a dealer and an end user of a forward contac
1 Describe the essential characteristics of equity forward contracts.
1 Describe the essential chracteristies of forward contacts on zero-coupon and
‘coupon bonds.
1" Explain the charectristcs ofthe Eurodollar time deposit marke
1 Define LIBOR and Euribor.
1" Describe the essential characteristics of forward rate agreements (FRAS).
"Calculate the payment at expiration of an FRA and explain each of the
‘component terms.
1" Describe the essential characteristics of eurency forward contracts,
18 Explain how the price ofa forward contract is determined.
1» Explain how the value of a forward contract is determined at initiation, during
the lf ofthe contract, and at expiration,
1» Explain why valuation ofa forward contact i important
1 Define an off-market forward contact and explain how it difers from the more
standard typeof forward contact,
'= Explain how an equity forward contracts priced and valued, given the different
possible pater of dividend payment, and calculate its price and valu.
1 Explaa how e forward contract ona fixed-income security is priced and
valued, and calculate it price and value.
"= Explain how an FRA is priced and valued, and calculate its price and value
1 Explain how a forward contract on a currency is priced and valued, and be able
to calulate is price and value.
1 Explain how credit ra artes ina forward contract and how market value isa
‘measure of the eed rsk to partyin forward contract. Introduction
1.2. Desautr Risk
AND FORWARD.
Contracts
1.3. TeRMINATION
OF A FORWARD
‘Contract
Russell 3000 Inde, the short would have to deliver tothe long a portfolio containing each
‘ofthe Russell 3000 stocks proportionate to is weighting in the index. Consequently, cash
Settlement is much more practical. Cask-seed forward contracts are sometimes called
NDP’, for nondeliverable forwards, although this term is used predominately with
respect to foreign exchange forwards
‘An important characteristic of forward contracts is that they are subject to default, Re-
patdess of whether the contact is for delivery of cash setement, the potential exists for
8 party to default. Inthe zero-coupon bond example above, the long might be unable
ay the $98 or the short ight be unable to buy the zero-coupon bond and make delivery of
the bond to the long. Generally speaking, however, forward contracts ae structed so that
‘only the party owing the greater amount can default. In other words, ifthe shot is obligated
to deliver a zero-coupon bond sling for more than $98, then the long would not be obligated
‘to make payment unless the short makes delivery. Likewise, ina cash setled contact, only
‘ove party—the one owing the greater amount—can defall We discuss the nature ofthis
‘credit isk in the following section and in Section 5 after we have determined how to value
Torward contracts, We also adress the topic of criti in derivative contacts in Chapter 9.
‘Let us note that a forward contacts nearly always constructed with the idea thatthe par-
ticipants will bold on to ther positions until the contract expies and either engage in de-
livery ofthe asset o sete the cash equivalent, as required in the specific contract. The pos-
silty exists, however, that atleast one of the participants might wish to terminate the
position prior to expiration. For example, suppose a party goes long, meaning that she
agrees to buy the asst at the expiration dat tthe price agreed on atthe start, but she sub-
Sequently decides to terminate the contract before expiration. We shall assume that the
contract call fr delivery rather than cash settlement at expiration,
"To sve the details ofthe contract termination, suppose itis pat ofthe way through
tho life of the contrat, andthe long decides that she no longer wishes to buy the aset at
‘expiration, She can then re-enter the market and create anew forward contract expiring a
the same time asthe original forward contract, taking the position of the seller instead,
Because of price changes in the market during th period since the original contract was
‘created, this new contract would likely have « different price at which she would have to
‘commit to sell. She would thea belong a contract to buy the ase at expiration at one price
‘and shor contract o sll the asset at expiration at a different price. I should be apparent
‘that she has no further exposure to the price ofthe ase.
For example, suppose she is long to buy at $40 and short to deliver at $42, Depend:
ing onthe characteristic ofthe contract, one of several possiblities could occur at expi-
ration, Everything could go as planned—the party holding the short position of the
contract on which she is long at $40 delivers the asset to her, and she pays him $40. She
then delivers the asset tothe party who is Tong the contract on which she is short at $42,
‘That pay pays her $42, She nets $2. The transaction is over,
"Thetis always a possibility that her counterparty on the long contact could default.
She is sill obligated to deliver the asset onthe short contrat, for which she will receive
‘$42, Buc if her counterpart on the long contract defaults, she has to buy the asset inthe
market and could suffer a significant loss. There is also possibilty thatthe counterparty
‘on her short contract could fail to pay her the $42. Of course, she would then not deliver
the asset but would be exposed to the risk of changes in the asses rie. This typeof prob>
Tem illustrates the credit risin a forward contract. We shall cover credit isk in more detail,
in Section 5 of this chapter and in Chapter 9
"To avoid the credit risk, when she re-enters the market o go short the forward con-
tract, she could contact the same counterparty with whom she engaged inthe long forward 26
Chapter 2_ Forward Markets and Contracts
1_INTRODUCTION
1.1. Deuvery AND
SETTLEMENT OF A
FoRWaR
Contaact
In Chapter 1, we gave a general overview of global derivative markets. We identified those
markets as forward markets, futures markets, options markets, and swap markets. The fl-
lowing series of chapters focuses individually on those markets. We bepin with forward
smarkels
First recall our definition of a forward contract: A forward contract isan agreement
benween no parties in which one party the buyer agres to bu from the other party, the
seller an underlying asset or other derivative, a a fatur date ata price established atthe
“Start ofthe contract. Therefore, iis & commitment by two partes to engage ina transac-
tion ata later date with the price set in advance. The buyer is oten called the ong and the
sellers often called the short. Although any two partes can agre on sucha contract,
this book we are interested only i forward contrat that involve large corporations, finan-
ial institutions, nonprofit organizations, or governments
Recalling an example from Chapter 1, a pension fund manager, anticipating the
receipt of eash ata foture date, might enter nto a commitment to purchase a stock porfo-
lio at a later date ata price agreed on today. By doing so, the manager's position is unaf-
fected by any changes inthe value of the stack portfolio between today and the dat of the
ctl investment in the stock portfolio, In this sense, the manager is hedged against an
increase instock prices until the cash is received and invested. The disadvantage of such
teansteion is thatthe manager is also hedged against any decreases in stock prices. If tock
Dries fall between the time the commitment is established and the time the cash is
Teoeived, the manager will regret having entered ino the forward contact because the
stock could have been acquired at «lower price. But that isthe nature of a forward con
tract hedge: It locks in a price.
‘An important festure of s forward contract is tht neithe party pays any money at
the star, In Chapter 9, we shall look at how the parties might require some collateral to
‘minimize the risk of default, bat for most ofthis book, we shall ignore this point. So keep
‘in mind thie very important aspect of forward contracts: No money changes hands atthe
‘When a forward contract expites, there arc two posible aangements tat can be used to
seftle the obligations of te partes. A deliverable forward Contract siplates tha the long
‘will pay the agreed-upon price to the short, who in tum will deliver the underlying asset
to the long, a proces called delivery. An alternative procedure, called eash settlement,
‘emits the long and shor to pay the net cash value of the position onthe delivery date.
Fr example, suppose two partes agree to a forward contract (o deliver a zero-coupon
bond at a price of $98 per $100 par. At the contracts expiration, suppose the underying
zero-coupon bond is selling ata price of $98.25. The long is due to receive from the short,
fn asset worth $98.25, for which « payment to the short of $98.00 is required. In a cah-
Settled forward contac, the short simply pays the long $0.25. If the zero-coupon bond
‘were selling for $97.50, the long would pay the short $0.50. Delivery of a zero-coupon
bond isnot a dificul thing to do, however, and cash-setled contracts ae more commonly
used in situations where delivery is impractical For example, ifthe underlying is the
spe oan her wih eps the wor anderying, he ates nus fen ss cs,
‘erhalten ander a pr spec un ht thy, Hence, werd ke nga hr
2 eer ower, tat be oie of delivery oes selene satan pon wae t expo. is
seoted been priest th Sa 28
Chapter 2_ Forward Markets and Contracts
‘contract. They could agree to cancel both contracts. Because she would be owed $2 at
‘expiration, cancelation ofthe contract would result in the counterparty paying her the
present value of S2. Tis termination or offset ofthe orignal forward position is clerly
desirable for both counterparties because it eliminates the credit risk. Its always possi-
ble, however, that she might receive a beter price from another counteparty If that price
is sufficiently attractive and she doesnot perceive the credit risk tobe 10 high, she may
choose to deal withthe other counterparty and leave the credit sk in the pictur
2 _THE STRUCTURE OF GLOBAL FORWARD MARKETS
‘The global market for forward contracts is part ofa vast network of financial institutions
that make markets in these instruments as well asin other related derivatives, such as
swaps and options. Some dealers specialize in certain markets and contracts, such as for-
‘ward contracts oa the euro or forward contacts on Japanese equity products. These deal-
ers are mainly large global banking instvtions, but many large non-banking institutions,
such as Goldman Sachs and Merl Lynch, ate also big players inthis market.
‘Dealers engage in transaction with two types of parties: nd users and other dea-
xs, Amend uteri ypically «corporation, nonprofit organization or govemment.*An end
tseris generally a pary witha risk management problem thats searching fora dealer to
provide it wit «financial transaction to solve that problem. Although the problem could
Simply be thatthe party wants to take postion in anticipation of @ market move, more
‘commonly the end user has a skit wants to reduce or eliminate.
‘As an example, Hoffian-LaRoche, the large Swiss pharmaceutical company, sls its
product globally. Aniipaing the receipt of a large amount of cash in U-S. dollars and wor-
‘ed about a decrease in the value ofthe dalle relative to the Swiss franc, it could buy a fore
‘ward contacto sll he dollar and buy Swiss fans. It might seek outa dealer such as UBS
‘Warburg, de investment fm fisted with the lage Swiss hank UBS, ot might approach
any ofthe other large multinational banks with which it does busines, Oritmight end up del-
ing witha. non-bank entity, like Meri Lynch. Assume that Hoffinan-LaRoche enters into this
contact with UBS Warburg Hoffman-LaRoche isthe end user; UBS Warburg is the dese.
“Transactions in forward contracts typically are conducted over the phone. Each
‘eater has a quote desk, whote phone number is well known to the major participant in
the market. I a party wishes to conduct a transaction, it simply phones the dealer for a
‘quote. The dealer stands ready to take either side of the transaction, quoting a bid and an
{sk price or rate, The bid is the price at which the dealer is willing to pay for the furure
purchase ofthe asset, and the ask isthe price at which the dealers willing to sell. When
| dealer engages in forward transaction, thas then taken on risk from the other party.
For example, in the aforementioned transection of Hoffiman-LaRoche and UBS Warburg,
by entering into the contract, UBS Warburg takes on a risk that Hoffman-LaRoche has
liminated. Specifically, UBS Warburg has now committed to buying dollars and selling
‘Swiss francs ata future date, Thus, UBS Warburg is effectively long the dollar and stands
2 Thiers md ert ssn hte peso ce wa thee is, Cet i
cater weve, an be a ate ares wt ees pti or eing ace en
psn tr euperse In easing ta acter elaine oh cei sk preted y the mae
Indie ce sik oer vein ents We wil cs se pols ar flim Caper 9.
4 The US, goremment doen nan frwrd ont other erate, swe oregn
overoent td cea ks J, Wit the nied Shr, boeve sre st nen poets do
{npg in forward conc nd ber eirve. The Structure of Global Forward Markets 29
to gain from a strengthening dollar weakening Swis rane. Typically dealers do not want
to hold this exposure. Rather, they find another party to offset the exposure with another
‘derivative or spt transaction, Thus, UBS Warburg i a wholesaler of risk—buying it, sll-
ing it and tying to ear a profit off the spread between its buying price and selling price.
‘One might reasonably wonder why Holfman-LaRoche could not avoid the cost of
dealing with UBS Warburg. In some eases, it might beable to. t might be avare of another
‘arty with the exact opposite needs, but such a situation is rare. The market fr financial
Products such as forward contracts is made up of wholesalers of risk management prod-
ots who use thet technical expertise, their vast network of contacts, and their access to
‘tcl financial market information to provide a more efficient means for end users 10
‘engage in such risk management transactions.
‘Dealers such as UBS Warburg lay off the risk they donot wish to assume by trans-
‘acting with other dealers and potentially other end uses. If they do this carefully, quickly,
‘and at accurate prices, they can ean a profit from tis market-making activity. One should
not get the impression, however, chat market making is a highly profitable activity. The
‘competition is irce, which keeps bid-ask spreads very low and makes it difficult to eam
much money on a given transaction, Indeed, many market makers do not make much
‘money on individual transactions—they typically make a small amount of money on each
transaction and do a large numberof transactions. They may even lose money on some
‘Standard transtetions, hoping to make up losses on more-complicated, nonstandard rans-
‘actions, which occur les frequent but have higher bid-ask spreads.
‘Rsk magazine conducts annual suevey’s to identity the top dealers in various deiva-
tive products. Exhibit 2-1 presents the results of those surveys fortwo of the forward prod-
ucts we cover here, curency and interest rate Forwards. Interest rate forwards ar called
forward rate agreements (FRAG). Inthe next section, we shall study the diferent types of
forward contracts and not that there are some others not covered in the Rsk surveys.
‘One ofthese surveys wa sent to banks and investment banks that are ative dealers in
‘over-the-counter decvaives. The oter survey Was sent to end users. The tabulations ae based
‘on respondents’ simple rankings of who they think are the bes dealers, Although the identities
ofthe specific desler fms are not crcl, itis interesting and help to be aware ofthe major
players in these types of contacts, Most of te word's leading global financial insintons are
Tisted, but many other big mies are no. Ts also interesting to observe that the pereptons of
the users ofthese dealer ims services difer somewhat fom the dealers’ self-perception. Be
var, however, at the rankings change, sometimes drsically each year
EXHIBIT 2-1 Risk Magazine Surveys of Banks, Investment Banks, and Corporate
End Users to Determine the Top Three Dealers in Currency and
Interest Rate Forwards,
Respondents
Currencies _Banks and Investment Banks ‘Corporate End Users
sie UBS Warburg Caigroup
Deatsche Bank Royal Bank of Sealand
JP Morgan Chase {JP Morgan ChaseBank of America
sw UBS Washurz Crigrup
Chigroup Bank of America
JP Morgan Chase {JP Morgn ChaseUBS Warburg Chapter 2_ Forward Markets and Contracts
se UBS Warburg Royal Bank of Scotland
Royal Bank of Scand sigoup ;
Hong Kong Stongha UBS Warbu
Banking Corporation
SSF ‘UBS Warburg ‘UBS Warturg
‘Cedi Suisse Fr Boston Citigroup
BNP Paribas rot Sane Fit Boston
Interest Rae Forwards (FRA)
s JP Morgan Chase BP Morgan Chase
Bank of America Royal Bank of Setland
Deatache Bank Bank of America
« Deutsche Bank ‘Royal Bank of Scotland
Ines BCI BP Morgan Chase
Royal Bank of Scotland Deuce Bank
¥ Mizoho Secures group
SP Morgan Chase Merl Lynch
[BNP Pastas Hong Kong Shanghai
‘Banking Corporation
£ Royal Bank of Scotland Royal Bank of Scotian
Commerzbank Bank of AmercwING Barings
Deatache Bank
se Credit Suisse Fest Boston UBS Warburp
UBS Wasture ‘Crit Suisse Fist Boston
Detach Bank iigrouvING Barings
ie $= U8 a = ¥ =e yn UR, pd ei SF = Se fe
‘ete a ent px os te ig eps i 03
Sree onan he
3 _TVPES OF FORWARD CONTRACTS
3.1 Equny
Forwanos
In this section, we examine the types of forward contracts that fall within the scope of this
book. By the word “type,” we mean the underlying asset proups on which these forward
contracts are created. Beeause the CFA Program focuses on the asset management indus:
{ry or primary interest is in equity, interest rate and fixed-income, and curreney forwards.
‘An equity forward isa contact calling for the purchase of an individual stock, a stock
pordoio, ofa stock index ata ater date. For the most part, the diferences in types of
feuity forward contracts are only slight, depending on whether the contract is on an
{individual stock, a potolio of stocks, o a stock index.
BLILTFoawao Contacts ON INDWIOUAL STOCKS
Consider an asset manager responsible forthe portfolio ofa high-net-wort individual. AS
js sometimes the case, such portfolios may be concentrated ina small munber of stocks,
sometimes stocks that have been inthe family fr years In many eases, the individual may ‘Types of Forward Contracts 3
te part of the founding family of particular company. Let us say thatthe stock is called
‘Gregorian Industries, In. or GI, andthe client isso heavily invested inthis stock that her
portale is not diversified, The clint notifies the portfolio manager of her need fr $2 mile
Tion in cash in six months. This cash can be raised by selling 16,000 shares at the cutent
‘rive of $125 per share, Ths, the risk exposure concems the market value of $2 milion of
‘Stock. For whatever reason, iis considered best not to sell the stock any earlier than nec-
tssary. The portfolio manager realizes that a forward contract to sell GI in six months will
‘accomplish the client's desired objective. The manager contacts a forward contrac dealer
fad obtains a quote of $128.13 asthe price at which a forward contact to sell the stock in
six months could be constrcted.* In other words, the portfolio manager could enter into a
Contract to sll the stock o the desler in six months at $128.13. We assume that this con
tract is deliverable, meaning that when the sale is actually made, the shares wil be deliv
‘red tothe dealer Assuming that the client has some flexibility in the amount of money
‘needed, lt us say that the contrac i signed forthe sal of 15,600 shares at $128.13, which
‘vill aie $1,998 828. OF course when the contrat expires, the stock could be selling for
‘ny price The client can gain of lose on the transaction, Ifthe stock rises to a price above
$128.13 during the six-month period, the lien will stl have to deliver the stock for
$128.13. But ifthe pric falls the client will still get $128.13 per share forthe tock.
3.1.2. Fomwano Contacts on Stock PoRrtOU0S
‘Because modem porftio theory and good common sense dictate that investors should
bold divesfied portolios, ts reasonable to atsume that forward contacts on specific
‘Stock portfolios would be wseful. Suppose a pension fund manager knows that in three
‘months he will need to sll about §20 millon of stock to make payments to retirees. The
‘manager has analyzed the portfolio and determined the precise identities ofthe stocks he
‘wants sel and the mamber of shares ofeach that he would ike to sel. Ths the manager
thas designated a specific subportfolio to be sold, The problem is tht the prices ofthese
stocks in three months are uncerai, The manager ezn, however, lck in he sae prices by
‘entering into a forward contrct to sell the portfolio. This ean be done one of two Ways
“The manager can enter into forward contract on each stock that he wants el
‘Alternatively he can enter ino a forward contract on the overall portfolio, The fist way
‘would be mee costly. as each contract would incur administrative cost, whereas the see=
‘ond way would incur only one set of costs * Assume thatthe manager chooses the second
method. He provides a ist ofthe stocks and number of shares of each he wishes to sll 9
the dealer and obtains a quot. The dealer gives him a quote of $20,200,000. So, in thee
‘months, the manager will sell the stock tothe dealer and receive $20,200,000. The tans~
faction can be stractared to cll for either actual delivery or cash settlement, butin ether
ase, he client will effectively receive $20,200,000 forthe stock.”
Ta Seaton 4 sal an Bow to eal frwrd ries sch sh one
* tgnoing se css, ere would ea fleece a ing err cones ivi wok ie
{orton comet on pri, Boose he noe ican of ayo as te for ops A
io opens the ae as an pine oli, ool of foward conct ith
aca! ont on 8 port, ning he reentoned oes.
7 te fr empl th stor worth $29.00 ah rans cl fr vey the mas wl ter
‘he snhsto ear and esne $200. The ce lett aes am ppt sof 300.00. F
‘te vomton snore wish see thc wl py the eer 300000 The emt wok en
‘Steen inte mt sing S20S00,00 a eng 8220000 ae sting he awn
‘Ste esr Sry ie stk sling fr sth ie sont ured yh rv ena he
‘Sent i eter be tsk ed reine $2200.00 he aman leach eth ce wll
Sheva the mttandmsie ash pment fom te dae, ang the eevee pe il $20.200000, Chapter 2 Forward Markets and Contracts
3.1.3 Forwano ConrRacts on Stock INDICES
Many equity forward contracts are based on a stock index. For example, consider a U:K.
asset manager who wants o protect the value of her portfolio thats a Financial Times Stock
Exchange 100 index und, o who wants to eliminate arsk for which the FTSE 100 Index
‘sa sufficiently accurate representation ofthe risk she wishes to eliminate. For example, the
‘manager may be anticipating the sale of a number of U.K. blue chip shares ata foture date
"The manager could, asin our stock portfolio example, take a specific portfolio of socks to
forward contract dealer and obtain a forward contract on that portfolio. She realizes, how=
‘ever, that forward contact on a widely accepted benchmark would result ina beder pice
quote, because the dealer can more easly hedge te risk with other transactions. Moreover,
the manage is not even sure which socks she will sil be olding at the later dat. She sim
ply knows tat she wil sella certain amount of stock at Iter date and believes thatthe
FISE 100 is representative of the stock tat she will sel. The manager is concerned with
the systematic risk associated withthe U.K. stock market, and accordingly, she decides that
selling a forward contrat on the FTSE 100 would be a good way to manage the risk.
"Assume that the portfolio manager decides to protect £15,000,000 of stock. The
eater quotes a price of £6,000 on a forward contract covering £15,000,000, We assume
that the contrac wll be cash settled because such index contrite ate nearly aways done
that way. When th contract expiration date aves, et us say thatthe index is at £5,925 —
1 decrease of 1.25 percent from the forward price. Because the manager is short the con-
‘wact and its price went down the transaction makes money. But how moch di it make on
‘notional principal of £15,000,000?
‘The index declined by 1.25 percent. Thus, the transaction should make 0.0125 X.
£15,000,000 = £187,500. In other words the desler would have to pay £187,500 in cash.
[If the portfolio were @ FTSE 100 index fund, then it would be viewed asa portfolio ini-
tally worth £15,000,000 that declined by 1.25 percent, a loss of £187,500. The forward
contract offets this loss. Of course in reality, the portflio is not an index fund and such
‘hedge isnot perfect, but as noted above, thee ae sometimes reasons for preferring that
the forward contact be based on an index.
3.14 Tu Exeter oF Dmaoenos
Teis important o note the effect of dividends inequity forward contracts. Any equity portfo-
Ho nearly alvays has at leat few stocks that pay dividends, and it is inconceivable that any
well-known equity index would not have some component stocks tha pay dividends. Equity
orward contacts typically have payoffs hased only on the price ofthe equity, valve ofthe
portfolio, or lve ofthe index. They donot ondinarily pay off any dividends pad by the com>
ponent stocks. An excepson, however, is that some equity forwards on stock indices are
‘based on ttl retum indices. For example, there ae two versions of the well-known S&P
'500 Index. One represents only the market vale ofthe stocks. The other, called the SAP 500
‘Total Retum Inde, is structured so that daily dividends pai by the stocks ar reinvested in
‘additional units of the index, as though it were a portfolio, In this manner, the rate of return
on the index, and the payofT of any forward contact based oni reflects the payment and
reinvestment of dividends into the underlying index. Although this feature might appear
race, itis not necessarily of much importance in risk management problems. The Vat-
bility of peices is so much greater than the variability of dividends that managing peice risk
is considered much more important than worrying about the uncertainty of dividends,
Tn summary, equity forwards can be bated on individual stocks, specific stock port
folios, of stock indices, Moreover, these underlying equities often pay dividends, which
‘can affect forward contracts on equities. Let us now look at bond and interes rate forward ‘Types of Forward Contracts
3.2 Bonp ano
terest RATE
Forwaro
Contracts
Forward contrsts on honds are similar to forward contracts on intrest rats, but the two
are ferent instruments. Forward contracts on bonds, in fat, re no more dificult o n-
‘derstand than those on equities, Dravving on out experience of Section 3.1, we simply ex-
tend the notion of a forward contact on an individual stock, a specific stock portfolio, or
‘stock index fo that of a forward contact on an individual bond, a specific bond portfo-
Tio, ora bond index.®
4.2.1 Forwakd CONTRACTS ON INDIDUAL BONDS AND BOND PORTFOLIOS
[Although a forward contact on «bond and one on stock ae similar, some basic differ-
‘ences nonetheless exist heen the two, For example, the bond may pay a coupon, which
‘corresponds somewhat tothe dividend that a stock might pay. But unlike a stock, a bond
‘matures, and a forward contract on a bond must expire prior othe bond’ maturity date, In
‘addition, bonds often have many special features such as calls and convertibility. Finally, we
‘should note that unlike «stock, a bond caries the risk of default. forward contract writ-
tenon a bond must contain a provision to recognize how default is defined, what it means
{or te bond to default, and how default would affect the putes to the contract
In addition to forward contracts on individual bonds, there ar also forward contacts
‘on portfolios of bonds as well as on bond indices, The technical distinctions between
forward contracts on individual bonds and collections of bonds, however, ar relatively
“The primary bonds for which we shall consider forward contacts are defautfree
‘zero-coupon bonds, typically called Treasury bills or ills inthe United States, which
‘serve asa proxy forthe risk-free rat.” Ina forward contract on a Fb one party agrees
to bay the Till ata later date, prior to the Bill's maturity, at a price agreed on today.
‘Phill ace ypically soldat a discount from par value and the price is quoted in terms of
the discount rate. Thus, ia 180-dey T-bills selling at a discount of 4 percent, its price per
‘I par willbe $1 ~ 0.04(180/360) = $0.98. The use of 360 days is the convention in al-
‘culating the discount. So the bill will sell for $0.98. If purchased and held to maturiy, it
‘wll pay off $1, This procedure means that the intrest is deducted from the face value in
‘advance, which is called discount interest.
‘The Toil is usually traded by quoting the discount rate, not the price. I is under-
stood tha the discount rte can be eaily converted to the price by the above procedure. A
forward contract might be constricted that would call for delivery of «0-day T-bill in 60
days, Such a contract might sel for 0.9895, which would imply a discount ate of 4.2 per-
cent because $1 ~ 0.042(90/360) = $0.9895, Later in this chapter, we shall ee how for-
‘ward prices of Fils ae derived.
Tn addition to forward contracts on zero-coupon bonds/Pills, we shall consider
forward contacts on default-freecoupon-bearing bonds, also called Treasury bonds in the
United States. These instruments pay interes, typically in semiannual installments, and
can sell for more (less than par vale ifthe yield is lower (higher) than the coupon rate.
Prices are typically quoted without te interes that has accrued since the last coupon date,
bot witha few exceptions, we shall always work with the fll price—that is, the price
‘including accrued interest. Prices are often quoted by stating the yield. Forward contracts
* Tay be wai seven Chal 1 a3 Fed come Anas fr he Charo anil Anat
Peary atk), New Hope, PA rk, abo Anais 200)
+x govrmc-sedzr-oapn on ipl d= ry fer is set ects tit
‘esol abe eo dt an be ache nde oma het elinining my mat
‘ee cd its oie eae ks no Sop I eb ged eee Ry
owes te tnt ye ent ine hein anole wh eng the mat pe Chapter 2_ Forward Markets and Contracts
cal for detivery of sch a bond ts date prie othe Bods maui, for which he short
pays the long the agreed-upon price.
3.2.2. Fonwato Conreacrs On INTEREST RATES: FORWARD RATE AGREEMENTS
So far in Section 3.2 we have discussed forward contracts on actual fixed-income securi-
tis, Fixed-ncome security prices are driven by intrest rates. A more common type of for-
‘ward contac iste interest rate forward contrac, more commonly called a forward rate
‘agreement or FRA. Before we can begin to understand FRAs, however, we must examn-
ine the instruments on which they are base.
‘Ther isa lage global market for time deposits in various currencies issued by lage
creditworthy banks. This markets primarily centered in London bat also exists elsewhere,
though not in the United States. The primary time deposit instrument is called the
‘Eurodollar, which isa dollar deposited outside the Unites States. Banks borrow dollars
from other banks by issuing Eurodlla time deposits, which are essentially short-term,
‘unsecured foans In London, the rate on such dollar loans i called the London Interbank
Rate, Although thre are rates for both borrowing and lending, nthe financial markets the
lending rate, called the London Interbank Offer Rate or LIBOR, is more commoaly
used in derivative contracts. LIBOR is the rate at which London banks lend dlls to other
“London banks. Eventhough it represents a loan ouside ofthe United States, LIBOR is
considered to be the best representative rat on a dollar borrowed by a piv, ie, non
governmental, high-quality borower. It should be noted, however, that he London market
includes many branches of banks from outside the United Kingdom, and these banks are
also ative participants inthe Eurodolat mack
‘A Eurodollar time deposit s structured as follows. Let us say a London bank such
as NatWest needs to borrow $10 million for 30 days. It obtains a quote fom the Royal
Bank of Scotland fora rate of 525 percent. Thus, 30-day LIBOR is 5.25 percent. IF
[NatWest rakes the dea, it will owe $10,000,000 > [i + 0:0525(301360)] = $10,043,750
in 30 days. Note that, like the Treasury bill marke, the convention in the Eurodllarmat=
‘et isto prorate the quoted interest rate over 360 days. In contasto the Treasury bill mar
‘et, the imerest isnot deducted from the principal, Rather, tis added on tothe fae valu,
‘procedure appropriately called add-on interest. The market for Eurodollar time deposits
is quite lage, and the rates on these instruments ae assembled by a central orgnization
1nd quoted in financial newspapers. The British Bankers Assocation publishes seri-
official Eurodollar ate, compiled from an average ofthe quotes of London banks.
‘The US. dolar is not the only instrument for which such time deposits exist.
Eurostering for example, trades in Tokyo, and Euroyen trades in London. You may be
‘wondering about Eureeuro. Actually, there is no such entity as Euroeuro at least not by
that name. The Eurodllar instrument described here hs nothing to do with the European
currency known as the euro. Eurodollars, Euroyen, Eurostrling, ete. have been around
Jonge than te euro currency and, despite the confusion, have rettined their nomenclatre,
‘An analogous instrument does exist, however—a euro-denominated loan in which one
bank borrows euros from another. Trading in euros and euro deposits occurs in most major
‘world cities, and two similar rates on such euro deposits ae commonly quoted, One, called
BuroLIBOR, is compited in London by the British Bankers Assocation, and the othe,
called Euribor, is compited in Frankfurt and published by the European Cental Bank.
Earibor is more widely use and i the rate we shal refer to in this book,
Now let us retum to the world of FRAS. FRA are contracts in which the underlying
{s neither a bond nor a Eurodollar or Euribor deposit but simply an interest payment made
in dotlars, Furibor, or any other cureney at arate appropriate for that currency. Our pri
‘mary focus willbe on dollar LIBOR and Euribor, so we shall henceforth adopt the termi
nology LIBOR to represent dollar LIBOR and Buribor o represent the euro deposit rate ‘Types of Forward Contracts 8
Because the mechanics of FRAs are the same for all currencies, for illustrative pur-
‘poses we shall use LIBOR. Consider an FRA expiting in 90 days for which the undely-
ing is 180-day LIBOR. Suppose the dealer quotes this instrument ata rate ofS. percent
‘Suppose the end user goes long and the desler goes shor. The end user is essentially long.
‘the rate and wil benefit if rates increase. The dealer i essentially shor the rate nd will
‘benefit if rates decrease, The contract covers a given notional principal, which we shall
assume is $10 milion.
‘The contract stipulates that t expiration, the partis identify the rate on new 180-day
LLIBOR time deposits. This rae is called 180-day LIBOR. Iti, thus, the underlying rate
‘on which the contrat is based. Suppose that t expiration in 90 days, the rate on 180-day
LLIBOR is 6 percent. Tha 6 percent interest wil be aid 180 days late. Therefore, the pres
cat value of 8 Eurodollar time deposit at tht point in ime would be
$10,000,000
4+ 0.06180
1+ 00453)
[Atexpration, then, the end user, the party going Tong the FRA in our example, receives
the following payment fom the dealer, which isthe party going shoe:
(0-085
0
+i)
he underying rate is less han 3.5 pereent, the payment is caeulted based on the die
ace between the 5.5 percent ae ad th ndeying ate ani pa bythe hong to tbe sho.
Tris important to note tat even though the contact expres in 90 das, the ati on a 180
day LIBOR instrament therefore, the ratecalculation adjusts bythe factor 18360. The fact
tha 0 days have eld at expan i ot elvan wo th calculation ofthe paye
‘Before presenting the general form, le us review the calculation nthe numer
torand denominator Inthe numerator, we ee hat the contacts obviously paying the i=
ference between te acura that exists inte maket on he conrat expiration date and
the aredrapon ste adjusted forthe fact thatthe rate epi toa 180-ayinsumen,
Imulplied by the notional principal. The divisor sppears Because when Eurodllr ates
fe quoted inthe market, thy ae based onthe assumption thatthe rae applies to an
isrument that acroes interest a tat rate withthe interes pai acon numberof days
here 180) ater When pricipams determine this rat athe London Eurodelar markt, it
Ss undesood to apply to a Eurdolla tine deposit tat begins now and matures 180 days
Inte So the nerest onan acta Eurodollar epost would not be paid unl 180 dys le.
‘Thus tisnecesary to adjust he FRA pao to reflect the fat thatthe amples pay
men tht vould occur 10 days ler ons standard Euodolar deposi. This adjustments
tasly doe by simply discounting the payment atte caret LIBOR, which het is 6 per-
tent, prorated over 180 days. These conventions ae also fllowed inthe market for FRAS
with ober underlying ete.
Tn general, the FRA payoff formula (rom the perspective af the party going long) is
(Undying ee at exprton ~ Forward cons ra (Det nang rte
Nosona pincpal | 8
1+ Underlying rate at expiration (Pusinandding a)
$10,000,000 = 924272 36
3.3 Currency
Forwaro
Contracts
Chapter 2 Forward Markets and Contracts
‘where forward contract rate represents the rate the two parties agree willbe paid and days
‘inunderving rate refers tothe number of days to maturity ofthe instrument on which the
underying rate is based.
One somewhat confusing feature of FRAS isthe fact that they mature ina certain
‘number of days and are based on arate that applies to an instrument maturing in a certain
numberof days measured from the maturity ofthe FRA. Thus, there are two day figures
associated with each contract. Our example was a 90-day contract on 180-day LIBOR. To.
void confsion, the FRA markets use a special typeof terminology that converts the num
ber of days to months. Specifically, our example FRA is referred to a8 83 % 9, reflecting
the fact thatthe contract expires in three months and tat six months later, of nine months
from the contract initiation date, the interest i paid on the underlying Burodolla time
Aepositon whose rate the contract is based.”
FFRAs are available in the market fora variety of maturities that are considered some-
what standard, Exhibit 2-2 presents the most common maturities, Most dealers follow the
‘conention that contacts should expire ina given number of exact months and should be
‘on the most commonly traded Furodollar rates such as 30-day LIBOR, 60-day LIBOR,
90-day LIBOR, 180-day LIBOR, and soon, Ifa party wants contract expiring in 37 days
‘on 122
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