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Forward Markets and Contracts

I. Intro to Forward Contracts

A. Agreement to Buy / Sell in Future

1. two partiesa. one agrees to buyb. one agrees to sell

2. parties agree on termsa. specific quantity of assetb. pricec. date at which transaction will occur

B. No Money Changes Hands When Contract is Entered Into

1. if price of underlying asset increases above contract price:a. buyer of forward contract wins

(i) b/c he is able to buy it at lower price

2. if price of underlying asset decreases below contract price:a. seller of forward contract wins

(i) b/c he is able to sell it at higher price

3. usually no margin is posteda. this is different from a futures contract

C. Reasons to Enter into Forward Contract

1. speculate

2. hedgea. eliminate uncertainty of future price

D. Types of Underlying Assets (On Which Forward Contracts are Written)

1. physical assetsa. e.g., commodities

2. financial assetsa. T-billsb. bondsc. equitiesd. foreign currencies

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II. Differences Between Long and Short Positions

A. Long Position

1. agrees to buy the physical or financial asset

2. has removed the uncertainty about price he can pay for asset in future

3. exposed to counterparty riska. the possibility that the other side will default (not honor contract)

B. Short Position

1. agrees to sell or deliver the asset

2. has removed the uncertainty about price which he can sell asset for in future

3. exposed to counterparty riska. the possibility that the other side will default (not honor contract)

III. Settling a Forward Contract

A. Contracts Will Specify How They Will Be Settled

1. deliverable forward contracta. deliver the actual asset

2. cash settlementa. calculate who won and who lost and transfer cash

(i) if price > agreed upon (forward) price, short party pays long(ii) if price < agreed upon (forward) price, long party pays short

B. Terminating Position Prior to Expiration

1. enter into an opposite positiona. if you are long…

(i) enter into a short contract

2. be careful: if the second contract is with a different party (than the first contract)a. you have credit risk (counterparty) risk

(i) the party that has to pay you may default

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IV. Dealers vs. End User of Contract

A. End User

1. party that has a risk they are trying to eliminatea. examples include:

(i) corporation(ii) government unit(iii) nonprofit institution

B. Dealers

1. parties that enter into these transaction as a businessa. try to balance their books

(i) have equal contacts on both sides (A) often enter into contracts with other dealers

(1) to hedgeb. profit from spread

(i) buying price(A) at which they will assume long position

(ii) selling price (higher)(A) at which they will assume short position

c. bid / ask spread must cover:(i) profit(ii) administrative costs(iii) default risk(iv) asset price risk

(A) if position unbalanced (unhedged)d. examples include:

(i) banks(ii) investment banks

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V. Characteristics of Various Types of Forward Contracts

A. Equity Forward Contracts Slide 1

1. underlying asset could be:a. single stockb. portfolio of stocksc. stock index

2. examplea. you want to sell 100,000 shares of X in 90 days

(i) don't want price riskb. you take short position

(i) locks in sales pricec. contract can be:

(i) physical delivery(ii) cash settlement

3. dividends are normally not included in contracta. too much uncertainty with dates, etc.b. could do a total return contract if you wanted to…

(i) but this is unusual

B. Zero Coupon (T-bills) Slide 2

1. quoted as a percentage discount from face valuea. percentage discount is annualized

(i) 4% (annual) discount for 90 day bond is 1%(A) (90 / 360) x 4% = 1%

(ii) same as price quote of:(A) (1 - .01) x $1,000 = $990

2. must settle before maturity

3. everything else works just like equity example above

C. Coupon Bonds

1. price is quoted as YTM as of settlement datea. excludes accrued interest

2. if bonds have possibility of default…a. specify obligations in event of default

3. also include special provisions if embedded options:a. callable bondsb. convertible bonds

4. contract can cover:a. individual bondb. portfolio of bonds

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VI. Characteristics of Eurodollar Time Deposit Market

A. Eurodollar Deposit

1. dollar denominated depositsa. in large banks

(i) outside US

B. LIBOR (London Interbank Offer Rate)

1. interest rate on dollar denominated loans

2. quoted as annualized rate a. based on 360 day year

3. an add-on rate Slide 3a. similar to a CDb. not a discount rate (like T-bill)

4. used as a reference rate for floating rate dollar-denominated loansa. used worldwide

5. 30 day LIBOR, 60 day LIBOR and 180 day LIBORa. for longer term floating rate loans:

(i) interest rate is reset periodically…(A) based on LIBOR at the time of reset

6. the equivalent rate on Euro denominated deposits:a. Euribor

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VII. Forward Rate Agreements

A. Characteristics of FRAs

1. forward contract to borrow / lenda. at particular rate

(i) in future

2. actually settle in casha. no actual loan is made

(i) essentially an interest rate bet(A) no credit issues

(ii) typically based on LIBOR

3. parties:a. long position

(i) party that would borrow the money(A) long the loan

(i) contract price is the interest rate on loan(ii) wins if interest rates increase

(A) contract to borrow at below mkt rate(B) receive payment

b. short position(i) party that would lend the money

(A) short the loan(ii) wins if interest rates decrease

(A) right to lend at above market rates

B. Calculating the Cash Settlement Payment of an FRA Slide 4

1. calculate the value of either:a. receiving a below market rate loanb. making an above market rate loan

2. the interest difference would come at the end of the loan perioda. b/c we think of interest as add-onb. so we calculate PV of interest "savings" (or "excess interest")

3. notes about FRA problems:a. terms of FRA and terms of "underlying loan" are often different

(i) settlement is usually multiple of 30 days(ii) mkt rate is usually some variation of LIBOR

b. e.g., 30 day FRA on 90-day LIBOR(i) settlement is 30 days from now(ii) payment at settlement is based on 90 day LIBOR

c. sometimes, terms are in # of months(i) the 30 day FRA on 90-day LIBOR would be:

(A) 1 x 4 FRA(ii) the 1 represents the # of months until FRA settles(iii) the 4 represents total time until interest payment

(A) note that this is not 3(1) 1 month from now we have

3 months to wait

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VIII. Currency Forward Contracts

A. Characteristics

1. agreement to exchange (in future):a. certain amount of one currency

for b. certain amount of another currency

2. contract will actually specify exchange ratea. that one party pays for fixed amount of other currency

3. e.g., need to exchange 5 million Euros for dollars in 90 daysa. receive a quote of USD0.97b. Long position:

(i) will purchase USD4.85MM for 5MM Euro(A) NOTE: $.97 x 5MM = $4.85MM

4. can be cash settled or physical deliverya. cash settlement is the net difference (based on current rates)

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Slide 1

Slide 1: Equity Index Forward Contract

A hedge fund wants to sell $10 million of the S&P 500 in 90 days.The manager asks for a quote so that he can enter into a short position.He wants this based on $10 million notional value.He receives a quote of 804 (this is based on the value of the S&P 500).At settlement, the S&P 500 is at 821.34.Calculate the amount that the manager pays or receives to settle the contract.

Step 1: Calculate the change in value as a percentage:

(821.34 - 804) = 2.1567%804

Step 2: Calculate the winning / losing payment:

2.1567% x $10MM = 215,671.64$

Step 3: Determine who makes payment and who receives payment:

Price increased, so long position wins -- receives payment

Think about it this way: he agreed to buy at 804 and whenthe time came, he could buy at 804 and sell at 821.34

Short party pays $215,671.64 to long party.

Hedge fund was short (they wanted to be able to sell at 804).

Slide 2

Slide 2: T-Bill Forward Contract

A forward on $100 million of T bills will have 80 days to maturity at settlementand is priced at 2.05 on a discount yield basis. Compute the dollar amount thatthe long party must pay at settlement.Assume physical delivery.

STEP 1: "un-annualize" the discount

2.05% x (80 / 360) = 0.004555556

STEP 2: calculate the dollar settlement price

(1 - .00455556) x $100MM = 99,544,444.44$

Long party will lose if interest rates increase.Long party will win if interest rates decrease.

Slide 3

Slide 3: Calculating Interest on LIBOR Based Loan

Calculate the interest on a $5MM loan for 30 days if 30 day LIBOR is quoted at 4%.

$5MM x 4% x (30 / 360) = 16,666.67$

The borrower would repay $5,016,666.67 at the end of 30 days.

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Slide 4: Forward Rate Agreement (FRA)

Examine an FRA with the following terms:

1. expires / settles in 60 days2. is based on a notional principal amount of $5MM3. is based on 90 day LIBOR4. specifies a forward rate of 4%

Assume that the actual 90 day LIBOR (60 days from now -- at expiration) is 4.5%.Compute the cash settlement payment at expiration and identify which party makes the payment.

STEP 1: Determine who wins.

The long can borrow at 4% even though the rate is 4.5% at settlement.

STEP 2: Determine the interest saved (or the excess interest).

(4.5% - 4%)(90 / 360) x $5MM = 6,250.00$

STEP 3: Calculate the present value of the savings.

6250 = 6,180.47$ 1 + (.045 x (90 / 360)

or…you could do this using your calculator

FV = 6250n = 1I = 1.125 note: I = 4.5% x (90 / 360) -- I turned the annual rate into periodic ratePV = ?

6,180.47$

Slide 5

Slide 5: Currency Forward

Your company expects to receive 20MM Euros three months from now.You enter into a cash settlement currency forward to exchange thoseEuros for USD at a USD1.25 per Euro.At settlement, the market exchange rate turns out to be USD1.27 perEuro.Describe the amount that your company pays or receives.

STEP 1: calculate how much the company will receive under the contract.

20MM EUR x 1.25 = 25MM USD

STEP 2: calculate how much the company would have received WITHOUTthe forward contract.

20MM EUR x 1.27 = 25.4MM USD

STEP 3: determine who makes payment.

Your company makes a payment of $400K.You agreed to receive 1.25 USD (per Euro) when rate turnedout to be 1.27USD.

NOTE: remember that Steps 1 and 2 didn't actually happen. In other words, we didn't exchange money based on thosesteps. These steps were simply the calcuation used to exchangemoney in step 3.