Forward Contracts
Bilateral contract - typically no cost to enter (whereas futures require margin posting to guarantee performance)
If expected future price of the asset goes up, right to buy at the contract price will increase in value.
Usually entered into to hedge a current risk
Party that agrees to buy has a LONG FORWARD position - the long of the contract
Party that sells or deliveres has the SHORT FORWARD position - the short of the contract
In a forward, one side owes and the other side is owed the equal amount.
Cash settlement - just pay the difference to the other party.
Termination - enter into opposite forward contract. You lock in your current loss, and enter into an agreement to buy one at one price and sell one at another price at the settlement date.
Problem though - if you are with another counterparty, you now have credit risk.
Alternative is to just enter into the offsetting contract with the original counterparty. In fact the equivalent would be to pay present value of the difference to the other party. If required payment is larger than this, must consider whether to pay it or take on additional credit risk.
Dealer vs. End User - end users are corporations, govt units, institutions. Dealers are banks and non-bank financial institutions who make markets and profit from the bid/ask spreads.
Equity forward contract - can do both for equities and for portfolios. Usually excludes dividends but can include these too. If price of equity goes up, short must pay the difference to the long, and vice versa.
On bonds must settle forward contracts before the maturity date. For Zero Coupons, settlement price is based on the discount. E.g. 90 day T-bill quoted at 4% discount basis yield means discount is 4% * 90/360 = 1%, so the price is 99. On coupon bearing bonds, price is usually stated as YTM exclusive of accrued interest.
Eurodollar Deposit - deposits OUTSIDE the US denominated in Dollars. Lending rate of these deposits is LIBOR. 360 day yr. EURIBOR is the equivalent rate for Euros, published by ECB.
Forward Rate Agreement - a forward contract to borrow or lend money at a certain rate at some future date. In practice these settle in cash (no actual loan is ever made). Creditworthiness is not an issue except for settlement amount to be paid.
Bilateral contract - typically no cost to enter (whereas futures require margin posting to guarantee performance)
If expected future price of the asset goes up, right to buy at the contract price will increase in value.
Usually entered into to hedge a current risk
Party that agrees to buy has a LONG FORWARD position - the long of the contract
Party that sells or deliveres has the SHORT FORWARD position - the short of the contract
In a forward, one side owes and the other side is owed the equal amount.
Cash settlement - just pay the difference to the other party.
Termination - enter into opposite forward contract. You lock in your current loss, and enter into an agreement to buy one at one price and sell one at another price at the settlement date.
Problem though - if you are with another counterparty, you now have credit risk.
Alternative is to just enter into the offsetting contract with the original counterparty. In fact the equivalent would be to pay present value of the difference to the other party. If required payment is larger than this, must consider whether to pay it or take on additional credit risk.
Dealer vs. End User - end users are corporations, govt units, institutions. Dealers are banks and non-bank financial institutions who make markets and profit from the bid/ask spreads.
Equity forward contract - can do both for equities and for portfolios. Usually excludes dividends but can include these too. If price of equity goes up, short must pay the difference to the long, and vice versa.
On bonds must settle forward contracts before the maturity date. For Zero Coupons, settlement price is based on the discount. E.g. 90 day T-bill quoted at 4% discount basis yield means discount is 4% * 90/360 = 1%, so the price is 99. On coupon bearing bonds, price is usually stated as YTM exclusive of accrued interest.
Eurodollar Deposit - deposits OUTSIDE the US denominated in Dollars. Lending rate of these deposits is LIBOR. 360 day yr. EURIBOR is the equivalent rate for Euros, published by ECB.
Forward Rate Agreement - a forward contract to borrow or lend money at a certain rate at some future date. In practice these settle in cash (no actual loan is ever made). Creditworthiness is not an issue except for settlement amount to be paid.
- Long position = the would be borrower. They benefit if rates go up because they can borrow at a cheaper rate.
- Short position = the would be lender. They benefit if rates go down because they can lend at above market rates.
Cash payment for settlement of a FRA is the PV of the interest 'savings.'
Currency Forward Contracts
Agree to exchange a certain amount of one currency for certain amount of another at a future date. Can be deliverable or settled in cash.
You lock in at a current rate, and transfer the risk to another party. At settlement, if you have gained, you have to give that gain to the counterparty. If you have lost, the counterparty must pay you.
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