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27 views22 pages

Forwards

Uploaded by

Ky Diaz
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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DETERMINATIO

N OF FORWARD
PRICE
FORWARD CONTRACT

• Refers to an agreement
between parties to buy or sell
an underlying asset on an
agreed-upon date and price
INVESTMENT
ASSETS
• Is an asset that is held for CONSUMPTION
investment purposes by at
least some traders ASSETS
• Example: Stocks and bonds • Is an asset that is held primarily for
consumption
• It is normally held for investment
• Example: commodities such as
copper, crude oil, corn, pork bellies
• Involves selling an
asset that is not
SHORT owned.
• It is something that is
SELLIN possible for some but
G not all investment
assets
• Suppose an investor instructs a broker to
short 500 shares of company X
• The broker will carry out the instructions
by borrowing the shares from someone
who owns them and selling them in the
ILLUSTRATIO market in the usual way
• At some later stage, the investor will
N close out the position by purchasing 500
shares so that the short position is close
out.
• The investor takes profit if the stock price
has declined and a loss if it has risen
ASSUMPTION

• The market participants are subject to no


transaction costs when they trade.
• The market participants are subject to
the same tax rate on all net trading
profits.
• The market participants can borrow
money at the same risk-free rate of
interest as they can lend money.
• The market participants take advantage
of arbitrage opportunities as they occur.
NOTATIO
•
•
T : Delivery date (in years)
So : Underlying asset’s current spot price
N
• Fo : Contract Forward price
• R : Zero-coupon risk-free rate of interest
per annum, expressed with continuous
compounding, for an investment maturing
at the delivery date (i.e., in T years).
• e : the mathematical irrational constant
approximated by 2.7183
NO
INCOME
• The easiest forward
contract to value is one
written on an
investment asset that
provides the holder
• Examples: Non-
dividends stocks and
zero-coupon bonds
No Income

Risk free rate


Time to maturity

Forward price
Underlying Asset
QUESTION 1:

• Consider a long forward contract to purchase a non-dividend paying


stock in 3 months.
• Assume the current stock price is $40 and the 3-month risk-free
interest rate is 5% per annum
• Suppose that the forward price s $43. An Arbitrageur can borrow $40
at the risk-free interest rate of 5% per annum by one share, and short
forward contract to sell one share in 3 months.
QUESTION 2:

• Consider a long forward contract to purchase a non-dividend paying


stock in 3 months.
• Assume the current stock price is $40 and the 3-month risk-free
interest rate is 5% per annum
• Suppose that the forward price is $39. An Arbitrageur can short one
share, invest the proceeds of the short sale at 5% per annum for 3
months, and take long position in a 3 month forward contract.
QUESTION 3:
KNOWN
INCOME
• A forward contract on
an investment asset
that will provide a
perfectly predictable
cash income to the
holder
• Examples: dividends
and coupon bearing
bonds
Income

Risk free rate


Time to maturity

Forward price
Income
Underlying Asset
QUESTION 1:

• Consider a long forward contract to purchase a coupon-bearing bond


whose current price is $900.
• Suppose that the contract matures in 9 months.
• Suppose that a coupon payment of $40 is expected after 4 months.
• Assume that 4 months and 9 months risk free interest rate are
respectively 3% and 4% per annum.
• Suppose that the forward price is $910. An Arbitrageur can borrow
$900 to buy the bond and short a forward contract. The coupon
payment has a present value of 40e^-.03x4/12=$39.60.
QUESTION 2:
• Consider a long forward contract to purchase a coupon-bearing bond whose
current price is $900.
• Suppose that the contract matures in 9 months.
• Suppose that a coupon payment of $40 is expected after 4 months.
• Assume that 4 months and 9 months risk free interest rate are respectively
3% and 4% per annum.
• Suppose that the forward price is $870. An Investor can short the bond and
enter into a long forward contract.
• Of the $900 realized from shorting the bond, $39.60 is invested for 4 months
at 3% per annum so that it grows into an amount sufficient to pay the
coupon on the bond. The remaining $860.40 is invested for 9 months at 4%
per annum and grows to $886.60
KNOWN
YIELD
• Consider a situation
where the asset
underlying a forward
contract provides a
known yield rather than
known cash income
• The income is express
in percentage
YIELD

Risk free rate


Time to maturity

Forward price AVE. YIELD

Underlying Asset
VALUING FORWARD CONTRACT
• The value of a forward contract at the time it is
first entered into is close to zero
• At later stage, it may prove to have a positive or
negative value.
• It is important for banks and other financial
institutions to value the contract each day.

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