5.69: Forward Markets and Contracts
FRAs for non-standard periods (a 45-day FRA or 132-day LIBOR)
are termed off-the-run FRAs
A "forward rate agreement" can be viewed as a forward contract to borrow/lend money at a certain rate...
at some future date; in practice, these contracts settle in cash, but no actual loan is made at the settlement date.
Dividends are usually not included in equity forward contracts...
As the uncertainty about dividend amounts and payment dates is small compared to the uncertainty about future equity prices.
The "end user of a forward contract" is typically...
A corporation, government unit, or nonprofit institution that has existing risk they wish to avoid by locking in the future price of an asset.
What are examples of FRAs?
Expires/settles in 30 days; Is based on a notional principal amount of $1M; Is based on 90-day LIBOR; Specifies a forward rate of 5% .
A forward contract is what?
It's a bilateral contract that obligates one party to buy and the other to sell a specific quantity of an asset, at a set price, on a specific date in the future.
The lending rate on dollar-denominated loans between banks is called what?
It's called the London Interbank Offered Rate (LIBOR)
LIBOR is quoted as what?
It's quoted as an annualized rate based on a 360-day year.
Eurodollar deposit is what?
It's the term for deposits in large banks outside the U.S. denominated in USD.
In contrast to a T-bill discount yields, LIBOR is an "add-on rate," like a yield quote on a short-term certificate of deposit...
LIBOR is used as a reference rate for floating rate U.S. dollar-denominated loans worldwide.
The bid/ask spread between the 2 is the dealer's compensation for administrative costs as well as bearing default risk and any asset price risk from unbalanced (unhedged) positions.
OK
The forward contract is used to eliminate uncertainty about the future price of an asset it plans to buy or sell at a later date.
OK
The only difference between this type of forward contract and several forward contracts each covering a single stock, is that the pricing would be better (a higher total price) for the portfolio because overall administration/origination costs would be less for the portfolio forward contract.
OK
The price specified in forward contracts on coupon-bearing bonds is typically stated as a YTM as of the settlement date, exclusive of accrued interest.
OK
The term of the FRA and the term of the underlying "loan" need not be the same and are NOT interchangeable.
OK
There is 30-day LIBOR, 90-day LIBOR, and 180 LIBOR depending on the term of the loan.
OK
To calculate the cash payment at settlement for a forward rate agreement, we need to calculate the value as of the settlement date of making a loan at a rate that is either above or below the market rate.
OK
Typically, neither party to the contract pays anything to get into the forward contract.
OK
Under the terms of a "currency forward contract," one party agrees to exchange a certain amount of one currency for a certain amount of another currency at a future date.
OK
While equities do not have a maturity date, bonds do, and the forward contract must settle before the bond matures.
OK
While the settlement date for an FRA can be any future date, in practice it is usually some multiple of 30 days.
OK
1+ (floating) (days/360)
This denominator is the discount factor.
(floating - forward) (days/360)
This numerator is the "interest savings" in percent
There is an equivalent Euro lending rate called Euribor, established in Frankfurt, which is published by...
the ECB (European Central Bank)
The party to the forward contract that agrees to sell or deliver the asset has...
a "short forward position" and is called the "short."
A dealer's quote desk will quote a buying price and a slightly higher selling price
OK
A forward contract on stock index is similar except that the contract will be based on a notional amount and will very likely be a cash-settlement contract.
OK
A party to a forward contract can "terminate the position" prior to expiration by entering into an opposite forward contract with an expiration date equal to the time remaining on the original contract.
OK
A portfolio manager who wishes to sell a portfolio of several stocks 60 days from now can similarly request a quote, giving the dealer the company names and the number of shares of each stock in the portfolio.
OK
As with other forward contracts, the cash settlement amount is the amount necessary to compensate the party who would be disadvantaged by the actual change in market rates as of the settlement date.
OK
At any point in time, including the settlement date, only one party to the forward contract will "owe" money, meaning that the side of the contract has a negative value.
OK
Currency forward contracts can be deliverable or settled in cash.
OK
Dealers are often banks, but can also be nonbank financial institutions such as securities brokers.
OK
Dealers will also enter into contracts with other dealers to hedge a net long or net short position.
OK
Each party to a forward contract is exposed to a "default risk" or "counterparty risk>"
OK
Equity forward contracts where the underlying asset is a single stock, a portfolio of stocks, or a stock index work in much the same manner as other forward contracts.
OK
For longer-term floating-rate loans, the interest rate is reset periodically based on the then-current LIBOR for the relevant period.
OK
For the "cash settlement" method, the party that has a position with negative value is obligated to pay that amount to the other party.
OK
Forward contracts on short-term, zero-coupon bonds and coupon interest-paying bonds are quite similar to those on equities.
OK
If the contract is on bonds with the possibility of default, there must be provisions in the contract to define default and specify the obligations of the parties in the event of default.
OK
If the expected future price of the asset increases over the life of the contract, the right to buy at the contract price will have positive value, and the obligation to sell will have an equal negative value.
OK
If the floating rate underlying the agreement turns out to be below the forward rate specified in the contract, the numerator in the formula is negative and the short receives a payment from the long.
OK
If the future price of the asset falls below the contract price, the results is opposite and the right to sell (at an above-market price) will have a positive value.
OK
If the reference rate at the expiration date is below the contract rate, the short will receive a cash payment from the long.
OK
If the short's new forward contract is with a different party than the first forward contract, some "credit risk" remains.
OK
It is unusual for any cash to actually be exchanged at the inception of a forward contract unlike futures contracts in which each party posts an initial deposit (margin) as a guarantee of performance.
OK
More often, a party seeks to enter into a forward contract to hedge a risk it already has.
OK
On the expiration (or settlement) date of the contract, the long receives a payment if the price of the asset is above the agreed-upon (forward) price; the short receives a payment if the price of the asset is below the contract price.
OK
Parties may enter into the contract as a speculation on the future price.
OK
Since forward contracts are custom instruments, the parties could specify a total return value (including dividends) rather than simply the index value.
OK
Since the interest savings would come at the end of the "loan" period, the cash payment at settlement of the forward is the present value of the interest "savings."
OK
Special provisions must also be included if the bonds have embedded options such as call features on conversion features.
OK
Forward contracts can be constructed covering...
individual bonds or portfolios of bonds.
The party to the forward contract that agrees to buy the financial or physical assets has a "long forward position" and is called a...
long
LIBOR is published daily by the British Banker's Association and is compiled from..
quotes from a number of large banks; some are large multinational banks based in other countries that have London offices.
The long position in an FRA is...
the party that would borrow the money.
