Académique Documents
Professionnel Documents
Culture Documents
Definition
forward contract is an agreement between two parties in which one party, the
buyer; agrees to buy from the other party, the seller; an underlying asset or
other derivative, at a future date at a price established at the start of the
contract.
The buyer is often called the long.
Seller is often called the short
Default Risk
Termination of the contract
Consider an FRA expiring in 90 days for which the underlying is 180-day LIBOR.
Suppose the dealer quotes this instrument at a rate of 5.5 percent and notional
principal is $10 million. Suppose that at expiration in 90 days, the rate on 180-day
LIBOR is 6 percent.
Present value of this amount would be
Price is the fixed price or rate at which the transaction scheduled to occur at
expiration will take place. This price is agreed to on the contract initiation date and
is commonly called the forward price or forward rate. Pricing means to determine
the forward price or forward rate.
Valuation, however, means to determine the amount of money that one would need
to pay or would expect to receive to engage in the transaction.
Many stocks pay dividends during the life of contracts so their effect should be
adjusted.
Suppose if there is a stream of dividends that would be received during the life of
contract is
that will occur at
then there present value would
be
Continued
Example
Consider a stock priced at $40, which pays a dividend of $3 in 50 days. The riskfree rate is 6 percent. A forward contract expiring in six months (T = 0.5) would
have a price of
Suppose if risk-free rate is 4 percent. The forward contract expires in 300 days and
is on a stock currently priced at $35, which pays quarterly dividends according to
the following schedule:
Continued
Continued
where
Example
Consider a forward contract on France's CAC 40 Index. The index is at 5475, the
continuously compounded dividend yield is 1.5 percent, and the continuously
compounded risk-free interest rate is 4.625 percent. The contract life is two years.
With T = 2, the contract price is, therefore,
Example
Consider a bond with semiannual coupons. The bond has a current maturity of 583 days and
pays four coupons, each six months apart. The next coupon occurs in 37 days, followed by
coupons in 219 days, 401 days, and 583 days, at which time the principal is repaid. Suppose
that the bond price, which includes accrued interest, is $984.45 for a $1,000 par, 4 percent
coupon bond. The coupon rate implies that each coupon is $20. The risk-free interest rate is
5.75 percent. Assume that the forward contract expires in 310 days. The present value of the
coupons is
Now assume it is 15 days later and the new bond price is $973.14. Let the risk-free interest
rate now be 6.75 percent. The present value of the remaining coupons is
Payoff on the FRA can be found by multiplying the notional amount with the following
Example
Continued.
Assume that we go long the FRA, and it is 25 days later. We need to assign a value
to the FRA First note that g = 25,h - g = 90 - 25 = 65,andh+ m - g = 90 + 180 - 25 =
245. Let the rates are