Forward Contracts Lecture

Forward Contracts Lecture - Debt Instruments and Markets...

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Debt Instruments and Markets Professor Carpenter Forward Contracts and Forward Rates 1 Forward Contracts and Forward Rates Outline and Readings Outline Forward Contracts Forward Prices Forward Rates Information in Forward Rates Buzzwords - settlement date, delivery, underlying asset - spot rate, spot price, spot market - forward purchase, forward sale, forward loan, forward lending, forward borrowing, synthetic forward - expectations theory, term premium Reading Veronesi, Chapters 5 and 7 Tuckman, Chapters 2 and 16
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Debt Instruments and Markets Professor Carpenter Forward Contracts and Forward Rates 2 Forward Contracts A forward contract is an agreement to buy an asset at a future settlement date at a forward price specified today. – No money changes hands today. – The pre-specified forward price is exchanged for the asset at settlement date. By contrast, an ordinary transaction that settles immediately is called a spot or cash transaction, and the price is called the spot price or cash price. Motivation Suppose today, time 0, you know you will need to do a transaction at a future date, time t . One thing you can do is wait until time t and then do the transaction at prevailing market prices - i.e., do a spot transaction in the future. Alternatively, you can try to lock in the terms of the transaction today - i.e., arrange a forward transaction today .
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Debt Instruments and Markets Professor Carpenter Forward Contracts and Forward Rates 3 What is the fair forward price? In some cases, the forward contract can be synthesized with transaction in the current spot market. In that case, no arbitrage will require that the contractual forward price must be the same as the forward price that could be synthesized. Synthetic Forward Price For example, if the underlying asset doesn’t depreciate, make any payments, or entail any storage costs or convenience yield, the synthetic forward price of the asset is Spot Price + Interest to settlement date How to synthesize? – Buy the asset now for the spot price. – Borrow the amount of the spot price, with repayment on the settlement date – You pay nothing now, and you pay the spot price plus interest at the settlement date.
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Debt Instruments and Markets Professor Carpenter Forward Contracts and Forward Rates 4 Synthetic Forward Contract on a Zero Suppose r 0.5 =5.54%, d 0.5 =0.9730, r 1 =5.45%, and d 1 =0.9476. Synthesize a forward contract to buy $1 par of the zero maturing at time 1 by 1) buying $1 par of the 1-year zero and 2) borrowing the money from time 0.5 to pay for it: 1) -0.9476 +1 2) +0.9476 ? Net: 0 -F = ? +1 |------------------------------|--------------------------| 0 0.5 1 Class Problem : What is the no-arbitrage forward price F? Arbitrage Argument Class Problem : Suppose a bank quoted a forward price of 0.98. How could you make arbitrage profit?
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Debt Instruments and Markets Professor Carpenter Forward Contracts and Forward Rates 5 In general, suppose the underlying asset is $1 par of a zero maturing at time T .
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