Lecture_4_Int_Rate_Deriv.pdf - Fixed Income Felix Matthys...

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Fixed Income Felix Matthys Lecture 4 Interest Rate Derivatives ITAM May 4, 2016
Outline 1 Forwards 2 Swaps 3 Futures 4 Options Felix Matthys Fixed Income ITAM 2 / 83
Forward Contract and Forward Rates Forward contract The forward contract or also called forward is a non -standardized agreement between to parties, where they agree today, to buy or to sell a security at a predetermined price in the future ( settlement date ). The predetermined price agreed upon today between the two parties is called the delivery price or the forward price which is exchanged for the asset at the settlement date. No money is exchanged at initiation of the contract. Since forward contracts are non - standardized and therefore not traded on an exchange, they are called over-the-counter ( OTC ) contracts. Forward contracts are usually used in order to hedge an exposed position or to speculate. The party that agrees to buy the asset holds a long position whereas the party that agrees to sell the assets holds a short position We denote by ( , ) = the forward price agreed upon today at time t , for settlement or delivery at time T > t . Felix Matthys Fixed Income ITAM 3 / 83
Forward vs. Spot Some more terminology: Transactions which occur today, in other words, settled immediately, are called spot (or sometimes also cash) transactions. Therefore, in a spot transaction, both money and securities change hands immediately. The current price of the underlying is usually referred to as the spot or sometimes cash price. We will use the notation S t for the price of the asset today at time t . Therefore, the future spot price at time T > t will be denoted by S T . Felix Matthys Fixed Income ITAM 4 / 83
Why do you want to use a forward contract? Suppose today t is April second, 2016 and you want to a transaction at a future date T , for instance August 31th, 2016. Assume that you hold an asset with current spot price S t that you would like to sell on the August 31th, 2016. You could wait until that future date and then do the transaction at the prevailing market price S T . In other words, you do a spot transaction in the future at time T . However, this will leave you with considerable price fluctuation risk as the market price of you asset will most likely move from today time t until August 31th, 2016. One way of eliminating this risk is to enter a forward contract today, to sell your asset in late August. In other words, you look in the terms of you transaction already today to fully eliminate any price movement risk. Felix Matthys Fixed Income ITAM 5 / 83

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