Fixed Income and Credit Risk

Prof. Michael Rockinger

B - 3 - Forward Products:
Forwards and Futures

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Learning Objectives

Forwards and Futures

Definitions

No-arbitrage price of a Forward

Formula of a forward contract on a Bond

Futures Contracts

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Forward contracts
A forward contract is a non-cash contract between two counterparties agreed
upon today (time t = 0) about exchanging a given security at a predetermined
forward price Pfwd (0, T) at a given future date T

Forward price Pfwd (0, T) is a price for a delivery at T of a security that

matures at some later date

We denote by P(T) the (spot) value of the underlying security at the delivery
date T

The payoff at T of being long the forward contract is:

P(T) − Pfwd (0, T)

Same expression as in the simple case of cows. Meuh!

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Forward contracts

Determination of the forward price of asset is obtained by considering strategies

with identical payoffs

One can get physically the bond which will be worth P(T) at time T by
purchasing the bond for a price P(0) at t = 0

One can also get the bond by paying a forward price of Pfwd (0, T) at T . At
t = 0 this is worth Z(0, T) · Pfwd (0, T)

Hence, in a non-arbitrage world, must be that

Z(0, T) · Pfwd (0, T) = P(0) ⇒ Pfwd (0, T) = P(0) · Z(0, T)−1

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Forward contracts
To establish the value of the contract at some late date, one needs to ask how
one could obtain the payoff
P(T) − Pfwd (0, T)
by some trading strategy

At time t if one purchases the bond at market price P(t) one is certain to get
the value of the bond at time T worth P(T)

The discounted value of Pfwd (0, T) at t is Z(t, T) · Pfwd (0, T)

Hence, at t value is
P(t) − Z(t, T) · Pfwd (0, T)

Since at t there is a new forward price Pfwd (t, T) = P(t) · Z(t, T)−1 one can
also write the value of the contract as:
 
V(t, T) = Z(t, T) · Pfwd (t, T) − Pfwd (0, T)

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Valuation of a forward contract on a bond

t=0 T1 T2 Tm
- Time
6 ? ? ?
c · 100 c · 100 (1 + 2c ) · 100
P(0) 2 2

Contract matures at T : 0 < T < T1 .

Bond pays semi-annual coupon c

2 · 100 at times Ti for i = 1, · · · , m. Maturity
of bond is at time Tm

Denote the set of all future payment dates by T = {T1 , · · · , Tm }

rewrite bond forward price as Pfwd (0, T, T)

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Valuation of a forward contract on a bond
Must have that
c c
Pfwd (0, T, T) Z(0, T) = · 100 · Z(0, T1 ) + · · · + · 100 · Z(0, Tm ) + 100 · Z(0, Tm )
2 2

This implies that:

c Z(0, T1 ) c Z(0, Tm ) Z(0, Tm )

Pfwd (0, T, T) = · 100 · + · · · + · 100 · + 100 ·
2 Z(0, T) 2 Z(0, T) Z(0, T)

recognize in the ratios of df the forward price in interest rate

c c
Pfwd (0, T, T) = · 100 · F(0, T, T1 ) + · · · + · 100 · F(0, T, Tm ) + 100 · F(0, T, Tm )
2 2

Forward bond price is obtained by discounting the future cash flows from the
future payment dates to the maturity date of the forward

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Valuation of an existing forward contract on a bond at
0<t<T

Suppose that 0 < t < T then

c c
Pfwd (t, T, T) Z(t, T) = · 100 · Z(t, T1 ) + · · · + · 100 · Z(t, Tm ) + 100 · Z(t, Tm )
2 2

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Valuation of a forward contract on a bond at 0 < t < T

The value of the forward contract for every τ s.t. 0 < t < T is equal to (results
from slide 5)
 
V fwd (t, T) = Z(t, T) Pfwd fwd
c (t, T, T) − Pc (0, T, T) .

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Futures contracts

Futures contracts, similarly to forward contracts, are contractual

agreements between two counterparties to deliver a certain security
or cash at maturity and for a predetermined price, called futures
price.

Yet, there are important differences:

Futures contracts are traded on a regulated exchange (e.g. CME),
which defines the characteristics of the contract, acts as counterparty
to investors, and guarantees that payments will be honored at maturity.

The security underlying the futures contract is standardized, there is

no room for customized requests from clients.

Profits and losses are marked-to-market daily, meaning that they

accrue over time to short and long traders with daily frequency.

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