Finance Chapter 15 Forwards And Futures Exhibit The Relationship Between Spot And Forward Prices The

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CHAPTER 15

FORWARD, FUTURES, AND SWAP CONTRACTS

15.1 An Overview of Forward and Futures Trading (Exhibits 15.1, 15.2, 15.3)

▪ Forward contracts are agreements negotiated directly between two parties in the OTC

15.1.1 Futures Contract Mechanics

▪ Futures exchange requires each customer to post an initial margin account in the form of

cash or government securities when the contract is originated.

▪ Margin account is adjusted, or marked to market, at the end of each trading day, according to

15.1.2 Comparing Forward and Future Contracts

15.2 Hedging with Forwards and Futures

15.2.1 Hedging and the Basis

▪ The goal of a hedge transaction is to create a position that will offset the price risk of another

1. Defining the Basis

▪ Basis is the spot price minus the forward price for a contract.

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15.2.2 Understanding Basis Risk

15.2.3 Calculating the Optimal Hedge Ratio

1. Definition: The ratio of the spot and forward price standard deviations multiplied by the

correlation coefficient between the two series ()

15.3 Forward and Futures Contracts: Basic Valuation Concepts

15.3.1 Valuing Forwards and Futures (Exhibit 15.4)

15.3.2 The Relationship between Spot and Forward Prices

▪ In the absence of arbitrage opportunities, the forward contract price should be equal to the

15.4 Financial Forwards and Futures: Applications and Strategies (Exhibit 15.5)

▪ Originally, forward and futures markets were organized largely around trading agricultural

15.4.2 Long-Term Interest Rate Futures (Exhibit 15.6)

1. Treasury Bond and Note Contract Mechanics

▪ Both the T-bond and the longer-term T-note contracts traded at the CBOT call for the

delivery of $100,000 face value of the respective instrument.

3. Treasury Futures Applications: Hedging a Funding Commitment

15.4.3 Short-Term Interest Rate Futures (Exhibit 15.7)

▪ A rapidly expanding segment of the exchange traded market. Currently, investors can hedge

1. Eurodollar Contract Mechanics

15.4.4 Stock Index Futures

1. Stock Index Futures Contract Fundamentals (Exhibit 15.8)

▪ The underlying financial asset for a stock index futures contract is a hypothetical

2. Stock Index Futures Valuation and Index Arbitrage (Exhibit 15.9)

▪ Stock index futures often are used to convert entire stock portfolios into synthetic

3. Implementing an Index Arbitrage Strategy (Exhibit 15.10)

4. A Stock Index Futures Application: Isolating Unsystematic Risk

15.4.5 Currency Forwards and Futures

1. The Mechanics of Currency Transactions (Exhibits 15.11 and 15.12)

▪ Buyer and seller negotiate for the exchange of a certain amount of a predetermined

commodity at a fixed cash price.

2. A Currency Futures Application: Covered Interest Arbitrage

▪ Interest rate parity specifies the “no arbitrage” relationship between spot and forward FX

15.5 OTC Forward Contracts

15.5.1 Interest Rate Contracts (Exhibit 15.14)

1. Forward Rate Agreements (FRAs)

▪ Two parties agree today to a future exchange of cash flows based on two different interest

2. Interest Rate Swaps (Exhibits 15.15, 15.16, 15.17, 15.18, 15.19, 15.20)

▪ Investors and borrowers are routinely exposed to interest rate movements at regular intervals

15.5.2 Equity Index-Linked Swaps (Exhibit 15.21)

▪ Equity swaps are equivalent to portfolios of forward contracts calling for the exchange of