L3 Financial Derivatives MBA

FINANCIAL DERIVATIVES FINC 612
FINANCIAL FORWARDS CONTRACTS
Saint Kuttu, PhD
Saint Kuttu, PhD 1

Alternative Ways to Buy a Stock
Four different payment and receipt timing combinations

Outright purchase: ordinary transaction
Fully leveraged purchase: investor borrows the full amount
Prepaid forward contract: pay today, receive the share later
Forward contract: agree on price now, pay/receive later
Payments, receipts, and their timing
Saint Kuttu, PhD 2

Pricing Prepaid Forwards
If we can price the prepaid forward (FP), then we can
calculate the price for a forward contract
F = Future value of FP
Three possible methods to price prepaid forwards
Pricing by analogy
Pricing by discounted present value
Pricing by arbitrage
For now, assume that there are no dividends
Saint Kuttu, PhD 3

Pricing Prepaid Forwards (contd)
Pricing by analogy
In the absence of dividends, the timing of delivery is irrelevant
Price of the prepaid forward contract same as current
stock price
F P 0,T S0 (where the asset is bought at t = 0, delivered at t = T)
Pricing by discounted preset value
(a: risk-adjusted discount rate)
If expected t=T stock price at t=0 is E0(ST), then

F P 0,T E0 (ST )ea T
Since t=0 expected value of price at t=T is E0 (ST ) S0 ea T
Combining the two,
Saint Kuttu, PhD 4

Pricing by arbitrage
Arbitrage: a situation in which one can generate positive cash flow by
simultaneously buying and selling related assets, with no net investment
and with no risk free money!!!
If at time t=0, the prepaid forward price somehow exceeded the stock
price, i.e., F P
0,T S , an arbitrageur could do the following
0
Since, this sort of arbitrage profits are traded away quickly, and cannot
persist, at equilibrium we can expect: F P S
0,T 0
Saint Kuttu, PhD 5

What if there are dividends? Is F P 0,T S0
still valid?
No, because the holder of the forward will not

receive dividends that will be paid to the holder
of the stock F P 0,T S0
F P 0,T S0 PV (all dividends paid from t=0 to t=T)
Saint Kuttu, PhD 6

Example 5.1
XYZ stock costs $100 today and is expected to
pay a quarterly dividend of $1.25. If the risk-
free rate is 10% compounded continuously,
how much does a 1-year prepaid forward cost?
F p 0,1 $100 4 i 1 $1.25e0.025i $95.30
Saint Kuttu, PhD 7

For discrete dividends Dti at times ti, i = 1,., n

The prepaid forward price:
F P 0,T S0 ni1PV0,ti (Dti )
For continuous dividends with an annualized yield d,

the prepaid forward price is
F P 0,T S0 ed T
Saint Kuttu, PhD 8

Example 5.2
The index is $125 and the dividend yield
is 3% continuously compounded. How
much does a 1-year prepaid forward cost?
F P 0,1 $125e0.03 $121.31
Saint Kuttu, PhD 9

Pricing Forwards on Stock
Forward price is the future value of

the prepaid forward price
No dividends F0,T FV (F P 0,T ) FV (S0 ) S0 erT
Continuous dividends F0,T S0e( r d )T
Saint Kuttu, PhD 10

Pricing Forwards on Stock (contd)
Forward premium
The difference between current forward price
and stock price
Can be used to infer the current stock price
from forward price
Definition
Forward premium =
Annualized forward premium =
Saint Kuttu, PhD 11

Creating a Synthetic Forward
One can offset the risk of a forward by creating a synthetic
forward to offset a position in the actual forward contract
How can one do this? (assume continuous dividends at rate d)
Recall the long forward payoff at expiration: = ST F0, T
Borrow and purchase shares as follows
Note that the total payoff at expiration is same as

forward payoff
Saint Kuttu, PhD 12

Creating a Synthetic Forward (contd)
The idea of creating synthetic forward leads to following
Forward = Stock zero-coupon bond
Stock = Forward + zero-coupon bond
Zero-coupon bond = Stock forward
Cash-and-carry arbitrage: Buy the index, short the forward
Saint Kuttu, PhD 13

Thank You for Your Attention
Saint Kuttu, PhD 14

Financial Forwards Contracts
17/02/2017 Saint Kuttu, Ph.D. 15

Forwards Contracts
A forward is a contract between two parties,
where one (the long position) has the obligation
to buy, and the other (the short position) has an
obligation to sell an underlying asset at a fixed
price (established at the inception of the contract)
at a future date.
Typically, no cash changes hands at inception.

Market participants usually enter forward
contracts to hedge a pre-existing risk.

Forwards Contracts
The party that enters the forward contract with
the obligation to buy the underlying asset is said
to have taken a long position, while the party with
the obligation to sell the underlying asset has
taken a short position.
The long position benefits when the price of the

underlying asset increases, while the short
benefits when the price of the underlying asset
falls.

Forwards Contracts
Suppose that Jane enters a forward contract with
Michael to buy a share of GGLE stock after 30
days for 600. Jane has a long position while
Michael has a short position.
Neither of them pays any money to enter this
forward contract. There are two ways to settle the
forward contract at expiration.
We will illustrate the two settlement methods
assuming that GGLE stock is valued at 800 at
the settlement date (after 30 days).

Forwards Contracts
Jane pays Michael 600 and gets the GGLE

share (underlying asset) in return. This mode of
settlement is called delivery. The price increase
is beneficial for Jane (long position) because
she is able to acquire the share from Michael for
600, when its market value is higher ( 800).

Forwards Contracts
Michael pays 200 to Jane, which equals the
difference between the price of GGLE stock at
contract expiration ( 800), and the agreed
upon forward price ( 600). This method of
settlement is known as cash settlement (Non
Deliverable Forwards). Cash settlement is
usually the preferred method of settlement in
situations where it is impractical to deliver the
underlying asset.

Forwards Contracts
It is important to understand the element of
counterparty risk in forward contracts. If the party
that is adversely affected by price movements
defaults on its commitment, the counterparty with
the favourable position faces default risk.
This is true for both deliverable and cash settled

forward contracts. In our example, if Michael fails
to perform on his obligations under the forward
contract, Jane effectively loses the 200 gain.

Forwards Contracts
Sometimes a party to a forward contract may
want to exit her position before expiration of the
forward contract. Suppose that 20 days into the
forward contract (10 days before expiration)
GGLE shares have risen in value, and Michael
wants to exit his short position on the forward.
He can achieve this by entering into the opposite

position (long position) in another forward
contract on the same underlying asset (GGLE
stock), which expires at the same point in time as
the original contract (in another 10 days).
Forwards Contracts
Lets assume that Michael gets into this second
contract with Alice at a forward price of 750.
Michael now holds positions on two forward
contracts:
1. He has committed to sell GGLE stock for 600
to Jane in another 10 days and;
2. He has committed to buy GGLE stock for 750
from Alice in another 10 days.
Effectively, Michael has entirely eliminated any
exposure to changes in price of GGLE stock over
the next 10 days, and locked in a loss of 150
( 750 - 600).
Forwards Contracts
However, by entering the second forward,
Michael may have eliminated his exposure to
GGLEs stock price, but now he faces more credit
risk than he did earlier.
At expiration, under normal circumstances, Alice

would deliver a share of GGLE to Michael that he
would forward to Jane. However, if GGLEs stock
price rises further, Michael faces the risk that
Alice might not honour her commitment.

Forwards Contracts
For example, if GGLEs stock price shoots up to
800 at contract expiration, and Alice defaults,
Michael would have to bear a further loss of 50
to honour his commitment to Jane.
If Michael is able to enter the second contract

also with Jane, he can eliminate his exposure to
GGLE stock price risk and counterparty credit risk

Forwards Contracts
If Jane were willing to take the short position in
the second contract at a forward price of 750,
Michael could pay her the present value of 150
to exit the position immediately and close the
contract.
If Jane were only willing to terminate the contract

for a payment in excess of the present value of
150, Michael would then have to weigh the cost
of paying that little extra to Jane, against the
benefit of entirely eliminating counterparty risk.

Dealer and an End user of a forward
contract
The end users of forward contracts are usually
corporations, non-profit organisations and
government units that want to reduce or eliminate
an existing risk by locking in the future price of an
asset.
For example, suppose that a French company

will receive a large amount of dollars in 30 days,
and is worried about the dollar losing its value
against the euro in the interim. The company will
enter into a forward agreement to sell dollars (or
buy Euros) in 30 days to hedge the risk.
contract
Dealers in forward markets include banks and
non-banking financial institutions. When an end
user wants to enter a forward, dealers stand
ready to take either side of the transaction.
They quote bid and ask prices, where the bid is

the price that they are willing to buy the
underlying asset for in the future and the ask is
the price at which they are willing to sell the asset
in the future.

contract
Ask prices are slightly higher than the bid prices,
and the spread between bid and ask prices
represents the dealers compensation for
administrative costs, default risk, and any asset
price risk from unhedged positions.
Dealers try to balance their overall long and short

positions. In cases where their positions do not
balance, they enter into contracts with other
dealers to hedge any net long or short positions.

The Effect of Dividends in Equity Forwards
It is important to point out that equity forward
contracts usually do not include the effect of
dividends.
However, because equity forward contracts are

customised instruments, parties can specify that
they be based on total return, which includes
dividends, rather than on the index return, which
only accounts for price appreciation.

The Effect of Dividends in Equity Forwards
Although basing forwards on total return seems
more attractive, it is not usually the case.
The variability of stock prices is so much greater

than variability of dividends that investors are
more concerned with managing price risk than
managing the uncertainty of dividends.

Bond Forward Contracts
Bond forward contracts can be written on
individual bonds, a bond portfolio or a bond
index.
The mechanics of bond forward contract are

somewhat similar to those of equity forwards, but
there are some essential differences:

Bond Forward Contracts
Unlike stocks, bonds have terms to maturity.
Therefore, forwards on bonds must be settled before
the underlying bonds mature.
Bonds can have special features such as embedded

calls and conversion options. A forward contract on
such bonds must make provisions for these features.
Bonds carry the possibility of default so a bond

forward contract should specify the definition of a
default, and the implications of a default on both
parties.
Forward Contracts on T-Bills
In a forward contract on T-bills, the long commits to
purchase T-bills from the short at a future date
(which must be before the bills maturity) at a
specified price. This forward price is quoted in terms
of discount interest.
Consider a forward contract on a T-bill that will have

100 days to maturity at the time of forward contract
settlement. This forward is priced at 1.96% on a
discount yield basis. How much will the long have to
pay for delivery at settlement if the underlying
assets are T-bills worth $1,000,000?
The forward price quote (1.96%) is in terms of
discount interest. Discount interest is the
percentage annualised discount on par based on a
360-day year. Determining the value that the long
will pay for the bonds at contract expiration is a two-
step process:
Unannualize the discount based on a 360-day year:
Apply the discount to the face value of the

underlying:

For forwards on T-bills, if interest rates increase,

discount interest increases. This implies a reduction
in T-bill prices, which benefits the short position.

Forward Contracts on Treasury Bonds
Forward contracts on coupon-bearing bonds are
quoted at their yields to maturity (YTMs), as of the
settlement date.
Coupon-bearing bonds (the underlying in forwards

on Treasury bonds) make semi-annual interest
payments and can sell for more (less) than par if
yields are lower (higher) than their coupon rates.
Prices are usually quoted exclusive of accrued

interest, so full prices (prices inclusive of accrued
interest) must be calculated.
Eurodollar time deposit
Eurodollar deposits are dollar-denominated
deposits outside the United States. Banks borrow
dollars from other banks by issuing Eurodollar time
deposits, which are essentially short term
unsecured loans.
In London, these loans are issued at a rate called

the London Interbank Offered Rate (LIBOR). LIBOR
is an annualized rate based on a 360-day year.
However, unlike the T-bill market where interest is
deducted from principal, LIBOR is an add-on rate
where the interest is added on to face value.
For example, suppose that ABC Bank borrows $1
million from XYX Bank for 30 days, when LIBOR-30
(30-day LIBOR) equals 4.8%. At the end of the
period, ABC will owe XYZ a total amount of
$1,004,000, which is calculated as:
If the rate applicable on the loan were based on 30-

day LIBOR plus a quoted margin of 2%, we would
first add the spread to 30-day LIBOR (4.8% + 2% =
6.8%), and then unannualise the rate to determine
the total amount payable.

LIBOR is published daily by the British Bankers
Association and is compiled from quotes from a
number of large banks. It is considered to be the
best representative rate for a dollar loan to a non-
government high quality borrower.
Banks also borrow euro-denominated loan from

other banks. The borrowing/ lending rate on these
loans is called Euribor.
This rate is compiled in Frankfurt and published by

the European Central Bank.
A forward rate agreement (FRA)
A forward rate agreement (FRA) is a forward
contract where the underlying is an interest
payment in dollars.
Think about the long position in an FRA as the party

that has committed to take a hypothetical loan, and
the short as the party that has committed to give out
a hypothetical loan at the FRA rate.
However, no actual loan is made at FRA expiration

so there is no need to consider the creditworthiness
of the parties in determining the FRA rate.
The payoff on FRA is determined by market interest
rates at FRA expiration
If market LIBOR at FRA expiration is greater than

the FRA rate, the long benefits. Effectively the long
has access to a loan at lower-than-market rates,
while the short is obligated to give out a loan at
lower-than-market rates.

If the market rate at FRA expiration is lower than the

FRA rate, the short benefits. Effectively, the short
position is able to invest her funds at higher-than-
market interest rates, while the long is obligated to
take a loan at higher-than-market interest rates.

Let us understand the mechanics of an FRA with

the help of an example:
Rafael takes the long position on an FRA with

Katrina as the short.
The FRA expires in 30 days, and is based on 90-
day LIBOR.
Further, it specifies a forward rate of 8% and has a
notional principal of $1 million.
After 30 days, at FRA expiration, LIBOR-90 stands
at 9%.

The FRA expires in 30 days, after which Rafael

can take a 90-day loan at 8% from Katrina.
Since the underlying (LIBOR-90) at FRA expiration

is 9%, Rafael benefits and his interest savings are
calculated as:

The $2,500 interest savings are realized at the
end of the hypothetical loan (t =120).
However, the cash payment to settle the FRA

occurs at the FRA expiration date (t =30). To
determine the payoff, interest savings are
discounted over the term of the loan (90 days) at
the current (as of FRA expiration date) rate of the
underlying (9%).
Therefore at FRA expiration (t=30) Katrina will

make a payment to Rafael amounting to:
The $2,500 interest savings are realized at the
end of the hypothetical loan (t =120).
However, the cash payment to settle the FRA

occurs at the FRA expiration date (t =30). To
determine the payoff, interest savings are
discounted over the term of the loan (90 days) at
the current (as of FRA expiration date) rate of the
underlying (9%).
Therefore at FRA expiration (t=30) Katrina will

make a payment to Rafael amounting to:
The payoff to settle an FRA can be calculated

via the formula given below. It is essentially a
combination of the two calculations that we
performed above:


Numerator:
Interest savings on the hypothetical loan.
This number is positive when the floating rate is
greater than the forward rate. When this is the
case, the long benefits and expects to receive a
payment from the short.
The numerator is negative when the floating rate

is lower than the forward rate. When this is the
case, the short benefits and expects to receive a
payment from the long

Denominator: The discount factor for
calculating the present value of the interest
savings.

FRAs are quoted as x * y, where x represents

the number of months till the FRA expires and y
equals the number of months till the hypothetical
loan expires starting from the date of inception of
the FRA. In our example x equals 1 and y
equals 4.

Therefore, this is a 1-by-4 FRA (or 1*4 FRA).

Notice that the difference between y and x equals
the term of the hypothetical loan, which is 3
months or 90 days in our example.

currency forward
In a currency forward two parties commit to an
exchange of a certain amount of one currency
for another currency at a pre-determined
exchange rate (price) at a specified date in the
future.
Currency forwards are very useful in hedging

exchange rate risk.
Suppose Turnbull Inc. is a U.S. company that

will receive 10 million in 30 days.
currency forward
It plans to convert these pounds into dollars, and
does not want to expose itself to the risk that the
pound will depreciate (dollar will appreciate) in
the next 30 days.
Therefore, Turnbull will enter into a forward

contract as the short on the pound (long on the
dollar).
If it gets into the forward at a price of $2/,

Turnbull effectively locks in the receipt of $20
million in 30 days.
currency forward
Currency forward contracts can also be settled
in cash. Cash settlement requires the party
adversely affected by exchange rate movements
to make a payment to the other party.
For example, if at the end of 30 days, the

exchange rate were $2.5/, the pound would
have appreciated and the long position on the
pound would benefit.

currency forward
Turnbull would be adversely affected by this
exchange rate movement and would have to
make a payment of $5m [(2.5- 2) * 10m] to the
counterparty (that is long on the pound and short
on the dollar).
However, it will be able to exchange its 10

million for $25 million in the market, and realize
a net inflow of $20 million.

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FINANCIAL DERIVATIVES FINC 612

FINANCIAL FORWARDS CONTRACTS

Saint Kuttu, PhD

Saint Kuttu, PhD 1

Four different payment and receipt timing combinations

Payments, receipts, and their timing

Saint Kuttu, PhD 2

For now, assume that there are no dividends

Saint Kuttu, PhD 3

If expected t=T stock price at t=0 is E0(ST), then

Since t=0 expected value of price at t=T is E0 (ST ) S0 ea T

Combining the two,

Saint Kuttu, PhD 4

Saint Kuttu, PhD 5

No, because the holder of the forward will not

F P 0,T S0 PV (all dividends paid from t=0 to t=T)

Saint Kuttu, PhD 6

Saint Kuttu, PhD 7

For discrete dividends Dti at times ti, i = 1,., n

For continuous dividends with an annualized yield d,

Saint Kuttu, PhD 8

Saint Kuttu, PhD 9

Forward price is the future value of

Continuous dividends F0,T S0e( r d )T

Saint Kuttu, PhD 10

Annualized forward premium =

Saint Kuttu, PhD 11

Note that the total payoff at expiration is same as

Saint Kuttu, PhD 12

Saint Kuttu, PhD 13

Saint Kuttu, PhD 14

17/02/2017 Saint Kuttu, Ph.D. 15

Typically, no cash changes hands at inception.

17/02/2017 Saint Kuttu, Ph.D. 16

The long position benefits when the price of the

17/02/2017 Saint Kuttu, Ph.D. 17

17/02/2017 Saint Kuttu, Ph.D. 18

Jane pays Michael 600 and gets the GGLE

17/02/2017 Saint Kuttu, Ph.D. 19

17/02/2017 Saint Kuttu, Ph.D. 20

This is true for both deliverable and cash settled

17/02/2017 Saint Kuttu, Ph.D. 21

He can achieve this by entering into the opposite

At expiration, under normal circumstances, Alice

17/02/2017 Saint Kuttu, Ph.D. 24

If Michael is able to enter the second contract

17/02/2017 Saint Kuttu, Ph.D. 25

If Jane were only willing to terminate the contract

17/02/2017 Saint Kuttu, Ph.D. 26

For example, suppose that a French company

They quote bid and ask prices, where the bid is

17/02/2017 Saint Kuttu, Ph.D. 28

Dealers try to balance their overall long and short

17/02/2017 Saint Kuttu, Ph.D. 29

However, because equity forward contracts are

17/02/2017 Saint Kuttu, Ph.D. 30

The variability of stock prices is so much greater

17/02/2017 Saint Kuttu, Ph.D. 31

The mechanics of bond forward contract are

17/02/2017 Saint Kuttu, Ph.D. 32

Bonds can have special features such as embedded

Bonds carry the possibility of default so a bond

Consider a forward contract on a T-bill that will have

Unannualize the discount based on a 360-day year: