Kursangebot | Derivatives and Alternative Investments | Characteristics of Forward Contracts

Derivatives and Alternative Investments

Characteristics of Forward Contracts

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{*LOSnr6*}

 Explain delivery/settlement and default risk for both long and short positions in a Forward Contract.

Delivery/Settlement and Default Risk

Default risk in forward contracts is the risk to either party that the other party will not perform, whether that means pay cash or deliver the asset.

Forward contracts typically require a purchase/sale of the asset on the expiration/delivery date specified in the contract.

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{*LOSnr7*}

Describe the procedures for settling a forward contract at expiration, and discuss how termination alternatives prior to expiration can affect credit risk.

Procedures for Settling a Forward Contract

The party to the forward contract that agrees to buy the financial or physical asset has a long position and is called the long. The party to the forward contract that agrees to sell the financial or physical asset has a short position and is called the short.

Each party to a forward contract is exposed to default risk (or conterparty risk), the probability that the other party will not perform as promised. It is unusual for any cash to actually be exchanged at the inception of a forward contract, unlike futures contracts in which each party posts an initial deposit (margin) as a guarantee of performance.

  • Delivery of the asset specified in the contract: a short can terminate the contract by delivering the goods, a long by accepting delivery and paying the contract price to the short

  • Cash payment at expiration

  • A position can be terminated by making a close-out or offsetting trade in the futures market (most frequent)

  • An exchange for physicals; off the floor of the exchange (called an ex-pit transaction)

When a forward contract is terminated by an offsetting contract with a second counterparty, there is no further asset price risk, but since there are two separate contracts with different counterparties, all parties are exposed to default risk until both contracts are settled.

Since the two contracts may have different forward prices, the terminating party may have a future liability at settlement, but the amount is fixed at the time the offsetting contract is initiated.

The terminating party may have locked in a future gain or loss, depending on the difference between the forward prices of the two offsetting contracts.

Beispiel

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Example:

Some forward contracts are termed cash settlement contracts. This means:

A. at contract expiration, the long can buy the asset from the short or pay the difference between the market price of the asset and the contract price.

B. either the long or the short in the forward contract will make a cash payment at contract expiration and the asset is not delivered.

C. at settlement, the long purchases the asset from the short for cash.  

The answer is B. In a cash settlement forward contract there is a cash payment at settlement by either the long or the short depending on whether the market price of the asset is below or above the contract price at expiration. The underlying asset is not purchased or sold at settlement.

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{*LOSnr8*}

Differentiate between a dealer and an end user of a forward contract.

End Users and Dealers

End users: generally a party with a risk management problem, searching for a dealer to provide it with a financial transaction to solve that problem.

Dealers: market maker; banks and non-banking financial institutions provide market liquidity as well as bearing default risk and any unhedged positions.

Beispiel

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Example:

Differentiate between a dealer and an end user of a forward contract.

A. Forward contract dealers are often banks.

B. Dealers offer long and short forward contracts at different prices.

C. Dealers are compensated through up-front payments by the parties to forward contracts.  

The answer is C. There is typically no payment from either the long or the short to enter into a forward contract. Dealers make money through the bid-ask spread, the difference between the forward prices they offer to buyers and sellers.

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{*LOSnr9*}

Describe the characteristics of equity forward contracts and forward contracts on zero-coupon and coupon bonds.

Equity Forward Contracts and Forward Contracts

Equity forward contracts:

  • Underlying asset:a stock, a specific portfolio of stocks, or a stock index

  • Physical or cash settlement: for those products linked to stock index, the settlement methods are cash settled

  • Dividends are usually not included (small compared to the uncertainty about future equity prices).

  • Specify a total return value (including dividends) rather than simply the index value → effectively removes dividend uncertainty.

Beispiel

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Example:

Which statement about equity forward contracts is least accurate?

A. Equity forward contracts may require asset delivery or cash settlement.

B. Dividend payments are usually included in equity forward contracts.

C. Investors can use equity forward contracts to speculate on stock-price increases.   

The answer is B. Dividend payments are usually not included in equity forward contracts. Investors can use equity forwards to speculate on stock price movements. Most equity index forward contracts are settled in cash, but since they are custom instruments, forwards may specify either cash settlement or delivery of the equity shares specified in the contract.

Bond Forward Contracts:

  • Underlying asset:short-term, zero-coupon bonds (T-bills in the U.S.) and coupon interest-paying bonds

  • must settle before the bond matures

  • T-bill prices are often quoted as an annualized percentage discount from face value

  • Coupon bonds are often quoted as a YTM

Beispiel

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Example:

Which of the following is least likely a characteristic of bond forward contracts?

A. Contracts can be written on bonds with embedded options.

B. Contracts must settle before the bond matures.

C. Prices are stated as yield to maturity, including accrued interest.  

The answer is C. Bond forward contracts are typically stated as a yield to maturity exclusive of accrued interest. Both of the other statements are characteristics of bond forward contracts.

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{*LOSnr10*}

Describe the characteristics of the Eurodollar time deposit market, and define LIBOR and Euribor.

Eurodollar Time Deposit Market

  • London Interbank Offered Rate (LIBOR)

    • USD interest rates

    • Quoted as an annualized rates based on a 360-day year

    • Add-on rate

    • Single interest

  • Euribor is a similar rate for borrowing and lending in euros.

Beispiel

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Example:

Which of the following statements regarding Eurodollar time deposits is FALSE?

A. Sometimes the best rates are available in New York City.

B. Rates are quoted as an add-on yield.

C. They are available in Switzerland.  

The answer is A. Eurodollar time deposits are U.S. dollar denominated deposits outside the United States. Rates are quoted as an annualized add-on yield, based on a 360-day year.