Fixed Income and Credit Risk Prof. Michael Rockinger B - 3 - Forward Products: Forwards and FuturesLearning Objectives @ Forwards and Futures @ Definitions e No-arbitrage price of a Forward e Formula of a forward contract on a Bond e Futures ContractsForward contracts A non-cash contract is a contract (legally binding piece of paper) where at the time of the writing, there is no exchange of money. A forward contract is a non-cash contract between two counterparties agreed upon today (time ¢ = 0) about exchanging a given security at a predetermined forward price P’’“(0,7) at a given future date T @ Forward price P*"“(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: PCT) — P™(0,T) Remark: Here we assume that the underlying has no CFs till T, else one needs to remove them since the forward contract does not include the cash flows payed before T 3/18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(7) at time T by purchasing the bond for a price P(0) att = 0 @ One can also get the bond by paying a forward price of P/"“(0, T) at T. At t = 0 this is worth Z(0, 7) P"“(0, T) @ Hence, in a non-arbitrage world, must be that Z(0,T) - P™(0,T) = PO) > P™(0,T) = PO) -Z(0,T)"! 4/18Forward contracts To establish the value of the contract at some later date, one needs to ask how one could obtain the payoff P(T) = P*4(0,T) by some duplicating trading strategy @ Attime z if one purchases the bond at market price P(r) one is certain to get the value of the bond at time T worth P(T) @ The discounted value of P*"4(0, 7) at ris Z(t, T) - P*"4(0, T) @ Hence, at ¢ value is P(t) Z(t,T) - P™(0,T) @ Since at t there is a new forward price P/"“(t,7) = P(t) - Z(t, T)"! one can also write the value of the contract as: Vt,T) = Z(t, 1) - (P*4¢,7) - P™(0,7))Valuation of a forward contract on a bond tO =) Tr Tm —T TT PO) $100 §-100 (14 §)- 100 @ Contract matures at 7:0 <7 Jum i, Zoe On @ Both long and short parties establish margin accounts. For instance 40” ieTEME 79 oft 9,50 ~ Mb i rhinaia acpi / () @ Ifa margin account falls below 59for instance to 40) a margin call \ Uh practer | gets issued. The counterpart must then fill its accounts back to 70. If ||2 25 4a He me it does not, the counterpart is declared bankrupt | branes A here he [2d enn gl ty At maturity 7, long party pays short party the spot price (current market price) Over time there are adjustments between the 2 accounts: the market-to-market. These are compensation payments © vanickn Aner gi~ Now you should be perfectly confused! sereMarket-to-Market @ Because of the assumption that at 7, long pays spot to short it must be that P!(T,T) = P(T) @ To demonstrate this @ assume that P*"“(T, T) < P(7)... @ assume that P*"“(T, T) > P(7)... 13/18Market-to-Market Time to | Short Position Futures Long Position (uy maturity Seller YFT | Price Pf"4(¢, 7) Buyer ~ 8 70 (70) 70 7 70+10=80 160 70-10=60 6 80+20=100 140 60-20=40+30=70 5 100+20=120 120 70-20=50 4 130 3 140 2 120 T-t-1 110 TH0 | 100 7 AS Tow wr @ Exercise: fill matrix and verify that short receives from long overall 170 and that long pays to short overall 170 @ Exercise: when are there times of potential default? Why does default not matter? 14/18Market-to-Market Co terdial Arg muta 4 ds Time to | Short Position | Futures Long Position maturity Price P(t, 7) wt gal vent Lae 70- i 60 [aby fan a co argo | 60-20= I-70 es 6” yo 70-20=50 pee a ow" @ C4 Maw 100+20=120/] 120+104430 70-20=50 _| 50-10 saeah70 5). 70-10: Rocky cov ld olf Ado Fendsink 3 OO +30 oe Sse Nev psaccoun : =n a ian Yoo uote a ONE, Thea tal 14,2 ,!f no default, short receives 100 + 0 Alot: Din Gude Degree Te uly cu) Leo fbf, Fo wep BCom — Tal mr eM eb fe ino | fwd ove Macy me 200 75g Dan prylth Pop okoltDiscussion of Default Possibilities Time to | Short Position Futures Long Position maturity Seller Price P*"4(t, 7) Buyer 6 | 80+20=100 | 140 | 60-20=40+30=70 1 120+10=130 110 50-10=40+30=70 0 130+10=140 100 70-10=60 @ First moment of possible default: margin call at t = 6. In that case, short can enter a new contract with someone else. The new price would be P*“(7 — t = 6) = 140. It would seem that short gets much less than initially promised 170, but if one considers the margin account, the account has risen to 100 from 70. 100 — 70 = 30! @ Second moment of possible default: margin call at r= 1 16/18Discussion of Default Possibilities Time to | Short Position Futures Long Position maturity Seller Price P*”4(1, T) Buyer 0 | 130+10=140 | 100 | 70-10=60 @ Default at 7 of long position. @ If long defaults, short sells in spot market and receives 100. Since margin account increased by 70, overall short receives 170 @ Default at 7 of short position If short defaults, long can buy underlying in spot market for 100. Since margin account decreased by 10 and because of margin payments of 60, overall long will pay 170 17/18Pricing Futures and Forwards w sad sunt ak in nun adh cfieay in ovd bole A o}|Great news: If the interest rates are constant or do not vary a lot, then [the price of a future equals that of a forward @ Intuition: If interest rates are constant then the remuneration of the margin deposits will be the same be it a futures or a forward Ds veal fle Qinovute KA pot tm margin acioy ete ae fraction of Pobre pa. Sih dail, \mormel! yauicdion is $40, Guten nize preuinly repo ler® inet s0S-fne puttin op Merple eormad IT | a5 Will att peabingek ov ch rahe RENAME | To agstedol snidls Cletring hove wy 7 ope en Tse aw arstewouce wets ——— Dury CF (am) big pre'dinn euaivn it Killed To lla cca har eabkaedsg tid toe