Fixed Income and Credit Risk

Prof. Michael Rockinger

B - 1 - Forward Products:
Foundations

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Learning Objectives

Forward Products - Foundations

Notations and Definitions

Examples

Term structure of forward rates

Instantaneous forward rates

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Need for Forward products
firm wishes to lend/borrow forward

t=0 T1 T2 Time
-

bank can manufacture forward lending/borrowing

 -

To go further assume that one has bootstrapped from existing bonds a term
structure of discount factors Z(t, T) for all T.
This is, up to inversion, equivalent of having a term structure of rn (t, T) or
r(t, T)

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Notations for forward rates and discount factors (PV156)
F(t, T1 , T2 ) — the T1 -value of 1 currency unit at T2

fn (t, T1 , T2 ) — annualized n-times compounded

forward rate associated with F(t, T1 , T2 )

f (t, T1 , T2 ) — continuously-compounded forward rate

limn→∞ fn (t, T1 , T2 )
F(t, T1 , T2 ) is a discount factor to discount from T2 to T1 known at t
Proposition
Z(t, T1 ) × F(t, T1 , T2 ) = Z(t, T2 )
!−n×(T2 −T1 )
fn (t, T1 , T2 )
F(t, T1 , T2 ) = 1 +
n

Lemma
F(t, T1 , T2 ) = e−f (t,T1 ,T2 )×(T2 −T1 )
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Remark

We will generally assume equally spaced payment dates. Ti = Ti−1 + ∆. In

one year there are n time units ∆, so that ∆ = 1/n

The forward discount factor for a time increment ∆ is:

1
F(t, T, T + ∆) = (1 + ∆fn (t, T1 , T2 ))−n× n
1
=
1 + ∆fn (t, T1 , T2 )

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Remark

The relation
Z(t, T1 ) × F(t, T1 , T2 ) = Z(t, T2 )
is a bit more than a definition.

One can show that under assumptions of liquidity, non-default of the

economy, stability of banks etc (I am not joking) this relation must hold as a
non-arbitrage relation!

During the GFC of 2007, this relation failed to hold

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Moving cash across time

Z( t, T2 ) and r(t, T2 )
 -

Z(t, T1 ) and r(t, T1 )

 -
t=0 T1 T2 Time
-

 -
F(t, T1 , T2 ) and f (t, T1 , T2 )

If one has Z(t, T) this is equivalent to having one of the spot interest rates
r(t, T)

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Forward rate product: example (PV154)
Example
Today is April 28, 2020. A firm sells a piece of equipment to a client for $100 mln.
The client will pay in six months, on T1 = October 28, 2020.
The firm will need cash one year later, at T2 = April 28, 2021, to fund some
capital investment.
The firm would like to fix today the interest rate on the deposit of $100 mln
for the six month period from T1 to T2 .
The bank quotes the rate 4.21% and commits to pay $102.105 mln at T2 .
On April 28, 2020 (today), the value of the 6-months T-bill is $97.728 and the
value of the 1-year T-bill is $95.713. Assume that the nominal of T-bills is
$100.

How does the bank replicate such forward commitment by trading T-bills
today? Explain where the forward rate of 4.21% comes from.

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Make a Figure how to move cash

Bank places long-term

-

Bank borrows short-term


t=0 T1 T2 Time
-


Bank borrows forward

At T1 bank gets money from firm as firm receives its accounts receivables

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Forward rate product: example (continued)
The bank borrows 1 mln units of T-bills with maturity T1 = 6 months today
and sells them for $97.728 mln. Cash is then invested in 1-year T-bills
expiring at T2 . Given that the price of the latter is $95.713, the bank can now
purchase $97.728/$95.713 = 1.02105 mln of 1-year T-bills (with a total
nominal of $102.105 mln).
Today, net cash flow is zero, as cash obtained from the sale of the 6 months
T-bills has been used to purchase 1 year T-bills.
In 6 months, the bank must pay back $100 million to the counterparty it
borrowed the 6 months T-bills from. This is also the time when the firm will
give the bank $100 million. So, at T1 the net cash flow is zero, as the bank
receives $100 million from the firm and uses it to close the short position.
At T2 , 1.02105 mln of 1-year T-bills mature, the bank receives $102.105
million. It pays the firm this entire amount.
In reality, banks charges a commission.

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 FORWARD RATES AND FORWARD DISCOUNT FACTORS 141
Replicating forward rate
Table 5.1 Trading Strategy to Compute Forward Rate

Today (Time 0) T1 T2

(a) Receive $100 m

Sell short $97.728 m of T-bills
from firm
maturing at T1
(b) Close short position

Buy M = 1.02105 = $97.728

$95.713
(a) Receive 1.02105 × $100 m
of T-bills maturing at T2 (b) Give total to firm
Total Net Cash Flow = 0 Total Net Cash Flow = 0 Total Net Cash Flow = 0

The T
question is: How does the bank determine the forward rate f 2 ? = 95.713
The 1 −value of $1 at T2 , as viewed from today, is $0.979 97.728 .
The replication
 implies  a forward interest rate on the deposit that
By no arbitrage.
102.105In fact, on March 1, 2001 (today), the value of 6-months
equals 2 ×
Treasury bills is $97.728
100 − 1 = 0.0421
and the value of=1-year
4.21% .
Treasury bills is $95.713. In order
to guarantee the rate f2 to the client, the bank can perform the following strategy (see
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Bank lends forward

Bank borrows long-term



Bank places short-term

-
t=0 T1 T2 Time
-

-
Bank places forward

In this example, bank goes into financial markets and synthesizes a forward
lending position

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Term structure of forward rates

The term structure of forward rates measured at time t is

f (t, t + m, t + m + ∆) as a one-dimensional function of m (the investment
horizon ∆ is held fixed). We often set t = 0 and plot f (0, T, T + ∆) as a
function of T . The result is called a forward curve. There are as many
forward curves as there are different horizons ∆.

Market lingo: a continuously-compounded 2-year rate 1-year forward, i.e.,

f (0, 1, 3), is called by fixed-income traders a ‘1y2y rate’. ‘2y forwards’ would
mean a forward curve of 2-year rates, i.e., {f (0, T, T + 2)}T∈T1 ,T2 ,...,TN .

With both m and ∆ varying, you get a matrix of forward rates: an up-to-date
version of such object every fixed income trader and quant have at most one
click away at any time. Once you have got a discount curve, you can
easily calculate forward rates for any m and ∆.

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 Spot and forward term structure: example
US Spot and 2y forwards curves as of Mar 2020
Spot curve
2y forwards curve
2.0

1.5
Interest rate, %

1.0

0.5

1 2 3 4 5 6 7 8 9 10 12 14 16 18 20 22 24 26 28 30

Horizon, years

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Relation between spot and forward curves (PV160/161)

Claim:
r(t, t + m + ∆) − r(t, t + m)
f (t, t + m, t + m + ∆) = r(t, t + m) + (m + ∆) ,
∆
i.e., when the spot curve is increasing, forward curve is above spot curve

Proof:
Z(t, T2 )
F(t, T1 , T2 ) =
Z(t, T1
er(t,T1 )(T1 −t)
e−f (t,T1 ,T2 )(T2 −T1 ) =
er(t,T2 )(T2 −t)
⇒ r(t, T1 )(T1 − t) − r(t, T2 )(T2 − t) = −f (t, T1 , T2 )(T2 − T1 )

Set T1 = t + m and T2 = t + m + ∆. The rest is algebra.

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Relation between spot and forward curves (PV160/161)
Claim: For a set of dates {T1 , ..., Tn } such that Ti+1 = Ti + ∆ and T1 = ∆ we
have:
n
1 X
r(0, Tn ) = f (0, Ti−1 , Ti )∆,
Tn i=1
i.e., the annualized continuously compounded interest rate r(0, T) is equal
to the average of forward rates up to T .

Proof: Establish relation for t = 0, T1 , T2 , T3 . Generalization is obvious.

By definition: f (0, T0 , T1 ) = r(0, T1 )

Z(0, T3 ) Z(0, T3 ) Z(0, T2 )

= = F(0, T1 , T2 ) × F(0, T2 , T3 )
Z(0, T1 ) Z(0, T2 ) Z(0, T1 )
e−r(0,T3 ) T3
= e−f (0,T1 ,T2 )(T2 −T1 )−f (0,T2 ,T3 )(T3 −T2 )
e−r(0,T1 )T1
Set Ti − Ti−1 = ∆ and conclude easily.
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