Forward & Futures

Forwards&Futures

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Forward and Futures Contracts

Part I. Forward Contracts

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Contract design and trading mechanics. Finding forward price by an arbitrage argument: creating a synthetic forward. Finding PV of a seasoned forward position (marking to market a previously initiated position). We will consider three cases:

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Underlying asset provides no income prior to maturity of the forward contract Known cash dividends Known percentage dividend yield

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Currency forwards Forward Rate Agreements (FRAs) – interest rate forwards

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Contracts and Trading Mechanics

A forward contract is a contract to buy or sell an underlying asset at a predetermined price K (delivery price) on a specified future date T .

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Long party agrees to buy the underlying asset at the delivery price K at time T .

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Short party agrees to sell the underlying asset at the delivery price K at time T .

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Settlement: The contract is settled at maturity T : the short delivers the asset to the long in return for cash amount K .

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Counterparties:

bilateral

over-the-counter

(OTC)

contracts

negotiated

between two counterparties (between two financial institutions or between a financial institution and its customer).

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Payoff at Expiration:

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The long receives the asset worth ST (price of the asset at maturity of the forward T ) and pays the delivery price K . Thus the cash flow (payoff) from the long forward position at maturity T is:

ST − K . Some forward

contracts are cash physically settled, while some are cash settled.

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The short receives the cash amount K and delivers the asset worth ST in exchange (payoff is K − ST ).

Valuation Problem: how do you establish the delivery price K in the forward contract?

Notations:

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St : underlying asset price at time t ;

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K : delivery price specified at contract inception;...