Home > CFA L2, fundamental analysis > CFA Reading on Derivatives – Forward Markets & Contracts

CFA Reading on Derivatives – Forward Markets & Contracts

CFA Level 2 – Derivatives; Study Session 16, Reading 60 in 2011 curriculum/Reading 58 in 2010 – Forward Markets & Contracts

According to the Schweser, most people find the Derivatives topic to be the most difficult in Level 2 … I find it fun and relatively easy (perhaps because I want to work in the dazzling world of derivatives)… Because you need to understand forwards to understands futures and swaps, this will be a long post.

The key to derivatives is to understand how the price of the underlying asset and interest rates influence the value of the derivative…read on and it will be clear.

What is a Forward contract?

The following is verbatim from the CFA curriculum and I think it is succinct and to the point.

The holder of a long forward contract (the “long”) is obligated to take delivery of the underlying asset and pay the forward price at expiration. The holder of a short forward contract (the “short”) is obligated to deliver the underlying asset and accept payment of the forward price at expiration.

At expiration, a forward contract can be terminated by having the short make delivery of asset to the long or having the long and short exchange the equivalent cash value. If the asset is worth more (less) than the forward price, the short (long) pays the long (short) the cash difference between the market price or rate and the price or rate agreed on in the contract.

A party can terminate a forward contract prior to expiration by entering into an opposite transaction with the same or a different counterparty. It is possible to leave both the original and new transactions in place, thereby leaving both transactions subject to credit risk [counterparty risk], or to have the two transactions cancel each other. In the latter case, the party owing the greater amount pays the market value to the other party, resulting in the elimination of the remaining credit risk. This elimination can be achieved, however, only if the counterparty to the second transaction is the same counterparty as in the first.

What is the price and value of a forward contract?

The forward price is the price that a long will pay the short at expiration and expect the short to deliver the asset. There is no cash exchange at the beginning of the contract and hence the value of the contract at initiation is zero.

The value of a forward contract after initiation and during the term of the contract as the price of the underlying asset (S) changes. The value (profit/loss) of a forward contract between initiation and expiration is the current price of the asset less the present value of the forward price (at expiration).

Here is a payoff chart of a long position in a forward contract

The value or payoff of a short position is the opposite of the long i.e. if long is valued at +10, short is valued at -10… this is true for all derivatives because derivatives are a zero-sum game i.e. one’s gain is another’s loss.

Why we need to value forward contracts:

Valuation of a forward contract is important because 1) it makes good business sense to know the values of future commitments, 2) accounting rules require that forward contracts be accounted for in income statements and balance sheets, 3) the value gives a good measure of the credit exposure, and 4) the value can be used to determine the amount of money one party would have to pay another party to terminate a position.

Formulas to calculate Forward Price and to value forward contract

  • General formula (for security without cash flows i.e. dividends, interest, etc):

Calculating the forward price of a security with cash flow includes one additional which is either the present or future value of the cash flow discounted at the risk free rate.

  • FP of an equity security (can be stocks, stock portfolios or stock indices) with discrete dividends:

Vt (value of a long position at time t)

 

  • FP of a fixed income security (Instead of dividends, we adjust coupons, in reality there are adjustments for special features i.e. call, put, convertible, etc):

Vt (value of a long position at time t)

(note that forward contracts on bonds must expire before the bond’s maturity, no point buying a bond on maturity)

 

  • FP of an equity index or a continuous compounding security (instead of a discrete cash flow, we assume continuous cash flow)

Vt (value of a long position at time t)

 

  • FP of a currency forward contract = forward exchange rate quoted as domestic currency/foreign currency (remember that currency units are always quoted in terms of another currency i.e. CADUSD = USD/CAD where USD = Domestic Currency & CAD = Foreign Currency)

(Hint: numerator interest rate corresponds to currency of numerator, for example if spot price was quoted as USD/CAD, the RDC = USD interest rate & RFC = CAD interest rate). In words of CFA Institute:

The [forward]price, which is actually an exchange rate, of a forward contract on a currency is the spot rate discounted at the foreign interest rate over the life of the contract and then compounded at the domestic interest rate to the expiration date of the contract.

Vt (value of a long position at time t)

… next post will cover FRAs and Futures Markets & Contract

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  1. Lowendo
    May 29, 2011 at 9:43 PM

    Great stuff! thanks!

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