MSA

722 Fixed Income and Derivatives I

Forward Contracts

This week we transition from the fixed income material to the derivatives material. Essentially,
when we speak of derivatives, we are referring to a set of financial instruments that are
contracts whose value are tied, or derived from, another underlying asset. Derivatives, from a
general perspective, are categorized as forwards, futures, options or swaps. This first week of
derivatives will cover the basics of derivatives contracts and start our analysis of derivatives
with an examination of forward contracts.

In this course (MSA 722: Fixed Income and Derivatives I), the key point of the derivatives
material is to understand the basic characteristics of the types of contracts as well as computing
their payoffs. In the advanced course (MSA 736: Fixed Income and Derivatives II) taken later, the
focus is pricing of derivatives through arbitrage arguments.

Derivatives Intro
A derivative security is an investment instrument whose value is dependent upon the value of an
underlying asset or future outcome. Specifically, a derivative is a contract with a finite life
between two parties, a buyer and a seller, who agree to financial terms today relating to a
transaction to take place on a predetermined future date, called the settlement date.

For example, an investor may enter into a derivative contract where she agrees to purchase
1,000 common shares of Citigroup from another investor for $35 per share in a future
transaction to occur exactly six months from today. In a derivative contract, it is important to
note that the financial terms of the future transaction, contract price and quantity, are agreed
upon today by both parties. So, in six months, when the Citigroup stock sale occurs between the
buyer and seller to settle the derivative contract, the share price to be paid by the buyer is $35
irrespective of the actual market share price of Citigroup. As will be presented later, the
difference between the actual market price of the underlying asset on the settlement date and
the contract price effectively leads to gains for one party and losses for the other party involved
in a derivative contract. In essence, a derivative contract allow for an investor to lock in a price
today for a transaction that will occur in the future.

In derivative contracts, the party who agrees to buy the underlying asset is generically referred
to as the long, and the party who agrees to sell the underlying asset is referred to as the short.
In the current example, the buyer of Citigroup stock is said to be long the contract, and the
seller is said to be short the contract. In general, the long (short) party in a derivative
contract gains as the underlying asset increases (decreases) during the life of the
derivative contract, and loses as the underlying asset decreases (increases).

To see this in the current example, the buyer, who is long the contract, stands to gain financially
as the share price of Citigroup increases during the life of the contract because no matter how
high the actual Citigroup stock price is on the contract settlement date, the buyer will pay the
contract price of $35 per share. Of course, the seller will lose as the Citigroup share price
increases during the life of the contract, as he will be forced to sell the Citigroup stock for $35
even if the actual Citigroup share price on the settlement date is much higher than $35. Similarly,
the buyer will lose as the share price of Citigroup decreases during the life of the contract, as she
is forced to pay $35 per share even if the share price is much lower than $35 on the settlement

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date. The seller benefits financially as the share price of Citigroup decreases during the life of the
contract the seller will receive $35 per share even if the actual Citigroup share price on the
settlement date is much lower than $35. In summary, the higher (lower) the price of Citigroup
on the settlement date, the larger the gain to the buyer (seller).

To illustrate, suppose that, on the settlement date, the price of Citigroup stock is $42 per share.
The buyer will pay $35 per share for the contracted 1,000 shares, a total of $35,000, to the seller.
However, had the buyer not entered into the contract, she would have paid $42 per share, a total
of $42,000. Effectively, by entering into the derivative contract, the buyer has gained $7,000.
Similarly, the seller loses $7,000 rather than selling the Citigroup shares for the actual market
price of $42 per share, he is forced to sell for $35 per share. In all derivatives contracts, the
winning partys gain is equal to the losing partys loss (derivatives are a zero-sum game)

In the current example, the underlying asset in the derivative contract is a particular stock,
namely Citigroup common stock. However, the underlying asset in derivative contracts can take
the form of many things, including an agricultural product, an individual stock, an equity index
such as the S&P 500, an individual bond, a currency exchange rate, an interest rate, or even
credit-related or weather-related outcomes, among others.

Types of Derivative Contracts
Derivative contracts are defined by six characteristics: contract type, underlying asset (or
interest rate, currency, or other outcome), contract price, contract size (or contract multiplier, or
notional principal), settlement date, and settlement type. In the case of the Citigroup derivative
contract, the type of contract is a forward contract, the underlying asset is Citigroup common
stock, the contract price is $35 per share, the contract size is 1,000 shares, and the settlement
date is six months from today. The settlement type was not explicitly provided, but in most
cases, forward contracts offer both physical delivery and cash settlement as methods to settle.

There are four major types of derivatives contracts:
Forward contracts
Future contracts
Option contracts
Swap contracts

Forward contracts and future contracts are bilateral contractual agreements between a buyer
and a seller in which the buyer agrees to buy an underlying asset from the seller at a
predetermined future date and at a predetermined contract price. In essence, forward contracts
and futures contracts allow for investors to lock in an asset purchase price or sell price for a
single transaction to occur in the future. The Citigroup derivative contract above is an example
of a forward contract.

Option contracts are similar to forward and future contracts but are unilateral contractual
agreements. In an option contract, one party, the option buyer, pays another party, the option
seller, a fee for the right but not the obligation to buy an underlying asset from the option seller
at a predetermined contract price on or before a predetermined future settlement date. In
option markets, the settlement date is referred to as the option expiration date, and the contract
price is referred to as the strike price. The fee paid by the option buyer to the option seller is
referred to as the option premium.

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Swap contracts are contractual agreements between two parties to exchange a series of periodic
cash flows over the life of the swap contract. Similar to a forward or future contract, the swaps
periodic cash flows to be exchanged between the two parties are linked to an underlying asset or
future outcome with multiple settlement dates. In essence, a swap contract is merely a series of
individual forward contracts.

Settlement of a Derivative Contract
In most cases, a derivative contract can be settled in two ways on the settlement or expiration
date: through physical delivery or cash settlement. Physical delivery refers to the process of
actually having the long buy the underlying asset from the short on the settlement date. Cash
settlement refers to the process of settling the derivative contract with a cash payment in lieu of
actually conducting the contracted transaction.

For example, reconsider the scenario above where the market price of Citigroup stock on the
settlement date was $42 per share. Under physical delivery, on the settlement date, the short
would actually sell 1,000 shares of Citigroup stock to the long for the contract price of $35 per
share, or $35,000. Again, given that the market price of $42 per share is greater than the
contract price of $35 per share, the long is paying $7 less per share by having entered into the
contract, for a total savings or gain of $7,000. Similarly, the short is receiving only $35 per share
by having entered into the contract instead of the actual market price of $42 per share this is
an effective total loss of $7,000 for the short. Under cash settlement, rather than actually selling
the shares to the long for $35 per share as would occur with physical delivery, the short can
make a cash payment to the long for $7,000 to settle the derivative contract.

It is important to note that the two settlement scenarios effectively offer the same outcome of
the short losing $7,000 and the long gaining $7,000. Under physical delivery, the long can
purchase shares for $35 per share and immediately resell them, if desired, at the current market
price of $42 per share, a gain of $7,000. Similarly, the short loses $7,000 by being forced to
accept $7 per share less than the current market price. Under cash settlement, the long could
purchase 1,000 shares of Citigroup stock in the open market at the current price of $42 per
share, a total of $42,000. However, the receipt of the cash payment of $7,000 from the short
results in the net cost of the share purchase to be $35,000. The type of contract settlement varies
across derivative contracts; in some cases, physical delivery and cash settlement are both
available, and in some cases, cash delivery is the only settlement method. In most cases,
however, cash settlement is typically permitted as a convenient method of settling derivative
contracts.

Uses of Derivatives
Investors use derivatives as investment instruments to reduce or hedge unwanted risks or to
gain exposure to desired risks. Also, in some cases, derivatives allow investors to gain exposure
to assets with significantly less required capital and with lower transaction costs than would be
the case if investors directly invested in the underlying assets. Finally, derivative contracts allow
investors to gain exposure to assets that are themselves directly not investable. For example, an
investor who believes the broad equity markets will increase over the next year may enter into a
forward contract as the long where the underlying asset is the S&P 500 index with a settlement
date one year from today. Similar to the Citigroup example, the long will financially benefit as
the S&P 500 increases over the life of the forward contract. This is an example of an investor

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gaining exposure to the broad equity markets without buying actual stock, and also obtaining
exposure to an asset, the S&P 500 index, that is not directly investable.

Companies also use derivative contracts for risk management purposes. For example, consider
Microsoft, a U.S. company who sells computer software in foreign markets. When Microsoft sells
its software in Europe, it receives its sales revenue in Euros, and these Euros must be then
converted to U.S. dollars. Consequently, Microsoft is exposed to currency risk. Microsoft may be
concerned about the value of the U.S. dollar declining against the Euro in the future, which of
course would lead to less U.S. dollars being received when the Euros are converted. To mitigate
this currency risk, Microsoft may enter into a forward contract today that allows the company to
convert Euros into U.S. dollars at a specific exchange rate at a future settlement date. By entering
into the forward contract, Microsoft can reduce its currency risk exposure. Financial institutions
who are generally exposed to some degree of interest rate risk may also use derivative contracts
to reduce their interest rate risk. In general, derivative contracts allow investors to manage
specific risks related to interest rates, currency and equity exposures and even uncontrollable
factors like weather.


Forward Contracts
A forward contract is a contractual agreement between two parties to buy or sell an asset at a
prespecified price, agreed upon today, at some predetermined settlement date in the future. For
example, an investor may enter into a forward agreement today with an investment bank to sell
his 100,000 shares of ABC stock for $50 per share in three months. In a forward contract, the
seller of the asset is called the short, and the buyer of the asset is called the long. So, the investor
would be the short, and the investment bank would be the long. The contract price is referred to
as the forward price.

Forward contracts do not trade on public exchanges but rather are traded between investors in
private markets. These private markets are referred to as over-the-counter (OTC) markets. The
forward market is quite large, and the participants in forward markets largely consist of retail
banks, investment banks, corporations and governments. Forward contracts are privately
negotiated between parties and therefore these contracts can usually be customized to meet any
set of contract specifications. The ability to create a customized, non-standard contract allows
for forward contracts to cater to investors specific needs for a particular contract size and
settlement date. However, the private nature of forward contracts exposes each party in a
forward contract to counterparty risk.

Counterparty risk is the risk that the other party in the forward contract will not fulfill their
forward contract commitment. That is, on the settlement date of a forward contract, there is a
risk that the losing party may not fulfill their contractual obligation. In some cases, the parties in
a forward contract may agree to post collateral in an effort to mitigate any counterparty risk
concerns. It is important to note that investors in forward contract are contracted to fulfill the
obligation of the forward contract if they are still a party to the forward contract on the
settlement date.

Forward contracts are non-standard, customized contracts that trade in private OTC
markets and not on publicly traded contracts. In contrast, futures contracts are nearly identical
to forward contracts except futures contracts are publicly traded contracts. As a result, forward
contracts offer the ability to create customized contracts between two parties that exactly meet

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the needs of the two parties. Futures contracts are standardized contracts and therefore do
not offer investors the ability to customize. For example, an investor who wants to buy a $1,000
par T-bill in 6 months cannot use a T-bill futures contract to lock in the price today because the
T-bill futures contract is standardized to buy/sell a $1 million par T-bill. However, an investor
could potentially enter into a customized forward contract with another party that will be tied to
a $1,000 par T-bill.

As it relates to financial derivatives, which is what we will examine in this course, we will look at
contracts that underlie equity assets (single stock and portfolio contacts), fixed income assets
(such as T-bills and T-bonds), interest rates, and currencies. An equity forward contract is a
forward contract where the underlying asset to be exchanged is a single stock (such as the above
example) or even a portfolio of portfolio stocks or equity index. A fixed income forward contract
is a forward contract where the underlying asset is a single bond or a portfolio of bonds. An
interest rate forward contract, known as a forward rate agreement (FRA), is effectively a
contract to exchange a rate in the future (for example, a borrower may want to lock in a rate
today by agreeing with an counterparty to borrow in 3 months at a prespecified rate today).
Lastly, a currency forward is a contract to exchange currency in the future at a prespecified
exchange rate.

Early termination of a forward contract
Forward contracts are generally designed such that both parties will fulfill their commitment to
transact the underlying asset on the contract settlement date at the contract price. However, it
may be the case that one party may desire to terminate the forward contract prior to the
settlement date. This may occur when the market price of the underlying asset has moved
significantly in an adverse direction since the inception of the contract, causing significant
contract losses for a particular party. Another reason that may justify the desire for a party to
want to terminate early would be an increased concern that the counterparty of the forward
contract may default.

In general, to terminate the forward contract early, the party wishing to terminate may negotiate
a settlement payment with the counterparty to terminate early. The termination payment would
typically be linked to the amount of time remaining on the forward contract, the current market
price of the underlying asset, and the counterpartys expectations about the direction of the
underlying asset price until the settlement date.

Another way to exit a forward contract position early is by taking an offsetting position in
another forward contract with a different counterparty. It is important to note that exiting a
forward contract position via offset carries counterparty risk, now relating to two
counterparties. As might be expected, it is preferable in most cases to terminate early by
negotiating a settlement payment with the original forward contract counterparty, as this ends
the forward contract and does not expose the party terminating early to further counterparty
risk. Also, terminating a forward contract early may prove to be difficult given the customized
nature of forward contracts.

Now, lets look at how to compute forward contract payoffs.

Commodity forwards
There are forward contracts where the underlying asset is a particular commodity. The long
agrees to purchase a contracted quantity of the particular commodity at the contract price from

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the short on the settlement date. There are forward contracts on agricultural commodities such
as corn, soybeans, and wheat, among others. In addition, forward contracts on precious metals,
such as gold, silver or platinum, are available to investors, as well as forward contracts on
industrial metals such as aluminum, copper and palladium. Forward contracts on other food and
fiber commodities such as cocoa, coffee, and cotton are also available to investors, as well as
forward contracts on energy commodities, such as crude oil and natural gas.

Consider the following crude oil forward contract example:

It is April, and an oil refinery that needs purchase to a significant quantity of crude oil in June is
concerned about the recent volatility in crude oil prices. Consequently, the refinery decides to
enter into a forward contract with a counterparty to mitigate crude oil price risk. The forward
contract quantity is 10,000 barrels and the forward contract price is US$100 per barrel.

Questions:
1. Should the refinery take a long or short position in the forward contract?
2. If the crude price at June settlement is US$90 per barrel, who gains? (refinery or
counterparty)
3. Suppose the contract is cash settled. What is the amount of the payment?

Solutions:
1. The refinery will take a long position as they are going buy crude oil. The buyer in a forward
contract is the long.
2. The refinery will pay US$100 per barrel at settlement to the short irrespective of the actual
price of crude on the settlement date. If the price of crude is actually $90 per barrel, the refinery
loses, as they are forced to buy the crude oil at the higher forward price of $100 per barrel.
3. The cash settlement payment would be ($100 - $90) x 10,000 barrels = $100,000. The
payment would be paid by the refinery to the counterparty. Effectively, the refinery would buy
the oil at the market price of $90, but experience a $10 per barrel cost by making good on the
forward contract. Thus, the refinery will effectively pay $100 per barrel even if cash settled.

Equity forwards
Forward contracts where the underlying asset is a particular equity security, equity portfolio or
equity index are referred to as equity forward contracts.

Consider the following equity forward contract example:

Consider an investor who needs to sell some of her stock position for a down payment on a
house due in 3 months. She intends to sell the stock to raise the necessary down payment, but is
worried about a potential sharp decline in the share price over the next few months. As a result,
she would prefer to hedge this risk by entering into a forward agreement with a counterparty to
sell 5,000 shares of BAC stock in 3 months. After consultation, she enters into an equity forward
contract with an investment bank to sell her shares in 3 months at a forward price of $15. The
current share price is $14.

Now, it is 3 months later, and the forward contract date has arrived and its time to settle the
contract. Since contract initiation, the price of BAC has increased from $14 to $17. What will
happen?

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In short, the investor will deliver the 5,000 shares for $15 per share and collect $75,000. Note:
she locked in this price per share three months ago at contract initiation. As it relates to the
forward contract transaction, the share price of $17 prevailing at the contract date is actually not
relevant.

But, lets look at the transaction a bit more closely. As of the settlement date, the share price is
$17 and the forward price is $15. The forward contract calls for delivery of 5,000 shares. Put
yourself in the position of the investor. Currently, your 5,000 shares are worth $17 each but you
agreed three months ago to sell the shares for $15 each today. So, you are effectively losing $2
per share by having to sell for the $15 forward price instead of the market price of $17. For the
5,000 shares, this is a $10,000 total loss.

Here is the point. Rather than actually delivering the shares to the investment bank and having
them buy the shares for $15 each, it is more conventional to cash settle. To cash settle in a
forward contract, the losing party pays the gaining party the difference between the market
price at the forward date and the spot price. So, in this case, the investor will sell her shares on
the open market at $17 and collect $85,000; separately, she will cash settle the forward contract
by paying the loss of $10,000; again, she ends up with $75,000 just as if she has sold the shares
to the investment bank directly.

To summarize:

At contract inception:
Share price was $14;
Forward contract price was $15 for delivery of 5,000 shares in 3 months

At settlement in 3 months (delivery or cash settle):
Delivery: Cash settle:
Delivery of shares to investment bank @ $15 Sell shares on market at $17
Receive: $75,000 Receive $85,000
Pay loss on forward of $10,000
Net receipt: $75,000

Note that the $10,000 payment from the investor to the investment bank in order to cash settle
the forward contract is called the contract payoff. In most cases, forward and future contracts
are cash settled and are rarely settled through actual delivery of the asset.

Lets go back to the long (buyer) and short (seller) discussion. Note that the long (the investment
bank) gained and the investor (who is short) lost. This will always be the case when the asset
increases in value during the life of the contract. However, the opposite would have been true
had the share price decreased during the life of the contract. Thus, when the underlying asset
increases (decreases) in value during the life of the contract, the short (long) will owe the long
(short) the payoff amount.

Consider the following equity index forward contract example:

Suppose an investor enters into an equity forward contract as the long where the underlying
asset is the S&P 500 index with settlement in 3 months. The contract price is 1,400, and the
notional principal of the contract is $25 million. Now, assume the forward contract was settled

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three months later on the settlement date when the level of the S&P 500 index was 1,372. What
will be the investors gain or loss?

Solution:
In this example, the long position has experienced a loss, as the long must effectively purchase
the S&P 500 index at the contract price of 1,400 instead of its current market level of 1,372. To
cash settle the contract, the long will make a cash payment to the short. The cash settlement
payment will be equal to $500,000, equal to the decrease in index level from the contract price of
1,400 as a percent, or 2% (= 28 / 1,400), multiplied by the notional principal of $25 million (=
2% x $25 million = $500,000).


Forward rate agreements (FRAs)
Forward contracts where the underlying asset is a particular interest rate are referred to as
forward rate agreements (FRAs). In a forward rate agreement, the contract price is an interest
rate, typically referred to as the reference rate. The contracts financial payoff to the winning
party is linked to the level of the underlying interest rate prevailing on the settlement date and a
notional principal. In essence, in an FRA, the long is buying the interest rate at the contract
rate, and the short is selling the interest rate at the contract rate. Consequently, the long
(short) in a FRA gains as the underlying interest rate rises (falls) during the life of the contract.
Essentially, one can think of the long as a borrower wanting to benefit if rates rise, and the
short as a lender wanting to benefit if rates fall. Most FRAs are linked to short-term London
Interbank Offer Rate (LIBOR) rates, and all FRAs are cash settled.

In terms of understanding the payoff of an FRA, it is best to take a look at an example. The
payoff of an FRA is the most challenging calculation in the calculations of forward payoffs.

Consider the following FRA contract example:

Suppose that, in three months, ABC Corp. expects to borrow $10 million for a period of 180 days.
The firm is concerned about a short-term increase in rates and would like to hedge by locking in
the interest rate today by entering into a 3-month forward rate agreement (FRA). ABC comes to
an agreement with JP Morgan at the forward rate on 180-day LIBOR of 7.5% on a contract with a
notional principal of $10 million. Assume that in 3 months at settlement, 180-day LIBOR is equal
to 8.5%. Should ABC go long or short the FRA? What is the FRA payoff on the settlement? Who
owes who?

Lets start by identifying whether ABC should be the long or short party in the FRA. Since ABC
needs to borrow, they should go long in the FRA. If rates rise, ABC will be hurt by higher
borrowing costs; however, the borrowing costs will be reduced by a payoff from the FRA.

Now, lets suppose we are now 3 months forward and are at the settlement date. We want to
compute the FRA payoff and determine who is the winning and losing party. First, note that the
firm needs to borrow for six months, so we will start by looking at what rate ABC would have to
borrow at if they had not entered into the FRA. The problem states that, at settlement, 180-day
LIBOR is equal to 8.5%; this would be the rate at which ABC would have to borrow without the
FRA.

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However, ABC entered in the FRA at the forward rate of 7.5%, so in essence, ABC Corp. will
benefit by being able to effectively borrow at 7.5% and not 8.5%! How much will they save? The
interest savings for 6 months to ABC Corp. from borrowing at the lower forward rate is
calculated as:

(8.5% 7.5%)(180/360)($10,000,000) = $50,000

Note: LIBOR follows a 360-day year convention.

Recall that LIBOR interest is paid at the end of the loan term (interest is add-on interest similar
to a certificate of deposit). So, by entering into the FRA, when ABC pays the interest on the loan,
they will have saved $50,000. Here is the tricky part of FRAs: today is FRA settlement (3 months
after FRA initiation); but the loan interest is not owed for another 6 months (9 months after FRA
initiation); so, rather than the $50,000 interest difference being the FRA payoff, we have to
calculate the present value of the $50,000 to be received at settlement!

$50,000 / [1 + 0.085(180/360)] = $47,962 (rounded)
The prevailing six-month rate (180-day LIBOR) is used to discount the interest savings.

The FRA payoff is the $47,962. Who owes who? Since 180-LIBOR at expiration of 8.5% was
above the forward rate of 7.5%, the long party gains and the short party loses. So, to settle the
FRA, JP Morgan will pay ABC Corp. a cash payment of $47,962 to settle the FRA (via cash
settlement).

Lets look at the transaction a bit more closely. As of the settlement date, 180-day LIBOR was
8.5% and the contracted forward rate was 7.5%. So, again, by entering into the FRA, ABC as the
borrower saves 1% in interest expense leading to a savings of $50,000.

It is important to note that JP Morgan is NOT going to actually lend money to ABC Corp!
The use of the FRA is merely a contractual agreement that allows the firm to hedge the
borrowing rate before the start of the loan. So, this FRA is cash settled with a cash payment to
ABC, and ABC will borrow in the market from some bank at 8.5%. Putting this all together, at
settlement, ABC will borrow at the market rate of 8.5% from some bank, but will receive what is
effectively a 1% payment from the payoff of the FRA resulting in a net borrowing rate of 7.5%.

To summarize:

At contract inception:
ABC enters in a 3-month FRA as the long at the forward rate on 180-day LIBOR of 7.5%.

At settlement in 3 months:
At settlement, 180-day LIBOR is equal to 8.5%.
JP Morgan (short) will pay ABC Corp. (long) a cash payment of $47,962, calculated as:
(8.5% 7.5%)(180/360)($10,000,000) = $50,000 (interest savings)
$50,000 / [1 + 0.085(180/360)] = $47,962 (PV of interest savings at settlement date)

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Again, the reason for the present value of $50,000 is due to the fact that this interest savings will
not be realized for another 6 months after settlement (the loan will start on the settlement date
and accrue interest for six months).

The reading uses an A x B terminology to describe FRAs, where A is the length of the FRA
(in months), and B is the sum of the months of the FRA length and the borrowing period
length. In this example, the reading would term this a 3 x 9 FRA (the length of the FRA is
three months, and the sum of the FRA length of 3 months and the borrowing period length
of 6 months equals 9).

Lets put it all together:
At settlement, ABC Corp. will actually borrow at 8.5% (the market rate) in the debt markets, and
will owe interest in six months of:
(8.5%)(180/360)($10,000,000) = $425,000

Note: The amount of interest that would be paid if paying 7.5% would be:
(7.5%)(180/360)($10,000,000) = $375,000
This creates the interest savings of $50,000 by having entered into the FRA.

However, also at settlement, ABC will receive the $47,962 and assuming they invest the
proceeds for six months at 180-day LIBOR, it will accrue to $50,000.

So, ABC will only have to contribute $375,000 in interest themselves since, when this is added to
the $50,000 proceeds, they will have enough to pay the 8.5% interest of $425,000. So, by
entering in the FRA, ABC will effectively pay 7.5% on the borrowed funds.

In general, the FRA payoff, from the perspective of the long, is calculated as:

Lets do another FRA example.

Suppose that, in 30 days, XYZ Corp. expects to borrow $1 million for a period of 90 days. The
firm is concerned about a short-term increase in rates and would like to hedge by locking in the
interest rate today by entering into a 1-month forward rate agreement (FRA). ABC comes to an
agreement with Bank of America at the forward rate on 90-day LIBOR of 5.0% on a contract with
a notional principal of $1 million. Assume that at settlement (in 1 month), 90-day LIBOR is equal
to 6.0%.

Questions:
1. Should XYZ go long or short the FRA?
2. What is the FRA payoff on the settlement? Who owes who?

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Solutions:
First, note that this is a 1 x 4 FRA.

Since XYZ is a borrower looking to hedge against a rise in interest rates, they will go long the
FRA. One month later at FRA settlement, since rates have risen and XYZ Corp. was long the FRA,
XYZ Corp. will gain and Bank of America will lose.

The payoff on the FRA is equal to the PV of the interest savings:
Interest savings: (6.0% 5.0%)(90/360)($1,000,000) = $2,500
PV of interest savings $2,500 / [1 + 0.06(90/360)] = $2,463 (rounded)

Again, it is important to note that Bank of America is NOT going to actually lend money to
XYZ Corp! The use of the FRA is merely a contractual agreement that allows the firm to hedge
the borrowing rate before the start of the loan. So, this FRA is cash settled with a cash payment
to XYZ, and XYZ will borrow in the market from some bank at 6.0%. Putting this all together, at
settlement, XYZ will borrow at the market rate of 6.0% from some bank, but will receive what is
effectively a 1% payment from the payoff of the FRA resulting in a net borrowing rate of 5.0%.

In reality, XYZ will owe the lending bank (not Bank of America) interest of:
(6.0%)(90/360)($1,000,000) = $15,000

However, after the receipt of $2,463 from the FRA, and assuming it is invested for 3 months at
the market rate of 6%, it will accrue to $2,500. In essence, XYZ will only need to come up with
$12,500 in interest, which effectively is a rate of 5% (which was the FRA contract rate):
(5.0%)(90/360)($1,000,000) = $12,500

Lets do one last example.

Consider a 90-day FRA on 180-day LIBOR with a notional principal of $10 million and a contract
rate of 5.5%. Now, assume at settlement that the prevailing 180-day LIBOR is 5%.

Question:
What is the FRA settlement, and who owes who?

Solution:
First, note that this is a 3 x 9 FRA.

Since the prevailing 180-day LIBOR rate of 5% is lower than the contract rate, the short, who is
short the rate, gains and will receive the settlement payment from the long.

The gain is equal to:
(5.0% 5.5%)(180/360)($10,000,000) = $25,000 (negative is loss to long, gain to short)
$25,000 / [1 + 0.05(180/360)] = $24,390 (rounded)

Thus, the long will make a settlement payment to the short at settlement for $24,390.

In a given FRA problem, be able to determine whether the party should go long or short, and be
able to compute the settlement payment and determine which party (long or short) must pay
the settlement payment.

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Currency forwards
Forward contracts where the underlying asset is a particular currency exchange rate are
referred to as currency forward contracts. In a currency forward, the contract price is a
particular currency exchange rate. The long agrees to purchase a specific quantity of a particular
currency at the contract exchange rate from the short, who agrees to sell the currency, on the
settlement date. Currency forwards are mostly used by banks and companies to manage
currency risk.

Consider the following currency forward contract example:

Suppose Microsoft expects to receive 50 million Euros in 3 months for sales generated in
Europe. The Euros must be converted to US dollars, and MSFT is concerned with the recent
volatility in the exchange rate. In short, to protect against an adverse movement in the exchange
rate, MSFT may enter into a currency forward contract today to essentially lock the exchange
rate at which the currency will be converted to US dollars in three months. Suppose MSFT
enters into a 3-month currency forward contract with a counterparty agreeing to convert 50
million Euros into dollars at the exchange rate of $1.20/Euro.

Question:
Suppose in 3 months (at settlement), the prevailing exchange rate is $1.30/Euro. What is the
payoff of the currency forward at settlement and who owes who?


Solution:
To answer this, we examine what would happen to MSFT in the absence of the currency forward
and compare it to what it will receive without the currency forward. In the absence of the
currency forward, MSFT will convert the 50 million Euros at the prevailing exchange of $1.30. In
this case, MSFT would receive:

50 million Euros x $1.30 = $65 million

However, under the currency forward, MSFT will receive only:
50 million Euros x $1.20 = $60 million

So, effectively, MSFT has lost money by entering into the currency forward. The loss is $5
million. So, to settle the currency forward, MSFT will pay the counterparty a $5 million payment.

Lets look at the transaction a bit more closely. As of the settlement date, the exchange rate is
$1.30/Euro and the forward rate is $1.20/Euro. Put yourself in the position of MSFT. Currently,
your 50 million Euros are worth $65 million (at the prevailing exchange rate of $1.30/Euro) but
you agreed three months ago to exchange the Euros at the exchange rate of $1.20/Euro. So, you
are effectively losing $0.10 per Euro by having to exchange the Euros at the $1.20/Euro
exchange rate instead of the market exchange rate of $1.30. For the 50 million Euros, this is a $5
million total loss.

Rather than actually delivering the Euros to the counterparty for US dollars, it is more
conventional to cash settle. In this case, MSFT will convert the Euros to US dollars on the open
market at the prevailing exchange rate of $1.30 and collect $65 million; separately, MSFT will

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cash settle the currency forward contract by paying the loss of $5 million; again, MSFT ends up
with $60 million just as if MSFT has exchanged the currency to the counterparty directly.
To summarize:

At contract inception:
Forward contract to exchange 50 million Euros at $1.20/Euro in 3 months

At settlement in 3 months (delivery or cash settle):
Delivery: Cash settle:
Exchange 50 million Euros @ $1.20/Euro Exchange 50 million Euros on
Receive: $60 million market at $1.30/Euro
Receive $65 million
Pay loss on forward: $5 million
Net receipt: $60 million
($1.20/Euro)

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