Forward Contract Valuation

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Questions and Answers

Explain how no-arbitrage condition at forward contract initiation ensures zero value for both the long and short positions.

The no-arbitrage condition sets the forward price such that the initial cost of entering the contract is zero, leading to no initial value for either party.

How does an increase in the underlying asset's spot price after forward contract initiation affect the value of the long and short positions?

An increase in spot price benefits the long position, making its value positive; conversely, it negatively impacts the short position, making its value negative.

Why is there no discounting needed when calculating the value of a forward contract at expiration?

At expiration, there is no time left until settlement, so the time value of money (discounting) is irrelevant. The contract's value is simply the difference between the spot price and the forward price.

In an equity forward contract, how are expected dividend payments handled when pricing the forward price?

The spot price is adjusted by subtracting the present value of expected dividends (PVD) or adjusting forward price by subtracting the future value of dividends (FVD). Signup and view all the answers

Explain how to calculate the value of a long position in a forward contract on a dividend-paying stock after some time has passed.

It involves subtracting the present value of remaining expected discrete dividends (PVDt) from the current stock price (St), then subtracting the discounted forward price. Signup and view all the answers

How is the formula for pricing a forward contract on a fixed-income security (coupon-paying bond) analogous to that of a dividend-paying stock?

The present value of expected coupon payments (PVC) replaces the present value of dividends (PVD) in the formula. Signup and view all the answers

Explain the interest rate parity relationship and its implications for pricing currency forward contracts.

Interest rate parity states that the forward exchange rate should reflect the interest rate differential between the two currencies to prevent risk-free arbitrage opportunities. Signup and view all the answers

Outline the steps to calculate the value of a currency forward contract prior to maturity.

Calculate it using the current spot rate, the original Ft, domestic and foreign risk-free rates, and the time remaining until maturity. Signup and view all the answers

Describe the no-arbitrage principle in pricing Treasury bill (T-bill) futures contracts.

Pricing relies on using the cost of buying and holding the underlying asset (the 90-day T-bill at maturity) for a period of T years. Signup and view all the answers

How do coupon payments affect the no-arbitrage futures price for a Treasury bond (T-bond) contract?

The future value of the expected coupon payments (FVC) is subtracted from the no-arbitrage futures price on a bond with no coupon payments. Signup and view all the answers

Explain the purpose of a conversion factor (CF) in T-bond futures contracts and how it is applied.

CF adjusts the settlement payment for delivering different bonds in the contract. Signup and view all the answers

How are stock dividends accounted for when pricing futures contracts on individual stocks?

Adjusting the future value of expected dividends, which is similar to how T-bonds with coupon payments are handled. Signup and view all the answers

How is the price of a currency future derived, and what key variables are involved?

SO is the spot exchange rate, and FT is the price of a futures contract of T years duration. Signup and view all the answers

Define VA and VF when hedging an equity portfolio.

VA = Current value of the portfolio and VF = Current value of one futures contract. Signup and view all the answers

Elaborate on why index options are settled in cash instead of physical delivery of the underlying stocks.

Physical delivery for a stock index option would require delivering all stocks in the index in the correct proportions. Signup and view all the answers

Explain how a portfolio manager can use put options on a well-diversified index to implement portfolio insurance.

Buying these contracts protects the portfolio value by providing a payoff that offsets losses when the index falls below the strike price K. Signup and view all the answers

How does the beta of a portfolio affect the number of put options required for portfolio insurance?

If the portfolio’s beta (β) is not 1.0, then β put options must be purchased for each 100S dollars in the portfolio. Signup and view all the answers

Provide a formula of computing the delta of a call option.

Delta (call) = C1-C0/S1-SO = AC/ AS where AC = change in the price of the call over a short time interval and AS = change in the price of the underlying stock over a short time interval Signup and view all the answers

Why should you short the option when you need to create a delta-neutral hedge?

You're short an asset, as the underlying price rises, you lose, and when the price falls, you win. Signup and view all the answers

Explain the basic concept of a Credit Default Swap (CDS).

It provides insurance against the risk of a default by a particular company: the reference entity. Signup and view all the answers

What is the notional principal in a CDS, and how does it relate to the protection provided?

The contract is written on a face value of protection called the notional principal Signup and view all the answers

Name common types of credit events that trigger a payment under a CDS.

Bankruptcy; Failure to pay; Restructuring. Signup and view all the answers

In the context of a CDS, explain the meaning of probability of default and hazard rate.

Given that it has not already occurred the conditional probability of default or hazard rate. The credit risk of a reference obligation and hence the cost of protection is proportional to the hazard rate. Signup and view all the answers

Provide a formula for (expected loss)t.

The long position profits as the contract has fixed a borrowing rate below the now-current market rate. Signup and view all the answers

What are Collateralized Debt Obligations (CDOs)?

The loans are pooled together and then split into a series of classes known as tranches. Senior tranche, Mezzanine, Equity tranche. Signup and view all the answers

In general terms, what is a bull spread strategy using options, and what is its payoff profile?

The value of the option sold is always less than the value of the option bought. Signup and view all the answers

Describe a butterfly spread strategy and its intended outcome.

The value the Butterfly spreads require a small investment initially. Signup and view all the answers

Describe a calendar spread strategy using options.

The profit pattern for a calendar spread produced from call options is similar to the profit from the butterfly spread. Signup and view all the answers

Flashcards

V0 (of long position at initiation)

Initial value of a forward contract for a long position.

Vt (of long position during life of contract)

Value of a long position during the contract's life.