10/10/2018 nattawoot koowattanatianchai 1fin.bus.ku.ac.th/ba 747 investment analysis and... ·...
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10/10/2018 Nattawoot Koowattanatianchai 1
10/10/2018 Nattawoot Koowattanatianchai 2
Investment Analysis &
Portfolio Management
Assistant Professor
Nattawoot Koowattanatianchai,
DBA, CFA
10/10/2018 Nattawoot Koowattanatianchai 3
Email:
Homepage:
http://fin.bus.ku.ac.th/nattawoot.htm
Phone:
02-9428777 Ext. 1212
Mobile:
087- 5393525
Office:
9th floor, KBS Building 4
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Lecture 4
Forward contracts
Discussion topics
Forward contracts
Nature of a forward contract
Types of forwards
Pricing and valuation of equity
forwards
Pricing and valuation of bond
and interest rate forwards
Pricing and valuation of currency
forwards
Credit risk in forwards
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Readings
CFA Program Curriculum 2015 -
Level II – Volume 6: Derivatives
and Portfolio Management.
Reading 47
Don M. Chance and Robert
Brooks, An Introduction to Derivatives and Risk Management, 9th Edition, 2013,
Thomson.
Chapters 8-9
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Derivative contracts
Definition
A derivative contract derives its value from the
performance of an underlying entity (e.g., asset,
index, or interest rate).
Derivative contracts covered in this course
Forwards
Futures
Options
Swaps
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Forward contracts
Definition
A forward contract is an
agreement between two
parties in which one party, the
buyer or the long, agrees to
buy from the other party, the
seller or the short, an
underlying asset or other
derivative, at a future date at
a price established at the
start of the contract.
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Forward contracts
Example
A pension manager, anticipating the receipt of
cash at a future date, enters into a commitment to
purchase a stock portfolio at a later date at a price
agreed on today.
The manager is hedged against an increase in stock
prices until the cash is received and invested.
The manager is also hedged against any decrease in
stock prices.
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Forward contracts
Important features
Transaction price and quantity
are agreed today.
Neither long or short pays any
money at the start, although
some collateral may be
required to minimize the
default risk.
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Delivery and settlement
At expiration
A deliverable forward contract stipulates that the
long will pay the agreed-upon price to the short,
who in turn will deliver the underlying asset to the
long.
Alternatively, a cash settlement forward contract
permits the long and short to pay the net cash
value of the position on the delivery date.
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Delivery and settlement
Example
Two parties agree to a forward contract to trade a
zero-coupon at a price of $98 per $100 par.
At expiration, the underlying zero-coupon bond is
selling at a price of $98.25.
Delivery: The long is due to receive from the short an
asset worth $98.25, for which a payment to the short of
$98.00 is required.
Cash settlement: The long is due to receive $0.25 from
the short.
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Default risk
Only the party owing the
greater amount can default.
Delivery: If the short is obligated
to deliver a zero-coupon bond
selling for more than $98, then
the long would not be obligated
to make payment unless the
short makes delivery.
Cash settlement: Since the
short is owing the greater
amount, he/she may default.
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Termination of a forward contract
Assuming that the contract calls for a delivery
at expiration, and that the long decides that
he/she no longer wishes to buy the asset at
expiration.
The long can re-enter the market and create a
new forward contract expiring at the same time as
the original contract, taking the position of the
short instead. Doing so would mean that the long
has no further exposure to the price of the asset.
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Termination of a forward contract
Example
Amy is originally long to buy at $40 and later short
to deliver $42.
At expiration, the short of the original contract delivers
the asset to Amy, and she pays him $40.
Amy then delivers the asset to the long of the
subsequent contract and receive $42.
Amy nets $2.
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Termination of a forward contract
Example
Amy is exposed to a possibility of default from her
counterparty (credit risk).
The counterparty of her original contract defaults, she
has to buy the asset in the market and could suffer a
significant loss.
If the counter party of her subsequent contract defaults,
she would then not deliver the asset but would be
exposed to the risk of changes in the asset price.
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Termination of a forward contract
Example
Amy can avoid the credit risk by
contacting the original
counterparty with whom she
engaged in the long forward
contract and go short the forward
this time.
If both agree to cancel both
contracts, the counterparty would
pay Amy the present value of $2.
The credit risk is eliminated.
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Termination of a forward contract
Example
Amy could choose to deal
with the other counterparty
and leave the credit risk in
the picture.
She might receive a better price
from another counterparty.
She might perceive the credit
risk to be too high.
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Types of forward contracts
Types of forward
contracts
Equity forwards
Bond and interest
rate forward
contracts
Currency forward
contractsOther types
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Equity forwards
Definition
Equity forward is a contract
calling for the purchase of an
individual stock, a stock
portfolio, or a stock index at a
later date.
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Equity forwards: Individual stocks
Example
A portfolio manager is responsible for the portfolio
of a high-net-worth individual. This individual is
heavily invested in the stock called Gregorian
Industries, Inc. (GII). The client notifies the
manager of her need for $2 million in cash in six
months. This cash could be raised by selling
16,000 shares at the current price of $125 per GII
share. For whatever reason, it is considered best
not to sell the stock any earlier than necessary.
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Equity forwards: Individual stocks
Example
Portfolio manager’s actions:
Contacting a forward contract dealer and obtaining a
quote of $128.13 as the price at which a deliverable
forward contract to sell the stock in six months. Signing
the contract for the sale of 15,600 shares at $128.13
which will raise $1,998,828.
Possible consequences at expiration:
The client gains if the GII stock rises to a price above
$128.13 during the six-month period.
The client loses if the price falls below $128.13.
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Equity forwards: Stock portfolios
Example
A pension fund manager needs to sell about $20
million of stocks to make payments to retirees in
three months. The manager has analyzed the
portfolio and determined the precise identities of
the stocks and number of shares of each that he
would like to sell.
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Equity forwards: Stock portfolios
Example
Pension fund manager’s
possible options:
Option 1: Entering into a forward
contract on each stock that he
wants to sell and incurring
administrative costs for each
contract.
Option2: Entering into a forward
contract on the overall portfolio
and incurring only one set of
costs.
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Equity forwards: Stock portfolios
Example
Pension fund manager’s actions:
Choosing Option 2 and providing a list of the stocks and
number of shares of each he wishes to sell to the dealer.
Obtaining a quote of $20,200,000 from the dealer.
If the stock is worth $20,500,000 at expiration.
Deliverable: The manager will transfer the stock to the
dealer and receive $20,200,000. This means that the
client effectively takes an opportunity loss of $300,000.
Cash settlement: The client will pay the dealer $300,000
and sell the stock in the market, receiving $20,500,000.
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Equity forwards: Stock indices
Example
A UK asset manager wants to protect the value of
her Financial Times Stock Exchange 100 (FTSE
100) index fund. The manager wants to sell a
certain amount of UK blue chip shares at the later
date, but is unsure which stocks she will still be
holding then. She simply knows that FTSE 100 is
representative of the stock that she will sell. The
manager is also concerned with the systematic
risk associated with the UK stock market.
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Equity forwards: Stock indices
Example
Asset manager’s possible
options:
Option 1: Taking a specific
portfolio of stocks to a forward
contract dealer and obtaining a
forward contract on that portfolio.
Option 2: Obtaining a forward
contract on the FTSE 100 that has
a better price quote because the
dealer can more easily hedge the
risk with other transactions.
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Equity forwards: Stock indices
Example
Asset manager’s actions:
Assume that the manager
decides to protect
£15,000,000 of stocks. She
chooses Option 2 and
obtains a quote price of
£6,000 on a short forward
contract covering
£15,000,000 from the dealer.
The index contract is nearly
always cash settled.
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Equity forwards: Stock indices
Example
At expiration, the index is at £5,925.
The index declines by 1.25%. Thus, the manager should
receive 0.0125 × £15,000,000 = £187,500 from the
dealer.
If the portfolio perfectly matches a FTSE 100 index fund,
then it could be viewed that the loss of 1.25% of the
portfolio initially worth £15,000,000 (loss of £187,500) is
covered by the forward contract.
In reality, the portfolio is not an index fund and such a
hedge is not perfect.
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Forward contracts on bonds
Definition
Bond forward is a contract calling for the purchase
of an individual bond, a bond portfolio, or a bond
index at a later date.
Similarities between equity forwards and
bond forwards
A bond may pay a coupon, which corresponds
somewhat to the dividend that a stock may pay.
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Forward contracts on bonds
Differences between equity forwards and bond
forwards
A bond matures. Thus, a forward contract on a bond must
expire prior to the bond’s maturity date.
Bonds often have many special features such as calls and
convertibility.
A bond carries the risk of default. So, a forward contract
written on a bond must contain a provision to recognize
how default is defined, what it means for the bond to
default, and how default would affect the parties to the
contract.
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Forward contracts on bonds
Example
Consider a forward contract on a default-free
zero-coupon bond (or a Treasury bill or T-bill) in
which one party agrees to buy the T-bill at a later
date, prior to the bill’s maturity, at a price agreed
on today.
Suppose the underlying is a 180-day T-bill, which is
selling at a discount of 4%.
Its price per $1 par will be 1- 0.04(180/360) = $0.98.
The bill will therefore sell for $0.98.
If purchased and held to maturity, it will pay off $1.
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Forward contracts on bonds
Example
Consider a forward contract that calls for delivery
of a 90-day T-bill in 60 days.
Suppose the contract sells for $0.9895. This implies a
discount rate of 4.2%.
$1 – 0.042(90/360) = $0.9895
T-bills are typically sold at a discount from par
value, a procedure called “discount interest”, and
the price is quoted in terms of the discount rate.
The use of 360 days is the convention in
calculating the discount.
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Forward contracts on bonds
Example
Consider a forward contract on a default-free
coupon-bearing bond, or a Treasury bond or T-
Bond.
The T-bond pays interest, typically in semiannual
installments, and can sell for more (less) than par value
if the yield is lower (higher) than the coupon rate.
Prices of T-bonds are typically quoted without the
interest that has accrued since the last coupon date. But
we shall always work with the full price – that is, the
price including accrued interest.
Prices are often quoted by stating the yield.
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Interest rate forward contracts
Eurodollar
A dollar deposited outside the US.
Banks borrow dollars from other banks by issuing
Eurodollar time deposits, which are essentially
short-term unsecured loans.
The rate on such dollar loans is call the London
Interbank Rate.
The lending rate, called the London interbank offered
rate (Libor), is more commonly used in derivative
contracts.
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Interest rate forward contracts
Libor
Libor is the rate at which
London banks lend dollars
to other London banks.
Libor is considered to be
the best representative
rate on a dollar borrowed
by a private, i.e., non
governmental high-quality
borrower.
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Interest rate forward contracts
Example: Eurodollar time deposit
Suppose a London bank such as NatWest needs
to borrow $10 million for 30 days. It obtains a
quote from the Royal Bank of Scotland for a rate
of 5.25%.
30-day Libor is 5.25%.
If NatWest takes the deal, it will owe $10,043,750 in 30
days.
$10,000,000 x [1 + 0.0525(30/360)] = $10,043,750
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Interest rate forward contracts
Example: Eurodollar time deposit
Unlike the T-bill market, the interest is not
deducted from the principal. Rather, it is added on
to the face value, a procedure appropriately called
“add-on interest”.
The rates on Eurodollar time deposits are
assembled by a central organization and quoted
in financial newspapers.
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Interest rate forward contracts
Example: Other time deposit instruments
Eurosterling trades in Tokyo.
Euroyen trades in London.
A euro-denominated loan
One bank borrows euros from another.
There are two rates on such euro deposits.
EuroLibor is complied in London by the British Bankers
Association.
Euribor is complied in Frankfurt and published by the
European Central Bank.
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Interest rate forward contracts
Forward rate agreement
(FRA)
FRA is a contract in which the
underlying is neither a bond
nor a Eurodollar or Euribor
deposit but simply an interest
payment made in dollars,
Euribor, or any other currency
at a rate appropriate for that
currency.
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Interest rate forward contracts
Example: FRA
Consider an FRA expiring in 90 days for which the
underlying is 180-day Libor. Suppose the dealer
quotes this instrument at a rate of 5.5%. Suppose
the end user goes long and the dealer goes short.
The contract covers a given notional principal of
$10 million.
The end user will benefit if rates increase.
In contrast, the dealer will benefit if rates decrease.
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Interest rate forward contracts
Example: FRA
At expiration in 90 days, the rate on 180-day Libor
is 6%.
The 6% interest will be paid 180 days later.
The present value of a Eurodollar time deposit at that
point in time would be:
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Interest rate forward contracts
Example: FRA
At expiration in 90 days, the rate on 180-day Libor
is 6%.
The end user, the party going long the FRA, receives
the following payment from the dealer, which is the party
going short:
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Interest rate forward contracts
Example: FRA
At expiration in 90 days, the rate on 180-day Libor
is 6%.
The numerator indicates that the contract is paying the
difference between the actual rate that exists in the
market on the contract expiration date and the agreed-
upon rate, adjusted for the fact that the rate applies to a
180-day instrument.
The divisor appears because it is necessary to adjust
the FRA payoff to reflect the fact that the rate implies a
payment that would occur 180 days later on a standard
Eurodollar deposit.
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Interest rate forward contracts
FRA payoff formula (from the perspective of
the party going long)
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Interest rate forward contracts
FRA descriptive notation and interpretation
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Notation Contract expires in Underlying rate
1×3 1 month 60-day Libor
1×4 1 month 90-day Libor
1×7 1 month 180-day Libor
3×6 3 moths 90-day Libor
3×9 3 months 180-day Libor
6×12 6 months 180-day Libor
12×18 12 months 180-day Libor
Currency forward contracts
Definition
A currency forward contract enables one party to
lock in a pre-agreed upon exchange rate at which
it will sell one currency and buy another currency
at a later date.
Use
Currency forwards are widely used by banks and
corporations to manage foreign exchange rate
risk.
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Currency forward contracts
Example
Suppose Microsoft has a European subsidiary
that expects to send it €12 million in three months.
When Microsoft receives the euros, it will then
convert them to dollars.
Microsoft is essentially long euros since it will have to
sell euros, i.e., Microsoft has euro-nominated assets that
exceed in value its euro-nominated liabilities.
Microsoft is essentially short dollars because it will have
to buy dollars.
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Currency forward contracts
Example
Microsoft’s actions
Obtaining a quote on a currency forward for €12 million
in three months.
JP Morgan Chase quotes a rate of $0.925.
Under this contract, Microsoft would know it could convert
its €12 million to 12,000,000 × $0.925 = $11,100,000 in
three months.
To hedge its position, Microsoft has to go short the
forward contract, i.e., goes short the euro and long the
dollar.
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Currency forward contracts
Example
At expiration, the spot rate for euros is $0.920.
Delivery: Microsoft is pleased that it is locked in a rate of
$0.925. It simply delivers the euros and receives
$11,100,000 at an exchange rate of $0.925.
Cash settlement: The dealer pays Microsoft
$12,000,000 × ($0.925 - $0.920) = $60,000. Microsoft
has to convert the euros to dollars at the current spot
exchange rate of $0.920, receiving 12,000,000 × $0.920
= $11,040,000.
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Other types of forward contracts
Examples
Commodity forwards
The underlying asset is oil, a
precious metal, various sources of
energy (electricity, gas, etc.), or
some other commodity.
Forward contracts on whether
The underlying is a measure of the
temperature or the amount of
disaster damage from hurricanes,
earthquakes, or tornados.
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Forward markets
Important characteristics
Forward contracts are private transactions,
permitting the ultimate customization.
Forward markets have only a light degree of
regulation. Default rates are high as a result.
Forward markets serve a specialized clientele,
specifically large corporations and institutions with
specific target dates, underlying assets, and risks.
Transactions in forward contracts typically are
conducted over the phone.
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