Finance 362 2022SC Workshop 1
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Finance 362
2022SC
Workshop 1
Topic 2: Introduction to Forwards and Futures
1. Types of derivatives contracts
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Forwards |
Futures |
Options |
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OTC |
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Customised product |
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P/L settled at maturity |
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No initial payment |
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Physical delivery |
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A/L |
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Some credit risk |
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High negotiation costs |
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Low liquidity |
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Neutralise your risk by fixing the price you buy/sell |
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2. Margining system of futures contracts
• Minimum price movement that will trigger a margin call:
e.g. An investor enters into five short futures contracts on frozen orange juice. Each futures contract is for the delivery of 15,000 pounds. The current futures price is 160 cents per pound, the initial margin is $6,000 per contract, and the maintenance margin is $3,000 per contract. What price change would lead to a margin call?
(NB: Always remember to indicate the direction of the movement, i.e. upward or downward?)
3. Forward Rate Agreement (FRA) - to protect themselves against a future interest rate movement for a specified period at a specified contract rate. (traded on OTC, cash settlement at maturity, no delivery of principal required)
0 m n
❖ BORROWER needs to FRA to hedge!
e.g (FRA under Australasian term)
- Borrower enter into a _______ FRA (buyer)
- At time 0, agree to borrow the 90 days BB @ rc at time m (i.e. in 1 month time)
- At time m, turns out that the actual 90 days BB interest rate is rm
- At time m, SA to be paid by the borrower at time m is therefore:
F F
1 + (rm×90⁄365) 1 + (rc ×90⁄365)
- At time m, borrow @ rm in the physical market (i.e. receive Pm = 
)
- effective interest rate is re = (
− 1) × 
e.g. (FRA under US term)
L(rm− rc) × #days⁄365
1 + rm × #days⁄365
RQ Topic 2 MCQ 5 to 7
A company plans to issue 90 day bank bills with a face value of $1 million in two months’ time. The treasurer enters into a 2X5FRA at a contract rate of 5.5% to hedge the interest rate risk. The bank bills are issued in two months’ time on the day the FRA is settled when the 90 day bank bill rate is 6.5%.
Q5. What is the settlement amount on a 2X5FRA on a face value of $1 million bought at a contract rate of 5.5% and settled at a market rate of 6.5%?
Q6. What is the effective interest payment on the borrowing (i.e. the discount on the bills issued plus/minus the settlement amount of the FRA)?
Q7. What is the effective interest rate on the borrowing?
Past Test Question
Consider a company that plans to borrow in 180 days by issuing 180-day bank bills. The company is worried that the 6-month interest rate will rise when it issues the bank bills so it entered into a long position in a 4.5% 6×12FRA (ie. a 6-month loan, 6 month from now) with a face value of $2.5 million. Assume all rates are measured with a compounding frequency reflecting the length of the period they apply to. Also assume there are 365 days in a year.
(a) At contract expiration, the 180-day bank bill rate has decreased to 3.5% p.a., which is below the contract rate
of 4.5% p.a.. Calculate the value of the FRA at its maturity. (Please record your answer in 4 d.p.)
(b) Suppose 90 days after the initiation (assume t = 90 now), the “new” FRA price on the original FRA decreased
to 4% p.a.. The 90-day bank bill rate is 3.5% p.a.. Value this FRA today (i.e. t=90).
4. Periodic v Continuous compounding
• The conversion between the simple rates & c.c. rates
e.g. The current interest rate offered by bank is 8% p.a. compounded annually, what is the equivalent quarterly compounded interest rate? And what’s the equivalent continuously compounded interest rate?
5. FRA rates are set to the “implied forward rate”, which is implied from current spot or zero coupon rates.
e.g. The 6-month, 12-month, 18-month, and 24-month zero rates are 3.9%, 4.5%, 4.7%, and 4.9% with continuous compounding. What is the c.c. forward rate for the six-month period beginning in 18 months?
2022-09-02