'Forward Contracts on Bonds' question question

tarik64

Example from Schweser SS17:

Question:

A forward contract covering $10m face value of T-bills that will have 100 days to maturity at contract settlement is priced at 1.96 on a discount yield basis. Compute the dollar amount the long must pay at settlement for the T-bills.

Answer:

Unannualize the discount rate: 0.0196 * (100/360) = 0.005444
Settlement price: $10m * (1-0.005444) = $9.95m

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Interpretation (expanding a bit more than the Schweser contents):
In order for long to profit- if the above contract is executed, the interest rate at/or before the settlement date must be either at or below the current rate, where the value of the T-bill will either be stable or increase. Long can have losses if the interest rate increases and value of the T-bill declines.

If a short was to execute the bilateral contract, the effect will be opposite, i.e. the short would sell at the same 1.96% rate and would profit from a rise in the discount rate and a loss in case of a rate decrease at/or before the settlement date.
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Is the interpretation above correct.

Thanks!

kamara5

I think it should be the opposite.

Long will benefit when i/r increase. Long has the obligation to borrow at the contract rate (say 5%). If i/r increase (say 10%), the long benefit by able to borrow at 5% instead of 10%. Opposite is true for shortist.

Bluetick1010

revenant Wrote:
-------------------------------------------------------
> I think it should be the opposite.
>
> Long will benefit when i/r increase. Long has the
> obligation to borrow at the contract rate (say
> 5%). If i/r increase (say 10%), the long benefit
> by able to borrow at 5% instead of 10%. Opposite
> is true for shortist.


This is a T-Bill foward not a Forward Rate Agreement (FRA) so no borrowing will take place. Sujan, I believe you are correct with your interpretation.

manasib

job71188 Wrote:
-------------------------------------------------------
> revenant Wrote:
> --------------------------------------------------
> -----
> > I think it should be the opposite.
> >
> > Long will benefit when i/r increase. Long has
> the
> > obligation to borrow at the contract rate (say
> > 5%). If i/r increase (say 10%), the long
> benefit
> > by able to borrow at 5% instead of 10%.
> Opposite
> > is true for shortist.
>
>
> This is a T-Bill foward not a Forward Rate
> Agreement (FRA) so no borrowing will take place.
> Sujan, I believe you are correct with your
> interpretation.

Sorry my bad. Brain beginning to switch off after 10 hours of studies.

ftwcfa

Thanks job71188. You are indeed correct that this is a forward contract problem (Tbill in this case).

Correct me if I am wrong but I have noticed that any problems concerning FRA will explicitly use the term FRA in it. And at all times I have ended up using the following formula to figure out the payment to the long at settlement, i.e.:

notional principal * (interest difference bet ref and the forward rate/discount rate to the settlement date)

Cheers

ramdabom

Actually the formula for FRA can be derived intuitively. I am able to get the correct answer on my first attempt at a FRA question without knowing theres a formula.

Try to derive intuitively and that will be 1 formula less from your memory