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5 Cards in this Set
- Front
- Back
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What is the No-Arbitrage Principle, and how is it used todetermine forward contract pricing? Pg 10-14, Derivs |
The No-Arb Principle is the idea that an investor should notbe able to make riskless economic profit by capitalizing on price discrepanciesof an asset (simultaneously buying and selling). This assumes that there are notransaction costs and that short sales are available. With this theory, we can determine the price of a forward byusing assets that are actively traded by assuming that the market will forcethe forward contract to a certain price because arbitrage is available. Keep inmind that with forward contracts, no assets are typically exchanged at theinitiation of the contract, so price must be determined by the no arbprinciple. |
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Explain how the value of a forward is determined over thelife of the contract, and be able to calculate it. Pg 14-16, derivs |
If you conceptually think about what the parties involved inthe contract will receive and be obligated to pay, it is fairly easy tocalculate the value of the forward at any particular point in time. At the initiation of a forward contract, the long positionagrees to receive the asset at a particular price at a particular point in thefuture. So at expiration (time T), the long position will receive the spotprice at time T and will be obligated to pay the agreed upon forward contractprice. So the formula for the value of the contract would be: Value of long position = Spot (t) – [Forward price / (1 +risk free)^(remaining years in contract)] The opposite is true for the short position, but theimportant thing to think about is which party receives what, and back into thevalue. |
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Use examples on pages 16-20 to be able to calculate anEQUITY forward contract value for both a regular paying stock and an index(continuous dividend paying stock). |
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Describe the mechanics behind a forward rate agreement(FRA), and be able to calculate the value of one at initiation, during the lifeof the contract and the value of a long position should interest ratesfluctuate. Pg 21-26, derivs |
A forward rate agreement is a contract whereby a loan isinitiated at a specified time in the future for a specified duration. Forexample a 1 X 4 FRA would be a 3 month loan that is initiated 1 month fromtoday. These contracts are quoted based on LIBOR (30/360 quote). The party who is receiving the loan is said to be “long” theFRA. This means that if interest rates increase during the life of thecontract, the holder of the long position will benefit because they are lockedinto the forward rate in the contract and will save the difference between themarket rate and the forward rate. It isimportant to remember that the value in the contract (ie the savings on theloan) are to be received at the end of the contract. Use the examples on pages 21-26 as they give a good step bystep explanation of the mechanics behind valuing the contracts. |
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Explain the credit risk of an FRA. Pg 29, derivs |
Over the life of an FRA, the fluctuations in market interestrates will benefit one of the two parties involved in the contract. The creditrisk in the contract is solely held by the party who is set to benefit from theinterest rate fluctuations, as they are the party which will be paid at the endof the contract. So, the credit risk in an FRA is held by only on party in the contract,and it is the amount by which the fluctuations in market interest rates varyfrom the contract rate. |
