Financial Markets and Institutions (2-downloads)

Forward contracts are agreements by two parties to engage in a financial trans-

action at a future (forward) point in time. Here we focus on forward contracts that

are linked to debt instruments, called interest-rate forward contracts; later in the

chapter we discuss forward contracts for foreign currencies.

Interest-Rate Forward Contracts

Interest-rate forward contracts involve the future sale or purchase of a debt instru-

ment and have several dimensions: (1) specification of the actual debt instrument

that will be delivered at a future date, (2) amount of the debt instrument to be deliv-

ered, (3) price (interest rate) on the debt instrument when it is delivered, and (4)

date on which delivery will take place. An example of an interest-rate forward con-

tract might be an agreement for the First National Bank to sell to the Rock Solid

Insurance Company, one year from today, $5 million face value of the 6s of 2029

Treasury bonds (coupon bonds with a 6% coupon rate that mature in 2029) at a price

that yields the same interest rate on these bonds as today’s, say, 6%. Because Rock

Solid will buy the securities at a future date, it has taken a long position, while the

First National Bank, which will sell the securities, has taken a short position.

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