FIN30021 Fixed Income and Debts Markets Week - 11 Forwards, Futures and Options Question 1 What is a FRA and what are the advantages and disadvantages for this instrument? FRA is a forward rate agreement which is traded over the counter. It is where one party (borrower or investor) wishes to lock in the rate for a future transaction. The other party (usually a bank or other financial institution) basically guarantees the rate for the future. If the future rate is different to the current market rate at the future date, the difference is paid by the bank or the borrower or investor. For example for a borrower the agreed rate may have been 4%. If the market rate is 5%, the bank will pay the borrower the extra 1%. If the market rate is 2.5%, then the borrower pays the bank the extra 1.5%. Advantages: Disadvantages: • Flexibility • Not formal market • Low transaction costs · Forfeit possible gains • Market depth • Credit risk · Settlement Question 2 Borrower Investor Investor Question 3 Transaction Issuing debt in future Buying a debt in the future Selling debt in the future Risk Increase in rates (decrease in price) Decrease in rates (increase in price) Increase in rates (decrease in price) Strategy Price high now and later will be lower, thus SELL futures now and BUY futures at later date. Price low now and later will be higher, thus BUY futures now and SELL futures at later date. Price high now and later will be lower, thus SELL futures now and BUY futures at later date. What is the major disadvantage for futures? The main disadvantage of a future is that if the rate moves in your favour than you will forfeit this gain as the future's strategy will have a negative outcome and erode the benefit gained in the physical market. Question 4 What is a future option and when would you use them? 1
A futures option is an option on a futures contract. When using futures any gains in the physical market will be eroded in the futures market. This erosion can be limited by using future options. In the case of a borrower who sells a future now and buys back later to protect against an increase in rates, can use a futures option to protect the second transaction. In this case the borrower would buy a call futures option (as the second transaction is to close out the futures contract by buying the futures.) and put a lower limit on the rate. If the rates do rise then you do not exercise as the original strategy works. If the rates decrease which is not favourable in the futures market (as you are buy back a security which has gone up in price.) then you exercise your option. Question 5 Why don't hedgers use options instead of futures? The main disadvantage with options is that there is a premium paid for the option. If you exercise