Fixed Income Forward
What Is a Fixed Income Forward?
A fixed income forward is a derivatives contract to buy or sell fixed-income securities at some date from now on, however at a price accepted today.
Fixed income alludes to a type of investment wherein real return rates or periodic income is received at normal spans and in all actuality unsurprising levels. Investors might utilize forward contracts on fixed-income securities to lock in a bond price today while taking ownership or selling the security itself later on.
How a Fixed Income Forward Works
The risk in holding fixed income forward contracts is that market interest rates for the underlying bonds can increase or diminish. These changes influence the bond's yield and in this manner its price. Forward rates then become the focal point of investor consideration, especially assuming the market for the fixed-income security is considered volatile. A forward rate is the interest rate that is applicable to a financial transaction that will occur from here on out.
The buyer of a forward contract is betting that the price will rise over the forward price among today and the forward date. The seller anticipates the inverse.
Special Considerations
Pricing a Fixed Income Forward
To compute the price of a fixed income forward contract you deduct the present value (PV) of coupon payments, over the life of the contract, from the bond price. This value is accumulated by the risk-free rate over the life of the option. The risk-free rate addresses the interest an investor would anticipate from a totally risk-free investment over a predetermined period.
The value of the contract is the bond price, less the current value of coupons, less the current value of the price which will be paid at expiration (bond price - PV coupons - PV price paid at expiration).
Profiting from a Fixed Income Forward
Profiting from a fixed income forward relies upon which side of the contract the investor is on. A buyer enters the contract trusting the market price of the bond will be higher in the future since the difference between the contracted price and the market price addresses profit. The seller expects that the bond price will fall.
While the number of coupon payments for the life of the bond might surpass the life of the contract, consideration is just on the payments due during the contract period. This payment limitation is brought about by certain bonds having maturities that are significantly longer than the duration of the contract. Contract participants are hedging for price developments over a more limited period.
Fixed income forward contracts are most loved instruments for investors who are looking to hedge interest rate or other risks in the bond market. Other traders are drawn to the fixed income forward market to profit from inconsistencies between the forward and spot markets for bonds and other debt instruments.
Fixed Income Forward versus Fixed Income Future
Fixed income derivatives might be traded on exchanges, where the underlying bond and terms of the contract are normalized. Dissimilar to a forward contract that trades over-the-counter (OTC), a normalized fixed income derivative is an exchange-traded futures contract. These exchanges distribute these rates alongside the types of bonds accepted as payment. Otherwise, forwards and futures operate in comparative fashion.
Features
- The value of a forward contract is the bond price less the current value of coupon payments less the current value of the price at expiration.
- A fixed income forward is an agreement to execute in a fixed-income security at a preset price at some date from here on out (the forward date).
- Forward contracts are utilized to moderate the risk associated with price volatility among today and some future date.
- Futures are like forward contracts however normalized. Forward contracts can be redone.
