Lesson 7 of 10
The forward contracts on bonds are similar to equity forward contracts except that they have bonds as the underlying asset. The forward contracts can be written on both zero-coupon bonds (such as T-bills in the US) and coupon paying bonds.
Since bonds have a maturity date, the forward contracts on these bonds must also settle before the maturity date of the bond.
We had earlier taken an example of a 180-day T-bill selling at 4%. This 4% is the annualized discount rate at which the T-bill is selling. This means that a $1,000 par T-bill is selling at $1000*0.04*(180/360) = $980. If this T-bill is held till maturity, it will fetch $1,000 to the investor.
Two parties can enter into a forward agreement such that Party A will buy this T-bill from Party B at a price of $985 30 days from now. This will be a forward contract.
When the market interest rates increase, the discount rate will increase, leading to a fall in the T-bill price. Since the long is required to purchase the bond, a decrease in price will be a loss for him and profit for the short. Similarly, when the price increases, it will be a profit for the long and loss for the short.
In case of coupon paying bonds, the price in the forward contract will be stated in terms of yield to maturity as on the settlement date. The yield excludes the accrued interest. There are separate provisions for the risk of default, and other features such as an embedded option.
These forward contracts can be on individual bonds as well as portfolio of bonds.