Level II Review, Forwards and Futures

Study session 16 in the Level II CFA Program curriculum starts the material on derivatives with two readings (48-49) on forwards and futures. The topic is worth between 5% to 15% on both the Level 2 and Level 3 exams so you will definitely see at least one item set and possibly more.
Forward Markets and Contracts
The forward price is based off of a no-arbitrage assumption that you shouldn’t be able to earn a riskless return above the risk-free rate. The price is a function of the spot price, the risk-free rate and the term of the contract = S0*(1+Rrf)T
You need to understand this simple equation to be able to calculate a cash and carry arbitrage, which often finds its way onto the exams.  This is where you borrow at the risk free rate, buy the bond and simultaneously short/long the forward contract to profit on the difference.
Example: You calculate the no arbitrage price on a four-month contract of $813.10 with a risk-free rate of 5% but the forward is priced in the market at $850. The cash and carry is borrow $800 at the risk-free and buy the bond while shorting the forward contract. At the settlement date, the short forward is satisfied by delivering the bond for a payment of $850 and used to repay the $800 loan. The total amount to repay the loan over the four month term is $800*(1.05).333 = $813.10 with an arbitrage profit of $850 – $813.10 or $36.89 (try several practice problems for this until you can easily do it for under- or over-priced forwards)
Once you have the basic formula down and can do a cash/carry example, the rest of the iterations on forward pricing are fairly easy. The forward rate agreement (FRA) is a little harder, but it is another highly testable item and you need to practice it until you know it. Remember to use 360 for the annual term in the denominator.
Futures Markets and Contracts
Make sure you understand the differences between futures and forward markets and products. Futures are marked to market, traded on organized exchanges, standardized, involve a third-party clearinghouse, and are regulated. Forwards are between private parties, not marked to market, customized and not regulated. Understand how this affects counter-party risk, liquidity, price and margin.
The futures price is also built on the same no-arb assumption so be ready to calculate it and work a cash/carry example.
Backwardation and contango are two important terms on which the curriculum has focused. Backwardation is where the futures price is less than the spot while the spot is less than the future price in Contango. Understand the basics of how these two phenomenon affect market participants for futures (growers and speculators).
Study session 17 in the Level II CFA Program curriculum concludes the material on derivatives with four readings on options, swaps, and rate derivatives.
‘til next time, happy studyin’
Joseph Hogue, CFA

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