Derivatives - Forward Contracts on Bonds
The basic characteristics of a forward contract on a bond are very much like those of equity. A bond pays a coupon similar to an equity paying a dividend.
The differences are:
- Bonds mature; this means that contracts must also mature before the maturity date.
- Bonds can have calls and convertibility.
- Bonds have a default risk, which means the contract must include remedies for this risk in case it occurs.
Forward contracts can be on an individual issue as well as on a portfolio of bonds or on a bond index.
For zero-coupon bonds like a T-bill, a forward contract has one party agreeing to buy the T-bill at a later date, but before its maturity, at a price that is agreed to at the time the contract is made.
Remember that T-bills are sold at a discount to par and are quoted in terms of the discount rate.
Example: Forward Contracts on Zero-Coupon Bonds
A 180 day T-bill is selling at 3.5%. The par of a $1 par value, therefore, would equal 1 - .035(180/360) = $ 0.9825. If the bond is held to maturity it will pay the investor $1. The 360 days in the above formula is market convention for the number of days in a year.
For coupon-paying bonds, interest payments, which are typically semi-annual and can sell at a premium or discount to the bond's par value, must be taken into account. Prices are usually quoted without the interest rate that has accrued from the last payment. We will typically work with a bond's full price, the price that includes accrued interest. Prices are quoted by stating the yield. Forward contracts call for the delivery of a bond prior to the bond's maturity where the short pays the long the agreed-upon price.