What is Fixed Income Forward
A fixed income forward is an options contract to buy or sell fixed income securities, in the future, at a price accepted today. Fixed income is a type of investment in which real return rates or periodic income is received at regular intervals and reasonably predictable levels.
Investors use options contracts for fixed income securities to lock in a bond price now while buying or selling the security itself in the future.
BREAKING DOWN Fixed Income Forward
The risk in holding fixed income forward contracts is that market interest rates for the underlying bonds can increase or decrease. These changes affect the bond’s yield and thus its price. Forward rates then become the focus of investor attention, especially if the market for the fixed income security is considered volatile. A forward rate is an interest rate applicable to a financial transaction that will take place in the future.
Pricing a Fixed Income Forward Contract
The calculation of the price of a fixed income forward contract is by subtracting the present value (PV) of coupon payments, over the life of the contract, from the bond price. This result is them compounded by the risk-free rate over the life of the option. The risk-free rate represents the interest an investor would expect from an entirely risk-free investment over a specified period.
The value of the contract is the bond price, less the present value of coupons, less the present value of the price which will be paid at expiration (bond price - PV coupons - PV price paid at expiration).
Profiting from Fixed Income Forward Contracts
Profiting from a fixed income forward depends on which side of the contract the investor is on. A buyer enters the contract hoping the market price of the bond will be higher in the future since the difference between the contracted price and the market price represents profit. The seller expects that the bond price will fall.
While the number of coupon payments for the life of the bond may exceed the life of the contract, consideration is only on the payments due during the contract period. This payment limitation is because some bonds will have maturities much longer than the duration of the contract. Contract participants are hedging for price movements over a shorter period.
Fixed Income Futures Trading
Often fixed income forward options are sold on exchanges, and the underlying bond is standardized. A standardized fixed income future investment means the bonds underlying the contract are fictional. Repayment of these futures can, therefore, be with a variety of real bonds at predetermined conversion rates. These exchanges publish these rates along with the types of bonds accepted as payment.
Fixed income forward contracts are favorite instruments for investors who are looking to hedge interest rate or other risks in the bond market. Other traders are attracted to the fixed income forward market to profit from anomalies between the forward and spot markets for bonds and other debt instruments.