What Is a Fixed Income Forward?
A fixed income forward is a derivatives contract to buy or sell fixed-income securities at some date in the future, but at a price accepted today.
Fixed income refers to a type of investment in which real return rates or periodic income is received at regular intervals and reasonably predictable levels. Investors may use forward contracts on fixed-income securities to lock in a bond price today while taking ownership or selling the security itself in the future.
- A fixed income forward is an agreement to transact in a fixed-income security at a preset price at some date in the future (the forward date).
- The value of a forward contract is the bond price less the present value of coupon payments less the present value of the price at expiration.
- Forward contracts are used to mitigate the risk associated with price volatility between today and some future date.
- Futures are similar to forward contracts but standardized. Forward contracts can be customized.
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 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 the interest rate that’s applicable to a financial transaction that will take place in the future.
The buyer of a forward contract is betting that the price will rise above the forward price between today and the forward date. The seller expects the opposite.
Pricing a Fixed Income Forward
To calculate the price of a fixed income forward contract you subtract the present value (PV) of coupon payments, over the life of the contract, from the bond price. This value is 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 a Fixed Income Forward
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 caused by some bonds having maturities that are much longer than the duration of the contract. Contract participants are hedging for price movements over a shorter period.
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.
Fixed Income Forward vs. Fixed Income Future
Fixed income derivatives may be traded on exchanges, where the underlying bond and terms of the contract are standardized. Unlike a forward contract that trades over-the-counter (OTC), a standardized fixed income derivative is an exchange-traded futures contract. These exchanges publish these rates along with the types of bonds accepted as payment. Otherwise, forwards and futures operate in similar fashion.