Forward Contract Quantitative Analysis April 15, 2008.
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Transcript of Forward Contract Quantitative Analysis April 15, 2008.
Forward Contract
Quantitative Analysis
April 15, 2008
2
Overview
1. PG&E’s Power Mix
2. What is a Forward Contract
3. Some features of Forward Contract
4. Why do we use Forward Contracts?
5. Pricing Forward Contract
6. Valuing Forward Contract
7. Swaps
3
What is Forward Contract?
• Definition:
An agreement between two parties to buy or sell an asset at a certain future time for a certain price.
• Example 1]
Company A contracts to buy 5,000 bushels of wheat from Company B for delivery in 1 year. Price is agreed at 300 cents/bushel
Total value of the contract (Forward Price)
= 300cents/bushel * 5000 bushels = $15,000
* 1 bushel ~ 60 lb
• Example 2]
Today, PG&E contracts to buy 10,000 mmBtu of Natural Gas from BP Energy Co. for delivery on the day of May 15 which in 1 month. Price is agreed at $8.25/mmBtu
Total Value of the contract (Forward Price)
= $8.25/mmBtu * 10,000 mmBtu = $82,500
* 1 mmBtu ~ 28.26 m³
4
Some Features of Forward Contract
• No money or goods change hands before maturity
• Can buy and sell risk without holding the physical
• Good for hedging (or speculating)
5
Why do we use Forward Contracts? PG&E Power Mix
6
Pricing Forward Contract
Suppose we have a forward contract on one share of common stock that pays no dividends.
rTrT
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F000
0 or
Under the assumption of no arbitrage, this should be equal to the current stock price, hence:
Under the assumption of no arbitrage, this should be equal to the current stock price, hence:
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7
Valuing Forward Contract
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at timeContract Forward theof value the, Find
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at time Price Forward Variable
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8
Swaps
• In reality, traders use Swaps rather than Forward Contracts or Futures (standardized Forward Contract traded in exchanges such as NYMEX)
• What is Swap?
Swap is an agreement to exchange one cash flow stream for another
Bank PG&E Energy ProducerVariable Price Variable Price
Gas 10,000 mmBtu/day
$8 Fixed Price
1. Purchase 10,000 mmBtu/day of gas for delivery at PG&E Citygate in Jan 20092. Execute a fixed-for-floating swap at $8/mmBtu also for delivery in Jan 20091. Purchase 10,000 mmBtu/day of gas for delivery at PG&E Citygate in Jan 20092. Execute a fixed-for-floating swap at $8/mmBtu also for delivery in Jan 2009