FINA2322ABC Tutorial 3
THE UNIVE RSITY OF HONG KONG
HKU BUSINESS SCHOOL
FINA2322ABC – DERIVATIVES
FIRST SEMESTER, 2024-2025
Tutorial 3 – Forward Rate Agreements and Interest Rate Futures
✓ Remarks on Forward Contracts
• Forward is a biased predictor of stock price (FV calculated based on risk-free
interest rate instead of expected rate of return)
• For cases with transaction costs, the forward price should be between 2 numbers:
(For simplicity and illustration, assume there are no dividends or transaction costs
at time 𝑇, transaction cost = 𝑘 at time = 0 for both stocks and forwards, bid-ask
spreads for stock is 𝑆 𝑏 < 𝑆 < 𝑆 𝑎 , and interest rate for forrowing and lending are
𝑟 𝑙 < 𝑟 < 𝑟 𝑏 .)
𝑙 𝑏
(𝑆 𝑏 0 − 2𝑘)𝑒 𝑟 𝑇 ≤ 𝐹0,𝑇 ≤ (𝑆 𝑎 0 + 2𝑘)𝑒 𝑟 𝑇
Proof:
CF
Transaction t=0 t=T
Buy Stock −𝑆0𝑎 − 𝑘 𝑆𝑇
Borrowing +𝑆0𝑎 + 2𝑘 −(𝑆0𝑎 + 2𝑘)𝑒 𝑟
𝑏𝑇
Sell forward −𝑘 𝐹0,𝑇 − 𝑆𝑇
Total 0 𝐹0,𝑇 − (𝑆0𝑎 + 2𝑘)𝑒 𝑟
𝑏𝑇
CF
Transaction t=0 t=T
Short Stock 𝑆0𝑏 − 𝑘 −𝑆𝑇
Lending −𝑆0𝑏 + 2𝑘 (𝑆0𝑏 − 2𝑘)𝑒 𝑟 𝑇
𝑙
Long forward −𝑘 𝑆𝑇 − 𝐹0,𝑇
Total 0 𝑙
(𝑆0𝑏 − 2𝑘)𝑒 𝑟 𝑇 − 𝐹0,𝑇
FINA2322ABC Tutorial 3
✓ Summary of different forms of interest rates
Relationship:
1 1
𝑃0 (0, 𝑇) = 𝑇 = = 𝑒 −𝑟𝑇
(1 + 𝑟0 (0, 𝑇)) 𝑒 𝑟𝑇
[1 + 𝑟0 (0, 𝑇)]𝑇 𝑃0 (0, 𝑡)
1 + 𝑟0 (𝑡, 𝑇) = =
[1 + 𝑟0 (0, 𝑡)]𝑡 𝑃0 (0, 𝑇)
𝐵0 (0, 𝑇, 𝑐, 𝑛) = ∑ 𝑐𝑃0 (0, 𝑡𝑖 ) + 𝑃0 (0, 𝑇)
𝑖=1
1 − 𝑃0 (0, 𝑇)
𝑐=
∑𝑛𝑖=1 𝑃0 (0, 𝑡𝑖 )
2
FINA2322ABC Tutorial 3
✓ Forward rate agreement (FRA)
• A guaranteed rate for lending/borrowing
• For long positions:
Settlement in arrears (at maturity): (spot rate – FRA rate) * notional principal
Settlement at initiation: (spot rate – FRA rate) * notional principal / (1+ spot rate)
Tutorial Exercise
Question 1 (Forward Rate Agreement)
Suppose that in order to hedge interest rate risk on your borrowing, you enter into an FRA
that will guarantee a 6% effective annual interest rate for 1 year on $500,000. On the date
you borrow the $500,000, the actual interest rate is 5%. Determine the dollar settlement of
the FRA assuming
(a) Settlement occurs on the date the loan is repaid.
(b) Settlement occurs on the date the loan is initiated.
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FINA2322ABC Tutorial 3
Question 2 (Synthetic FRA)
Given the Zero-coupon bond prices as follow:
Days to Bond Prices
Maturity
90 0.99009
180 0.97943
270 0.96525
360 0.95238
Suppose you are studying an FRA which fix the lending/borrowing rate on $10m for a 90-
day loan commencing on day 270.
Suppose the market FRA is 1.2% at time 0, suggest how you can capture an arbitrage
profit from FRA.
