What is a Fixed Income Forward?
A fixed income forward is a derivative contract to buy or sell fixed income securities at some future date, but at a price accepted today.
Fixed income refers to a type of investment in which real rates of return or periodic income are received at regular intervals and reasonably predictable levels. Investors can use forward contracts on fixed income securities to price a bond today while they take possession or sell the security itself in the future.
- A fixed income forward is an agreement to transact in a fixed income security at a pre-established price at some future date (the forward date).
- The value of a forward contract is the price of the bond minus the present value of the coupon payments minus the present value of the price at maturity.
- Forward contracts are used to mitigate the risk associated with price volatility between now 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 of holding fixed income forward contracts is that the market interest rates of the underlying bonds may rise or fall. These changes affect the yield of the bond and, therefore, its price. Forward rates become the focus of investors’ attention, especially if the bond market is seen as volatile. A forward rate is the interest rate that is applied 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 now and the forward date. The seller expects the opposite.
Fixed Income Forward Pricing
To calculate the price of a fixed-income forward contract, subtract the present value (PV) of the coupon payments, over the life of the contract, from the price of the bond. This value is made up of the risk-free rate over the life of the option. The risk-free rate represents the interest that an investor would expect from a completely risk-free investment during a specified period.
The value of the contract is the price of the bond, minus the present value of the coupons, less the present value of the price to be paid at maturity (price of the bond – PV coupons – PV price paid at maturity).
Benefiting from a Fixed Income Forward
The profit from a fixed income forward contract depends on which side of the contract the investor is on. A buyer enters the contract in the hope that the market price of the bond will be higher in the future, since the difference between the contracted price and the market price represents a profit. The seller expects the price of the bond to drop.
While the number of coupon payments during the life of the bond may exceed the life of the contract, the consideration is only on payments due during the contract period. This payment limitation is due to the fact that some bonds have maturities much longer than the duration of the contract. Contract participants are protecting price movements for a shorter period.
Fixed income forward contracts are the favorite instruments of investors looking to hedge interest rates or other risks in the bond market. Other traders are drawn to the fixed income forward market to profit from the anomalies between the forward and spot markets for bonds and other debt instruments.
Term Fixed Income vs. Future Fixed Income
Fixed income derivatives can be traded on exchanges, where the underlying bond and contract terms are standardized. Unlike an over-the-counter (OTC) forward contract, a standardized fixed income derivative is an exchange-traded futures contract. These exchanges post these rates along with the types of bonds accepted as payment. Otherwise, forward and futures contracts operate similarly.