Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 10

Managing Forward Risk

Managing forward risk is considerably more complex than managing spot risk due to the large number of dates on which forward payments can take place. With some forward markets going out to 30 years and even beyond, even if we restrict deliveries to take place on the 250 business days of a year, it still leaves 30 × 250 = 7,500 days on which future flows can occur, each of which requires a mark-to-market valuation and risk measurement. It is clearly impractical to have liquid market quotations for each possible forward, so modeling needs to be heavily relied upon.

Having a spot versus forward position is an interest rate differential position, not a price view. If I believe the market will get a surprise announcement that will raise the stock price, even if I think it will not come for three months, I don't want to be long the forward and short the spot. When the announcement comes, both will be roughly equally impacted. I want this position only if the announcement I expect is something like a one-shot dividend that will impact the relative value of the spot and forward. If I put on a long forward and short spot position, I'm taking a view on the interest rate.

Let me cite a real example. On June 24, 1998, a trader was holding a long forward position in Telecom stock against which he was short the stock. AT&T announced plans to purchase Telecom at a sizable premium, but the trader wound up with a sizable loss. Why? His outright position in Telecom ...