Forwards and Futures: Preliminaries
Chapter 1 described the determination of a price for spot settlement, that is, for the immediate exchange of an asset for cash. This chapter begins by describing the determination of a price for forward settlement, that is, for the exchange of an asset for cash at some future date. In swap markets, explicit forward agreements are common. In bond markets—with one caveat to be made in a moment—explicit forward contracts are rare but understanding them is important nonetheless. First, spot and repo positions are very commonly combined to create the economic equivalent of a forward contract on a bond. Second, futures contracts on bonds and rates, which are enormously important in fixed income markets (and the subjects of Chapters 14 and 15, respectively), are best understood as variants of forward contracts. Third, it is often useful for technical reasons to think of a fixed income option as an option on an appropriately defined forward position rather than as an option on a spot position.
Having said that explicit forward contracts are rare in bond markets, it must be noted that in one sense this is not true at all. Almost all bond trades that are thought of as spot transactions are actually for settlement one or two days after the trade date. Strictly speaking then, almost all bond trades are forward trades! In practice (and in Chapter 1), however, discount factors extracted from the market prices of normally settled trades are simply ...