The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• A forward contract, just like a futures contract, is an agreement for the future delivery of something at a specified price at the end of a designated period of time. In contrast to a futures contracts which are standardized exchange-traded agreements, a forward contract is usually nonstandardized, is an over-the-counter instrument with no clearinghouse (i.e., counterparties are exposed to counterparty risk), and secondary markets are often nonexistent or extremely thin.

• Futures contracts are marked to market at the end of each trading day and therefore subject to interim cash flows as additional margin may be required, whereas a forward contract may or may not be marked to market, depending on the terms negotiated by the two parties.

• The underlying instrument for a Treasury bond futures contract is $100,000 par value of a hypothetical 20-year coupon bond. The nominal coupon rate on the hypothetical bond is 6%. Since there are many acceptable Treasury issues that can be used to satisfy delivery of this contract, conversion factors are used for adjusting the price (the converted price) of each Treasury issue that can be delivered to satisfy the Treasury bond.

• For the Treasury bond futures contract the short will select the issue from among all the eligible issues that can be delivered that offers the highest implied repo rate. The issue that gives the highest implied repo rate is called the cheapest-to-deliver issue.

• The three delivery options available ...