1. Financial Risk Management of Insurance Enterprises Forward Contracts

2. Over the Next 5 Lectures... Basic structures of financial instruments used to manage financial risk Forwards Futures Swaps Options Interest Rate Options: Caps and Floors

3. Today - Forward Contracts Basic structure and definition Foreign Exchange (FX) forwards and interest rate parity (IRP) Forward rate agreements (FRAs) Applications of forwards in protecting against financial risk

4. Forward Contract Structure A forward contract is an agreement which obligates one party to sell and asset and another party to buy the assets. The exchange will take place some time in the future, but the price is fixed today. The exercise price is the contract price The buyer of a forward is long a contract, the seller of a forward is short a contract

5. Comments No payment until maturity Forwards occur everywhere –Sign apartment lease or buy a home Buyer of forward has a gain if underlying asset value increases –Buy asset at exercise price and can sell in market The contract price is set at origination so that the value is zero

6. Some Forward Contract Jargon Cash-settle: Value is paid in cash rather than physically exchanging the asset Notional principal or amount: Used to determine the value of the contract - the notional amount is not exchanged –Used in cash settlements At-market forward: A forward contract whose value is zero –Spot price and forward prices are equal

7. Example - Foreign Exchange Forward Party A agrees to buy and Party B agrees to sell £ 1 million in 6 months at an exercise price of $1.50/£ –£ 1 million is the notional principal If the £ strengthens (increases in value), Party A will have a gain If £ weakens, Party A will have a loss

8. Example (p.2) Let’s assume cash settlement –Rather than actually exchanging the foreign currency, the parties exchange the gain/loss Case 1 - £ strengthens –Party B pays Party A (P T - $1.50/£)x(£ 1 million) where P T is the spot exchange rate in 6 months –P T =$1.60/£, Party A receives $100,000 Case 2 - £ weakens –Party A pays Party B ($1.50/£ - P T )x(£ 1 million) –P T =$1.00/£, Party A pays $500,000

9. Illustrative Forward Contract (Figure 6-1 of Smithson text)

10. Payoff for Forward Contract Positions (Figure 6-2 of Smithson text)

11. Default Risk Remember, all exchanges are made at maturity If the price of the forward contract moves against a party, they may have difficulty making payment Forwards are pure credit instruments –You must evaluate the counterparty similar to a bank loan

12. Interest Rate Parity Spot rates, forward rates and interest rates are related to eliminate arbitrage Assures that the net present value of a FX forward is zero Essentially, investing money in any currency should have similar returns If 100¥ = $1, then 100¥(1+r ¥ )=$1(1+r $ )

13. Determining the Foreign Exchange (FX) Forward Rate Can replicate forward contract with the following transactions –1. Borrow $ for t years at a rate of r $ –2. Convert $ to ¥ at exchange rate S 0 –3. Invest ¥ at r ¥ for t years –4. Convert ¥ back to $ and payback loan (can use forward market to lock in exchange rate F T ) Set FX forward rates to guarantee that NPV=0

14. Determining the Foreign Exchange (FX) Forward Rate (p.2) Thus, to prevent arbitrage

15. Example What is today’s spot rate in terms of ¥/$ if r $ = 10%, r ¥ = 3%, and F T =100¥/$1 –Assume all maturities are one year

16. Forward Rate Agreement (FRA) Forward contract on interest rates –Not a commitment of borrowing or lending Like any forward, value for buyer increases as underlying increases –Here the underlying is an interest rate Payoff based on difference between market interest rate at settlement and the contract rate Gives protection against uncertainty in future interest rates

17. FRA Contract Settlement Value Contract period is the future period for which protection is needed Change in market rates affects interest over the contract period Payment at settlement date reflects discounting

18. FRA Contract Settlement Value On 1/1, an insurer enters an FRA contract for the period of 7/1-12/31, the contract rate is 5%, and the notional amount is $1 million If on 7/1 rates are 6%, a borrower without an FRA would pay $1,030,000 on 12/31 With an FRA, the amount of payment on 7/1 reflects PV of excess interest throughout contract period

19. Application of Forward Contracts US pension fund invests in 6-month, German zero-coupon bonds with a face value of DM 1 million –Exposure is increase in DM/$ exchange rate Pension fund can fix the exchange rate today by selling DM 1 million forward If DM/$ increases, gain in forward contract offsets loss on DM denominated bond holding

20. Application of FRAs Life insurer has fixed policy loan rate that resets every year Exposure is that in 2nd half of policy year, rates will increase and policyholders with- draw cash to earn higher interest elsewhere Purchase of FRA with 6 month settlement will mitigate risk –Rates increase, insurer receives cash –Rates decrease, FRA payment from bond gains

21. Next time... Futures contracts Difference between forwards and futures Hedging with futures Basis Risk Applications of future contracts