Homemade forward contracts
Suppose that you borrow £90.91 for one year at 10 percent and lend £90.91 for two
years at 12 percent. These interest rates are for loans made today; therefore, they are spot
interest rates.
The cash flows on your transactions are as follows:
Year 0 year 1 year 2
Borrow for 1 year at 10% + 90.91 100
Lend for 2 years at 12 % - 90.91
114.04
Net cash flow --------- --------- --------
0 100 + 114.04
Notice that you do not have any net cash out flow today but you have contracted to pay
out money in year 1. The interest rate on this forward commitment is 14.04 percent. To
calculate this forward interest rate, we simply worked out the extra return for lending for
two years rather than one:
Forward interest rate: (1+2- year spot rate)^2 - 1
(1+1- year spot rate
= (1.12)^2 1 = 1404, or 14.04 %
1.0
In our example you manufactured a forward loan by borrowing short term and lending
long. But you can also run the process in reverse. If you wish to fix today the rate at
which you borrow next year; you borrow long and lend the money until you need it next
year.
Swaps:-
Suppose that the possum company wishes to borrow Euro to help finance its European
operations. Since possum is better known in the United States, the financial manager
believes that the company can obtain more attractive terms on a dollar loan than on a euro
loan. Therefore, the company issues £10 million of five year 8 percent notes in the
United States. At the same time possum arranges with a bank to swap its future dollar
liability for euros. Under this arrangement the bank agrees to pay possum sufficient
dollars to service its dollar loan; in exchange possum agrees to make a series of annual
payments in euros to the bank. Possum and the bank are referred to as counterparties.
Swaps are not limited to future exchange of currency. The most common form of swap is
actually an interest rate swap, in which counterparties swap fixed interest rate loans for
floating rate loans. In this case one party promises to make a series of fixed annual
payments in return for receiving a series of payments that are linked to the level of short
term interest rates. Sometimes swaps are used to convert between floating rate loans that