FORWARD CONTRACTS ON INDIVIDUAL BONDS AND BOND PORTFOLIOS

FORWARD CONTRACTS ON INDIVIDUAL BONDS AND BOND PORTFOLIOS
Although a forward contract on a bond and one on a stock are similar, some basic differences nonetheless exist between the two. For example, the bond may pay a coupon, which corresponds somewhat to the dividend that a stock might pay. But unlike a stock, a bond matures, and a forward contract on a bond must expire prior to the bond’s maturity date. In addition, bonds often have many special features such as calls and convertibility. Finally, we should note that unlike a stock, a bond carries the risk of default. A forward contract written on a bond must contain a provision to recognize how default is defined, what it means for the bond to default, and how default would affect the parties to the contract.
In addition to forward contracts on individual bonds, there are also forward contracts on portfolios of bonds as well as on bond indices. The technical distinctions between forward contracts on individual bonds and collections of bonds, however, are relatively minor.
The primary bonds for which we shall consider forward contracts are default-free zero-coupon bonds, typically called Treasury bills or T-bills in the United States, which serve as a proxy for the risk-free rate.9 In a forward contract on a T-bill, one party agrees to buy the T-bill at a later date, prior to the bill’s maturity, at a price agreed on today. T-bills are typically sold at a discount from par value and the price is quoted in terms of the discount rate. Thus, if a 180-day T-bill is selling at a discount of 4 percent, its price per $1 par will be $1 – 0.04(180/360) = $0.98. The use of 360 days is the convention in calculating the discount. So the bill will sell for $0.98. If purchased and held to maturity, it will pay off $1. This procedure means that the interest is deducted from the face value in advance, which is called discount interest.
The T-bill is usually traded by quoting the discount rate, not the price. It is understood that the discount rate can be easily converted to the price by the above procedure. A forward contract might be constructed that would call for delivery of a 90-day T-bill in 60 days. Such a contract might sell for $0.9895, which would imply a discount rate of 4.2 percent because $1 – 0.042(90/360) = $0.9895.