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Forward contracts are agreements by two parties to engage in a financial transaction at a future (forward) point in time. Here we focus on forward contracts that are linked to debt instruments, called interest-rate forward contracts; later in the chapter, we discuss forward contracts for foreign currencies.

Interest-rate forward contracts involve the future sale (or purchase) of a debt instrument and have several dimensions: (1) specification of the actual debt instrument that will be delivered at a future date, (2) amount of the debt instrument to be delivered, (3) price (interest rate) on the debt instrument when it is delivered, and (4) date on which delivery will take place. An example of an interest-rate forward contract might be an agreement for the First National Bank to sell to the Rock Solid Insurance Company, one year from today, $5 million face value of the 6s of 2023 Treasury bonds (that is, coupon bonds with a 6% coupon rate that mature in 2023) at a price that yields the same interest rate on these bonds as today's, say 6%. Because Rock Solid will buy the securities at a future date, it is said to have taken a long position, while the First National Bank, which will sell the securities, has taken a short position.

APPLICATION. Hedging with Interest-Rate Forward Contracts

Why would the First National Bank want to enter into this forward contract with Rock Solid Insurance Company in the first place?

To understand, suppose that you are the manager of the First National Bank and have bought $5 million of the 6s of 2023 Treasury bonds. The bonds are currently selling at par value, so their yield to maturity is 6%. Because these are long-term bonds, you recognize that you are exposed to substantial interest-rate risk: If interest rates rise in the future, the price of these bonds will fall and result in a substantial capital loss that may cost you your job. How do you hedge this risk?

Knowing the basic principle of hedging, you see that your long position in these bonds can be offset by an equal short position for the same bonds with a forward contract. That is, you need to contract to sell these bonds at a future date at the current par value price. As a result, you agree with another party—in this case, Rock Solid Insurance Company—to sell it the $5 million of the 6s of 2023 Treasury bonds at par one year from today. By entering into this forward contract, you have successfully hedged against interest-rate risk. By locking in the future price of the bonds, you have eliminated the price risk you face from interest-rate changes.

Why would Rock Solid Insurance Company want to enter into the futures contract with the First National Bank? Rock Solid expects to receive premiums of $5 million in one year's time that it will want to invest in the 6s of 2023, but worries that interest rates on these bonds will decline between now and next year. By using the forward contract, it is able to lock in the 6% interest rate on the Treasury bonds that will be sold to it by the First National Bank.

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