Valuing Forwards, Futures and Swaps: How the Measurement Assists in Managing Financial Risk

Abstract:     
This paper focuses on the valuation of forwards, futures and swaps. This is a pertinent process towards developing an effective risk management strategy. Forward contracts, for instance, are valued using either continuous or discrete methods before the expiration date. The same is true for other derivative instruments. Distinctively, futures contracts are marked to market and are reset daily hence often considered a series of forward contracts. However, swaps involve the exchange of future cash flows based on a principal notional amount. In taking positions in derivative instruments, it is important that the derivative’s value be set to equal that of the underlying asset, otherwise a costless arbitrage would arise. Related to the foregoing is the concept of net cost of carry, which is of essence in understanding the state of equilibrium, and whether costless arbitrage opportunities exist. The relationship between risk and return is also explained within the context of the Capital Asset Pricing Model. Finally, an optimal hedging process is discussed.

Number of Pages in PDF File: 8

Keywords: forwards, futures, swaps, derivatives, net cost of carry, arbitrage

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