So if you own a bond: -Gain when Interest rates decrease (price of bond goes up) -Lose when Interest rates increase (price of bond goes down) To protect against this, you could go short a forward contract: - If price of contract rises above price at inception, I lose. (how do interest rates move here?) - If price of contract falls below price at inception, I gain. (how do interest rates move here?)
Always revert back to these formulae for forwards/futures:
(So - PV(cpn)) x (1+rf))^t = FP
Vt (Value to long) = (St - PV(cpn)) - (FP/((1+rf)^(T-T)))
At maturity Vt = St - FP
If you short a forward contract then as interest rates decrease St (spot price of the bond) will increase. FP does not change and this causes you to gain value if long or lose value if short - these contracts are a zero-sum game
Relating back to St helps me understand these derivatives