Hi guys, this is my first time on this site, I love that there’s a meeting place for all of us so we can all light a fire under us to study. Here’s a question: From the book, pg. 32, Reading 71 in the Derivatives book about forward contracts: An alternative procedure, called cash settlement, permits the long and short to pay the net cash value of the position on the delivery date. For example, suppose two parties agree to a forward contract to deliver a zero-coupon bond at a price of $98 per $100 par. At the contract’s expiration, suppose the underlying zero coupon bond is selling at a price of $98.25. The long is due to receive from the short an asset worth $98.25, for which a payment to the short of $98.00 is required. In a cash-settled forward contract, the short simply pays the long $0.25. I understand the logic here, but what’s the point if the value of what’s transferred is equal to its market value? Why not just buy it in the market that day and forget making the contract?
This is just a way of hedging against unknown risk. The price of the zero coupon bond can go below 98 as well which means he can buy the bond for a lower price but has commited to buy for 98 and has to bear a loss. If the price is worth more than 98, long will benefit from it as he has to pay only 98.
Party A: Hey B! Party B: What’s up, A? Party A: nothing much going on around here. How about those zeros? Party B: Up $0.25. Give me $98, I’ll give you a zero worth $98.25 in the market. Party A: Well…I don’t really need/want the bond. You keep it, just give me my gain of $0.25. Party B: Oh well, ok then, let’s settle for cash. And that’s about it.
Of course you could also write a cash-setlled forward contract on things that are hard to deliver like $1,000,000*# inches of rain in Des Moines in July. Edit: “right” instead of “write”, WTF?