Is a bond forward above or below the bond's spot
Question
Consider a contract to buy a bond in six months. (a) If the bond is a 10-year zero-coupon bond, is the forward price higher or lower than the current spot price? (b) How does your answer change if the bond pays a large coupon?
Short answer
(a) Above spot; (b) usually below spot. The forward equals spot plus the cost of carry. A zero pays nothing in the meantime, so the forward is spot grown at the six-month financing rate. A high-coupon bond earns coupon income while held; if its coupon yield exceeds the short financing (repo) rate the carry is positive and the forward trades below spot.
Adapted from Crack, Heard on the Street, Q3.9, p.34; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Forward and Futures Prices: Cost-of-Carry, Known Income, and Continuous Yields
- Bond Prices, Discount Factors, and the Law of One Price
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