forward rate question in John Hull's book

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harry huang

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The paragraph in the book is something like:
joseph jett would buy some strips and then do a forward trade to sell them in the future. The strips pay no interest and so the forward price is higher than the spot price. Kidder's system reported the difference between the forward price and the spot price as a profit at the time of the trade. Of course, the difference represented the cost of financing the strip. But by rolling the forward contracts forward, Jett was able to prevent this financing cost from accruing to him.

I am just not sure what does the second half of the paragraph mean.
"Of course, the difference represented the cost of financing the strip. But by rolling the forward contracts forward, Jett was able to prevent this financing cost from accruing to him. "
can someone explain this a little bit? Thanks!
 
Oh this is the Joseph Jett case, basically he exploited a glitch in the profit calculator of kidder peabody.
A strip is a coupon less bond.
Suppose I have a bond that has a FV of 105 dollars, a maturity of 1 year and the risk free rate is 5%.
In a fair market the price of the bond is (105/1.05)=100. (Ie. I buy the bond for 100 bucks to get 105 a year later).
Now the forward price of the bond a year from now is 105 (since the cost to carry a 100$ asset that long is 5$).
Jett would buy the bond at 100 and then enter into a forward to sell the bond in a year at 105.
The kidder system didn't consider the time value of money and would immediately book the 5$ (105-100) as profit.
Of course the scheme is actually net zero (not considering transaction costs). Since I buy the bond at 100, then will sell it at 105 a year from now, my profit today is (105/1.05)-100=0.
Now at year 1 I buy a bond with 110.25 FV (if the risk free rate is the same) for 105 (the money I got from the previous sale), then enter into a forward to sell the bond in a year for 110.25, I ,"book" 5.25 in "profits". But again I actually made no money due to the time value of money, rinse and repeat.

It is a bit misleading since the trade itself is very near net zero, I think jett was using it to cover other past losses.
 
Michael Summerville said:
Oh this is the Joseph Jett case, basically he exploited a glitch in the profit calculator of kidder peabody.
A strip is a coupon less bond.
Suppose I have a bond that has a FV of 105 dollars, a maturity of 1 year and the risk free rate is 5%.
In a fair market the price of the bond is (105/1.05)=100. (Ie. I buy the bond for 100 bucks to get 105 a year later).
Now the forward price of the bond a year from now is 105 (since the cost to carry a 100$ asset that long is 5$).
Jett would buy the bond at 100 and then enter into a forward to sell the bond in a year at 105.
The kidder system didn't consider the time value of money and would immediately book the 5$ (105-100) as profit.
Of course the scheme is actually net zero (not considering transaction costs). Since I buy the bond at 100, then will sell it at 105 a year from now, my profit today is (105/1.05)-100=0.
Now at year 1 I buy a bond with 110.25 FV (if the risk free rate is the same) for 105 (the money I got from the previous sale), then enter into a forward to sell the bond in a year for 110.25, I ,"book" 5.25 in "profits". But again I actually made no money due to the time value of money, rinse and repeat.

It is a bit misleading since the trade itself is very near net zero, I think jett was using it to cover other past losses.
Click to expand...

i see what u saying there. thank you so much for explaining this in detail. I really appreciate it!
 

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