Pricing of Forward and Future

Dillip Khuntia
Master of Finance & Control
Utkal University
• Investment Asset:- Asset Held for investment
purpose by significant number of investor.
• Eg; Stocks, Bonds etc.
• Consumption Asset:- Asset Held Primarily for
Consumption.
• Eg; Copper, Oil, etc.

MFC 2
 Short Selling

• Involves Selling of Assets that is not owned.

• Margin Account is maintained with the

Broker.

MFC 3
Pricing

MFC 4
 Assumptions

• No Transaction Cost

• Same Tax for all.

• Interest Rate on Borrowing = Interest Rate on

Lending; i.e. at Risk-free Rate of Interest.

• Advantage of Arbitrage Opportunities.

MFC 5
 Forward Prices
• Stocks with No Income:-
F0 = S0 erT
Where
• T = Time to Maturity
• r = Risk-free Interest rate
• F0 = Forward Price
• S0 = Spot Price

MFC 6
• Stocks with Known Income:-
F0 = (S0 –I)erT
Where
• T = Time to Maturity
• r = Risk-free Interest rate
• F0 = Forward Price
• S0 = Spot Price
• I = Known Income

MFC 7
• Stocks with Known Yield:-
F0 = S0 e(r-q)T
Where
• T = Time to Maturity
• r = Risk-free Interest rate
• F0 = Forward Price
• S0 = Spot Price
• q = Average Yield

MFC 8
 Value of Forward Contracts

• The value of a forward contract at the time of

entering into the contract is zero.
• At later stage, due to fluctuation in the forward
price, the value of the forward contract change,
i.e. either positive or negative.

MFC 9
 Notations
• K = Delivery Price

• T = Time to maturity

• r = Risk-free interest rate

• F0= Forward Price

• f = Value of forward contract today.

MFC 10
 Value of forward Contract

For Long Forward contracts

f = (F0 – K) e-rT

For Short Forward contracts

f = (K – F0) e-rT

MFC 11
 Value of forward Contract on an Asset

With No Income;

f = S0 – Ke-rT

With a Known Income (I)

f = S0 – I - Ke-rT

With a Known Yield (q)

f = S0e-qT - Ke-rT
MFC 12
 Future Prices of Stock - Indices
• A stock index can be usually be regarded as an asset that
pays dividend.
• Here paid is considered as known yield rather than known
income.
• Thus Price of Stock Index Future;
F0 = S0e(r-q)T
Where, r = risk-free interest rate
q = Known yield from stock index future
T = Time to maturity
F0 = Price of Future contract
S0 = Spot priceMFC 13
 Index Arbitrage
• If, F0 > S0e(r-q)T, Profit can be made by buying
the stocks underlying the index at the spot price and
shorting futures contract. (Pension Funds)
• If, F0 ˂ S0e(r-q)T, Profit can be made by selling the
stocks underlying the index at the spot price and
buying futures contract. (Corporation Holding)
• This strategy is known as INDEX ARBITRAGE
MFC 14
 Forward & Futures Contract on Currencies
• The holder of the foreign currency can earn
interest at a risk-free rate prevailing in foreign
country.

F0 = S0e(r – rf)T
For known yield ‘q’
•
F0 = S0e(r – q)T

MFC 15
Forward & Futures Contract on Commodities
• Storage cost & Carries cost are taken into
account while determining the Price of Futures
on Commodities
• In the absence of storage cost and income
F0 = S0erT
• With storage cost ‘U’
F0 = (S0+U)erT
• Storage costs net of income(u) are proportional
to the price of the commodity
F0 = S0e(r+u)T
MFC 16
 Consumption Commodities
• No income, Significant Storage Cost
• Price
F0 ˂ (S0+U)erT
or
F0 ˂ S0e(r+u)T
Where,
u = Storage cost as proportion of spot price.

MFC 17
 Convenience Yield
Let; U = Present value of Storage cost.
y = Convenience Yield
F0eyT = (S0+U)erT
Or
F0eyT = S0e(r+u)T
or
F0 = S0e(r+u-y)T
Where,
u = Storage cost as proportion of spot price.
MFC 18
 The Cost-
Cost-of-
of-Carry
Cost of Carry (c) = (Storage Cost)
+
(Interest Paid to Finance the Asset)
-
(Income Earned on the Asset)

MFC 19
• For non-dividend paying stock
c = r (as no storage and no income)
• For Stock Index
c = r – q (as income is earned at ‘q’ rate)
• For Currency
c = r – rf (rf = risk-free interest rate of foreign
country)
• For Commodity
c = r – q + u ( Income ‘q’ and storage cost ‘u’)
MFC 20
• Future Price for investment asset

F0 = S0ecT

• Future Price for consumption asset

F0 = S0e(c-y)T

Where, c = cost of carry

y = convenience yield

MFC 21