Determination of Forward and

Futures Prices and their

relation with Spot Prices

Part I
Readings:

Chapter 5: 5.1 - 5.6, 5.9-5.14

 Pricing Forwards & Futures
We will determine forward/futures price in
relation to the spot price by using a no-arbitrage
argument asset that has price at the
beginning the end
& at But nothing

We start by looking atyunderlying assets that do

,

in b/w
Eg Stock
: -

that doesn't
pay Dividend

not provide interim cash payments (dividends or -

zero coupon Bond

interest payments) and require no storage costs

Extensions (conceptually small) to cash
payments, yields, storage costs will follow
We will first consider forward prices (i.e., prices
of forward contracts), as they are a bit simpler.
Then, we will make the extension to futures
prices
 Assumptions for Pricing
No or negligible transaction costs
Same tax rates for all market participants
Market participants can borrow or lend at
risk-free rate (Libor…)
r
rs

Investors rationally take advantage of

arbitrage opportunities
All above assumptions need not apply to
all investors: only a few large players
suffice
 Arbitrage y spending Any $
Not can generate
$$ .

Arbitrage - arises if an investor can

& construct a zero investment portfolio with
a sure (i.e., no risk) profit.
Since no investment is required, an
investor can create large positions to
secure large levels of profit.
In efficient markets, profitable arbitrage
opportunities will quickly disappear.
One of the most important concepts in
finance (and in this subject!)
Also referred to as free lunch, money
pump…
 Notation
• T: Time to maturity
• S0: Initial spot price
• ST: Spot price at maturity of the contract
• F0: Initial Forward or Futures Price
• r: risk free rate continuously compounded p.a.
Tper annum
• q: Continuous p.a. yield
• I: Discrete payments (dividends, income)
• U: Discrete storage costs (gold, commodities)
• u: continuous p.a. storage costs (like a
negative dividend yield)
afraid Pb @ T → short Fwd

No Arbitrage Argument
Action Cash Flow Cash Flow at T
at t=0
Buy 1 unit of -S0 ST
asset at t=0 ↳ CF when u sell

took short fwd position

Short 1 0 F0 – ST
Because I a ,

can close out by going Long

forward at t=0 Hence ,

Fo -

FT ✗
@ expiry =
# =s, HINA ,

Borrow $S0 at S0 -S0erT

rate r at t=0

Overall 0 S
-T+F0-S
/T-S0e
rT
Position
 No Arbitrage Argument
If it does not cost anything to enter into
the position at time t, then riskless
profits (CF>0) should not be earned at
time T

Therefore, the forward price at t=0 must

be:
F0 = S0erT
Arbitrage -
 Example 1
A forward contract is written on a
stock. The maturity of the contract
Tlp a) 0.5
SO
is 6 months. The stock price is $50
=
.

today and the risk free rate is 10%

per year. What is the no-arbitrage
forward price?
F0 = S0erT = 50e0.10(0.5) = $52.56
What if F0 is NOT $52.56?
 Arbitrage
Suppose F0=$53, and all other values
are those on previous slide
you can earn a riskless profit by
• At t=0 (no cash outlay):
Borrow $50 at the 10% p.a. rate for 6 months
Buy 1 share of stock at $50
Take a short position in the forward expiring at
T for delivery at $53: What happen Next

• At t=T
everybody will buy the
underlying & take short Forward Position

T
-

Buy underlying → Price

'

Short Forward
} Until free lunch is gone
position → price µ

Sell asset for 53

Pay back loan 50*e(0.1*6/12)=52.56
Realize a profit of $(53-52.56)=$0.44
 Arbitrage
If F0 > S0erT, arbitrageurs buy the
asset spot and short forward
contracts

If F0 < S0erT, arbitrageurs short the

asset spot and buy (long) forward
contracts.
 What Happens if the
Security Pays Income?
Dividend paying stocks with a known
(discrete) dividend
Coupon bonds
Let ‘I’ be present value of all known
cash income

Still determine today’s forward price

using no-arbitrage argument
 No Arbitrage…with Income
Action Cash Flow at t Cash Flow at T

Buy 1 unit of -S0+I ST

asset at t=0
Short 1 0 F0 – ST
forward at
t=0
Borrow $S0 at S0-I -(S0-I)erT
rate r at t=0
Overall 0 ST+ F0 -ST-
Position
(S0-I)erT = 0
Pricing a Forward with Income
Thus, the price of a forward contract
at time t=0 is:
F0=(S0-I)erT

• where S0-I is the dividend adjusted

underlying asset price and arbitrage
activities force the relation to hold
 Known Yield
For some securities, like stock
indices, it is easier and more
common to denote with a yield the
income they pay.
Assume that the yield is paid at an
annual rate of q, continuously
compounded
Thus, we can use the same no-
arbitrage arguments to find the
forward price.
No Arbitrage… with Known Yield
Instead of subtracting the income
from S0, we reduce S0 by adjusting
it for the dividend yield
S0e- q T
If there is no arbitrage on
assets paying a dividend yield of q
F0 = S0e- q T*erT =
S0e(r- q)T
 Stock Index Futures Pricing
Treat the stock index as a dividend-
paying stock
• Dividend is paid continuously with a
dividend yield rate of q
Then (again)
F0 = S0e(r- q)T
F- per annum
 Currency Forwards Pricing
Notation:
• S0: price in dollars of one unit of foreign
currency
• r: domestic interest rate with continuous
compounding
• rf: foreign interest rate with continuous
compounding
A foreign currency is analogous to a stock paying
a known dividend yield
The “yield” is rf
Interest earned on a foreign currency holding is
dominated in a foreign currency
 Currency Forwards Pricing
Recall that
F0=S0e(r- q)T
Replacing q by rf we can obtain the
forward/futures price on a foreign currency
F0 =S0e(r-rf)T

Also called Covered Interest Parity (CIP) in

International Finance
When r – rf < 0
• Futures price is less than the spot price, S0
When r – rf > 0
• Futures price is greater than the spot price, S0
 Commodity Forward/Futures
Unlike financial instruments which
are designed for investment,
commodities can be held for either
①
immediate consumption or
②
investment.
• Examples: pork bellies, gold, sugar,
crude oil, beef, wheat, corn, etc.
Let’s consider investment
commodities first
Gold Forward/Futures (and, more generally,
on investment commodities)
If there are no storage costs (SC),
then gold could be seen as an asset
paying no income.
Thus, the futures price is F0 = S0erT
If there are storage costs, they can be
regarded as negative income. If U is
the PV(SC) incurred during the life of
the contract and we replace I by –U in
the previous expressions, then:
F0 = (S0+U)erT
(Investment) Commodity Futures
Example
A futures contract is written on gold.
The maturity of the contract is one
year and the storage cost is $2/oz
per year. The payment will be made
at the end of the year. The spot
price is $1500 and the risk free rate
is 1% per annum.
What is the no-arbitrage futures
price?
(Investment) Commodity Futures
Example (cont’d)
First we need to find U
• U = 2e-0.01(1) = 1.980

¥ price
Then the (theoretical?) futures
is:
• F0 = (S0+U)erT = (1500+1.980)e0.01(1)
• F0 = 1517.08
Gold Forward/Futures (and, more generally,
on investment commodities)
Storage costs can also be seen as a
negative dividend yield.
Denote storage costs with ‘u’
Conceptually, we can replace q with
–u
Then
F0= S0e(r+u)T
Futures/Forwards on Consumption
Commodities anything gold but

If F0>(S0+U)erT
Borrow S0 + U, buy commodity spot, short
futures ….equality
If F0<(S0+U)erT
Sell commodity spot (to save storage cost),
invest at risk-free rate, long futures
But market participants holding commodity
for consumption are reluctant to sell due
they may as suffer Losses

inability
to the

F0<=(S0+U)e rT (limited arbitrage) of

conducting the
regular business
↳ by a % name
.

'

the
'
convenience yield
 Convenience Yield
The previous concept is related to the
convenience yield: i.e., the benefit from
holding the physical asset
In formulas, c.y. is defined as the rate y
such that
F0eyT = (S0+U)erT
or
F0eyT=S0e(r+u)T
The greater the expectation of shortage
the higher y (check level of inventories)
inventory A
Low → c. Y v.v

y=0 for investment assets

v.v .
.

Full / Close Full → c. Y V.①

 Week 5 lecture

"
Use this Formula :
Soe = Fo
Q : When will the Futures Price be bigger than So ?

Rafa Rogen
( VA)
Buying Asset at spot Market
'

-
to buy the underlying Asset
considering
in the Futures Market

↳ Long position on the underlying Asset

to a futures contract at t=o that expires @ T

Q who: should be
willing to pay
More ?

Take :
Fo =
So ert → T will always be ⑦

For Fo > so ert ,

it must be that r is a ⑦ Number
④⑦
so , e > I → As a result Fo = So Cx > D > So
If positive te greater than 0 Rafa is
willing to pay more
Analysis is
i
: r a no .
,

than Rogen .

Q : what is r ? •

cost of Financing
↳ Mau buy UA at spot ,
need $ now ,
can borrow @ rate r

Opportunity cost

↳ Got $ already pay so

→ can't
invest elsewhere the
,

so amount

so Roger is not at the same position Rafa has to

,
as as
Roger
Rafa
pay today pay @
.
will T . At the mean time Rafa can use that
,

money ( so ) & invest @ risk-free rate G)

As this Opp /Financing cost he's willing to less than

Roger incurs
i.
.

, pay

Rafa .

⑧
Hence ,
this is why as
long as the Opp /Financing cost
.
is ④ ,
the Fo >so

future contract is the + its will be

The longer the , price
*
explanation next page
 stock with Dividend yield
no
,

Take Cr 9) T
Fo Soe
-

: =

Rafa → Futures Roger → spot

inconvenience
-

No convenience
↳ -

worry about r ( Opp /Financing

.
cost)
OR convenience

inconvenience
↳ + Receives Dividend on the Asset

so it could be
,
convenience > non -

convenience q >r

Hence
In
reality ,

F- 0.3% 3.5 -4% this is

q :
,
possible

Rafa q >r
NOW , is
Roger actually willing to pay 9 than as .

9) T
Hence So ecr
-

:
Fo =

if
req crop is -0
' IT
e will be 21 and Hence Fo < so
,

↳ this means Roger is

willing to
pay
more than Rafa

-
:
so it's all about this relative
,
convenience to inconvenience b/w the spot &

Futures position → this determine to <so to v.v

Explanation :

Fo So =
er -1

So → fix ,
r→ fix
,
1-→ the bigger the T

↳ the * the to

i. So -01 longer maturity futures prices will be higher than shorten

,
as long as r is , maturity
futures prices
 Take :

)
So ecrtu
T
Fo EYT =

g) T
so elrtu
-

↳ Rewrite :
Fo =

Rafa : long Futures in crude oil Roger Long spot

: in crude Oil
inconvenience
↳ -

worry about r ( Opp /Financing

.
cost)
inconvenience
↳
storage cost
-

convenience
↳ + having the physical asset

If the convenience > non convenience -

, y>
( Rtu)

So ecrtu
-

g) T
:
Fo =
So
if rtu <
q crtu -

y) is -0
(rtu a) T
-

-0
e will be 4 and Hence Fo < so
,

↳ this means Roger is

willing to
pay
more than Rafa

-
:
so it's all about this relative
,
convenience to inconvenience b/w the spot &

Futures position → this determine to <so to v.v

 the spot which
Roger has to carry
y
,

have convenience to inconvenience

Cost of Carry
We can simplify and summarize our
discussion using the cost of carry
concept
Cost of carry is equal to:
The storage cost
inconvenience { Plus any interest paid to finance the asset ( r)
convenience
't
Less any income earned on the asset gg ,
 Cost of Carry
For a non-dividend paying stock, c = r
For a dividend-paying stock, c = r- q
For a currency, c = r – rf
For a commodity, c = r + u
Thus, for any investment asset, the forward
price is:
F0 = S0ecT
For any consumption asset
F0 = S0e(c-y)T
 Time 0 and Time t
All previous arbitrage examples assumed
that actions were taken at time t=0
But everything conceptually holds at any
time t during the life of the contract
All previous pricing formulas hold at each
time t between contact inception (t=0)
and contract expiration (t=T)

General formula: Ft = Ste(c-y)(T-t)

Negative Crude Oil Prices: Why?
7 due to
Fundamental Factors: demand ↓↓,
COVID-19

storage very tight drove down and

negative the spot price April 20th
in

Technical factors: front month WTI

(Cushing hub) contract about to expire,
storage place

very thin market on expiry, remaining

longs were squeezed
“Financialization” of commodities (USO,
“retail tourists”, mother of all Nowadays
↳
buy ,
people commodities
to
diversify their
portfolios
contangos…)
More regulation?
 Fundamental Factor

•
demand drops tremendously $
Supply can't easily be cut in the short Run

↳ stop pumping . . .
.
etc (take time>

IE in addition storage full The Fundamental Factors

[ Leading
to

>
Negative Price : The seller is
willing to pay the buyer to take

the oil

As a result , spot Price starts to 4

Technical Factor

Futures
price that went neg .
-0 → Futures Price for the MAY contract for WTI

Q How:
can the MAY contract expires in April ?
Hence MAY
A Yes Idea The delivery ( if
.

:
,
it does .
:
not close out will be in MAY contract

but the last which out

day by you need to close

(if don't want

delivery) actually happens in April 21st
(98-1)
As about to the 21st don't had
everything is expire on ,
most people who want
delivery
already close out their position The . ones left (2-1) are ferry few .

↳ Liquidity has dried up

Q: But ,
u said liquidity are v. high in expiration Month ?

Yes then almost

,
but not on the last trading day as
by everyone
has closed out .

" "

Remaining Loans were squeezed → U have long position ,

want to close

them at any price That's why they

.

accept -0 price .

Willing to
close Position Go short → sell @ Neg Price
a
long → .

All other contract (June, . - . .

) drop in price but not even close to 0 .

Only ,
the

holders
May contract dipped below 0 because of the squeeze the long position found

themselves in .
Negative Crude Oil Prices: Why?
What about the other (i.e., back months) maturities?

Price went back ④ → $5

→
As of April
21st, markets seemed to be believe that
storage bottlenecks for June and onwards will be more
manageable
What about now? Or, since April 21st?