Copyright © Alberto Manconi 2016–today, all rights reserved.

The material in this reader is made available only for personal use
by the students of my Introduction to Options and Futures course at
Bocconi University. This reader or any portion thereof may not be
distributed, reproduced, or used in any manner whatsoever without
express written permission from the author.
3
Forwards & Futures:
Pricing

Derivatives are priced by no–arbitrage. That means, intuitively,

that market forces align prices such that no investor can obtain an
“abnormal” profit (or return). This might sound like a strong as-
sumption: isn’t there an entire investment management industry,
built on the premise that at least some traders can make profits?
There are, however, good reasons to believe that it holds very pre-
cisely for derivatives, and at least most of the time for other finan-
cial assets. As we will see, assuming no–arbitrage provides a very
straightforward way to determine the price of the securities we ana-
lyze in our course, including forwards and futures.

Preparation questions

1. What’s arbitrage? Why is it useful to assume that financial

markets are free of it?

2. What are the two main approaches to pricing assets by no–

arbitrage arguments?

3. What pieces of data do we need, to determine the price of

a forward contract?

4. The S&P500 index stands at 2,476.55 today. The 3–month

index futures quote is 2,466.90. Is the futures contract fairly
priced?

3.1 The forward price: basics

Going back to our earlier notation for forwards, how is the forward
price F0 determined? Clearly, that depends on how much investors
are willing to pay for a given asset today (the spot price) vis–à–vis at
some future date T. In other words, determining F0 requires us to
find the future value of the underlying asset.
16 introduction to options and futures

Law of one price The simplest way to look at the problem, it turns out, is to apply a
no–arbitrage argument, which in this case really takes the form of the
Law Of One Price (LOOP). That is one of the most basic principles
of economics: If two assets, or portfolios of assets, give you identical
payoffs tomorrow, today they must have the same price. If this is
true, then we can find the unknown price F0 as a combination of
known asset prices, as long as we combine these assets in such a way
as to replicate the future payoff of the forward contract. You can
think of it, by analogy, as building a castle out of lego bricks, which
represent assets whose price we already know.
Let’s proceed analytically before we see an example. It is instruc-
tive to consider the position of the short party in a forward, so let’s
suppose that’s you. You face the risk that the underlying price appre-
ciates, so that at maturity T you make a loss equal to F0 − ST (which
is a negative number, in that case). You would like to hedge this risk.
Meet the “hedging portfolio” approach We are going to discuss hedging in much greater detail starting
from our next topic; for now, suffice it to say that one way to hedge
is to buy the underlying asset upfront, at time t = 0. This way, it
is in our pocket, and we don’t risk having to purchase it at a higher
price ST . That kills all the risk, i.e. you are hedged. To finance the
purchase today of the asset, which costs S0 , we borrow cash. We have
thus constructed a hedging portfolio, comprising our short forward
position, the underlying asset, and the cash loan we obtained. As we
will see in our course, quite often pricing problems can be solved by
determining an appropriate hedging portfolio.
What happens at maturity T? You receive the payoff F0 − ST on
your short forward position. In addition, you hold the value ST of the
underlying asset. Finally, you need to pay back your loan, which has
been accruing interest at a rate r. There are many ways to compute
interests (you should be familiar with them from your introductory
financial maths classes). Let’s use periodic compounding for now, so
that the amount we owe our lenders is S0 (1 + r ) T (what would that
be, with continuous compounding?). In other words, your payoff is
F0 − ST + ST − S0 (1 + r ) T = F0 − S0 (1 + r ) T .
How much did you actually spend to purchase the portfolio?
First, to purchase the underlying at S0 , you just borrowed money,
i.e. you took nothing out of your own pockets. Second: how much
does it cost to enter a forward contract? As we discussed at some
length by now: nothing. So our portfolio costs nothing. Now invoke
no–arbitrage: should we be able to make a profit from a zero initial
investment? Of course not (that is another version of the popular ar-
gument that you can’t make something out of nothing). So the value
of the portfolio at T must also be zero. But then:

F0 = S0 (1 + r ) T (3.1)

Meet the “replicating portfolio” approach Another way to look at this argument is as follows. Consider
the short position in the forward separately from the cash loan to
purchase the underlying asset, i.e. let’s treat the “underlying plus
cash loan” as a separate portfolio. Equation (3.1) implies that the
 forwards & futures: pricing 17

payoff from such a portfolio (ST − S0 (1 + r ) T ) is equal to the forward

payoff (ST − F0 ). Technically, we say that the “underlying plus cash
loan” portfolio replicates the forward payoff. The law of one price,
then, implies that the forward price F0 must be such that at time
t = 0 the forward and “underlying plus cash loan” should be worth
the same (i.e., zero). We have thus constructed a replicating portfolio.
As we will see in our classes, this approach to pricing derivatives is
equivalent to the hedging portfolio approach.
As a preview of something that we will discuss more seriously Risk–neutral pricing: Preview
when we talk about option pricing, let us consider again expression
(3.1) for the forward price. You may think of E(ST ), the expected
value of the underlying asset at maturity, as reflecting a required
rate of return k, which incorporates some compensation for risk, just
as you risk–adjust discount rates when you do corporate valuations.
In other words: E(ST ) = S0 (1 + k). The difference between this
expression and (3.1) is that in the latter the rate of return r does
not involve any compensation for risk (in fact, it is just the risk–free
rate). So: the price of the forward F0 would be equal to the expected
future spot price, in a world where investors are indifferent about
risk. Investors who are indifferent about risk are said to be risk–
neutral; therefore, we are doing risk–neutral pricing. Keep this idea
in mind — we will return to it.

3.2 The arbitrage mechanism

How is this all related to arbitrage? To understand that, let’s look

at an example. Suppose you have a one–year investment horizon,
the spot price of gold is $390/oz., and the one–year interest rate is
r = 5%. Plugging these values into (3.1) yields F0 = $409.50/oz.,
which is the fair price for the forward under no–arbitrage.
Suppose for a moment that F0 were $425.00/oz. instead. What
would you do? Knowing that the forward is overpriced, you would
like to benefit from this arbitrage opportunity. The recipe for arbi-
trage is always the same: when the prices of two assets or portfolios “Buy low, sell high”
are misaligned, buy the cheaper one, and sell the more expensive
one. In this case, the expensive asset is the forward, and the cheaper
portfolio is the replicating “underlying plus cash loan” portfolio.
So: sell (take a short position in) the forward; this requires no
money at all. At the same time, borrow money to buy gold. For the
sake of the argument, let’s say you borrow $425 to buy exactly one
ounce; again, this requires no money at all. So your total investment
at t = 0 is $0. One year from now, let’s compute your profits. First,
you have to settle the forward: Whatever the price of gold in one year
ST is, you earn F0 − ST = $425 − ST on your short forward. Next,
pocket ST on your gold holdings. Finally, pay back your loan: you
owe your lenders $390 × (1 + 5%) = $409.50 (i.e. the fair forward
price). Your net profit is $425 − $409.50 = $15.50 — you just made
a profit out of a $0 investment! Moreover, note that this is the profit
we make by purchasing one ounce of gold. But nothing prevents us
18 introduction to options and futures

from purchasing a kilogram, 100 kilograms, or a ton of it. That is: as

long as we are able to borrow (in the jargon of finance professionals,
“leverage”), we can earn potentially infinite profits this way.
Similarly, consider what happens if the forward is underpriced
instead, say if F0 = $390/oz. By a similar (but reverse) reasoning,
in this case we should enter the forward with a long position, sell
gold short, and invest the short sale proceeds in a one–year maturity
bond. We would earn a $19.50 profit per ounce of gold that we short;
and again, we can potentially make infinite profits.
Price adjustment via arbitrage That said, infinite profits are not common in financial markets.
That’s because arbitrage activity aligns prices to their no–arbitrage
values. Go back to our example with an overpriced forward. We
were able to devise an arbitrage strategy that sells (shorts) the for-
ward, and buys (goes long) the replicating portfolio. Simple demand–
and–supply reasoning suggests that if a large number of investors
engage in this strategy, the forward price should decrease, and the
replicating portfolio should become more expensive, either because
credit becomes more expensive (r goes up) or because gold itself (S0 )
does. This process will continue up to the point where no one wants
to enter the arbitrage strategy, because there are no more arbitrage
profits to be made. When we price a derivative by no–arbitrage, we
simply cut a corner and assume that this process has already taken
place.

3.3 Short selling; limits of arbitrage

As an aside, arbitrage activity affects the prices of derivatives, but

also of other securities, such as stocks. A key ingredient of it is short
selling, i.e. the ability to sell something you don’t own. Depending
on the market, the no–arbitrage assumption may be more or less
realistic: if the idea of short selling gold puzzles you, just think that
there is abundant short selling activity going on in equity markets.
What does short selling a stock involve? First, the trader needs to
locate and borrow the stock she intends to short. Typically, the stock
is borrowed by a broker on the trader’s behalf, from another investor
who makes it available for lending. Securities lenders are often large
institutional investors with a long investment horizon (e.g. think of
insurance companies), who aim to earn an extra return on securities
lending fees. The trader then sells the borrowed stock on the market.
Unintended effects of short selling bans What happens when short selling is restricted? Think about the
market as a sort of voting mechanism, where investors express their
opinions about a given stock by trading. At any point in time, if
there are no trading restrictions, the bullish and the bearish investors’
opinions are both reflected in the stock price. If we ban short selling
as, for instance, many regulators did in the wake of the 2007–2008 fi-
nancial crisis, only the bullish investors’ opinions are reflected in the
stock price — i.e. prices may be “too high” (this point was made orig-
inally by Miller (1977)). Bottom line: Yes, there may be arguments in
favor of restricting short selling, at least in some cases. However, we
 forwards & futures: pricing 19

should be careful: We also don’t want to fuel a bubble by limiting

short selling.
The broker in a short selling transaction is exposed to counter- Costs associated with short selling
party risk, because the trader may fail to return the stock. To protect
the broker against this risk, the trader is required to post collateral,
often corresponding to the entire proceeds from the short sale. If
prices move against the trader, she will be required to post addi-
tional collateral, just like in the margin accounts we saw for futures
in section 2.3. In addition, if any dividends are paid on the bor-
rowed stock, the trader has to pay the corresponding amount to the
securities lender.
In other words: short selling can be expensive. That means, only Limits of arbitrage
investors with ample capital can consistently act as arbitrageurs,
shorting overpriced securities. This is an example of a much broader
phenomenon, known among finance researchers as limits of arbi-
trage. When arbitrage is limited and some investors in the market
mis–value stocks, arbitrage opportunities may arise and persist over
time. In class, we discussed the case of 3Com and Palm, illustrat-
ing this kind of problem in the context of the tech bubble of the late
1990s–early 2000s. To learn more about this case, and similar cases
also related to equity carve–outs, you should read the original paper
by Lamont and Thaler (2003). In addition, you might want to read
Shleifer and Vishny (1997) for a more general argument about limits
of arbitrage.

3.4 Storage costs, income, foreign exchange

Expression (3.1) is the basic forward pricing equation; let’s see now
how we need to modify it, to account for a richer set of underlying
asset features.
We have seen, for instance, a couple of examples where gold is Storage costs
the underlying. Unlike for stocks or bonds, which are ultimately
“pieces of paper”, the owners of gold face non–negligible storage
costs. Intuitively, such costs must affect the value of gold, and as a
result its forward price. To see this, consider the arbitrage strategy
we devised when the forward on gold is overpriced. That strategy
involves borrowing cash to purchase gold on the spot market. At
maturity, we sell the gold and earn ST ; but we will also have to pay
storage costs. Let’s denote the present value (value at t = 0) of the
storage costs by C. If you plug C in the arbitrage strategy, you’ll find
that we need to modify the no–arbitrage forward price as:

F0 = (S0 + C )(1 + r ) T (3.2)

A similar logic tells us what happens when the underlying gener- Income
ates income. For instance, it may be a dividend–paying stock, or a
coupon bond. Just as storage costs make it more expensive to hold
the underlying in the replicating portfolio, increasing the value of
the forward, income makes it cheaper, so that the forward price goes
down. Letting I denote the present value of all income generated
20 introduction to options and futures

by the underlying over the forward contract’s life, the no–arbitrage

forward price is:
F0 = (S0 − I )(1 + r ) T (3.3)

Income yield A slightly separate case can be made for forwards (or futures) on
stock indexes, such as the S&P500. Within an index, each stock pays
a dividend at a different point in time in general. Because of that,
it can be convenient to move to continuous time, and assume that
the index earns an infinitesimal dividend q at each instant. q is then
known as the income (in this case, dividend) yield, and the above
expression is modified as:

F0 = S0 e(r−q)T (3.4)

Cost of carry When describing these expressions, practitioners often refer to the
underlying logic as the “cost of carry” argument. The cost of carry
is defined as storage cost, plus the interest paid to finance the asset,
minus the income earned on the asset. In the simplest case, with no
storage cost and no income yield, the cost of carry is simply r; with
an income yield q, it is r − q, etc. The cost of carry logic can be useful,
because it allows us to quickly derive expressions to price forwards
in an intuitive way.
Foreign currencies An example is foreign currency forwards. The idea is that you can
think of the foreign currency as a security earning a yield equal to the
foreign rate of interest r f . That gives us an expression for forwards
on foreign currency:
F0 = S0 e(r−r f )T (3.5)

This should be familiar to you: it’s the interest rate parity expres-
sion from international finance. In your international finance class,
you (probably) derived it by comparing two investment strategies:
(a) you have an amount of foreign currency, you invest it in the for-
eign market earning r f , and enter a forward to hedge, so that your
payoff is F0 er f T ; and (b) you have an amount of foreign currency,
you convert it immediately into your local currency at the exchange
rate S0 , and invest it at the local interest rate r, so that your payoff
is S0 erT . The payoffs from these two strategies must be equal (by
no–arbitrage), hence F0 = S0 e(r−r f )T . As you can see, this result is
consistent with a cost of carry argument.

3.5 Futures and expectations

Futures prices are often considered indicative of market expectations

about future spot prices. What’s behind this argument?
In the first place, we know that futures prices must converge to the
spot price around the delivery date. The reason is that, if the futures
price is greater than the underlying price during the delivery, there’s
an arbitrage opportunity (also see our practice questions, where you
are asked to prove this). How about earlier in the life of the futures
contract?
 forwards & futures: pricing 21

Historically, three hypotheses have been made about the rela-

tionship between futures prices and future spot prices. The first
one is the expectations hypothesis. According to this hypothesis, Expectations hypothesis
F0 = E(ST ), i.e. the futures price is simply equal to the expected
future spot price. This hypothesis has the advantage of being sim-
ple. However, it is often not supported in the data (we have seen
a few examples in class). Furthermore, intuitively it is incomplete:
ST is risky, and the simple expectations hypothesis does not seem to
account for this risk.
A second hypothesis is known as backwardation, and it assumes Backwardation
that F0 < E(ST ). Celebrated economists J.M. Keynes and J.R. Hicks
argued that if speculators tend to hold long positions and hedgers
short positions, the price of the underlying asset will be below the
futures price. Why? Because the speculators require compensation
for the risk they bear, i.e. a lower underlying price, and thus a higher
expected return.
The opposite situation is called contango, where F0 > E(ST ). If Contango
hedgers tend to hold long positions and speculators short, by the
same reasoning the futures price should be above the expected spot
price.
The modern approach to valuing financial assets tells us that the Modern approach: Risk & return
price of any asset should relate to its risk and its expected return.
Let’s follow this approach to understand the relationship between
futures prices and future spot prices. Suppose you are a speculator,
and take a long position in the futures hoping that ST will be greater
than F0 at time T.
To do so, you do the following. First, enter the futures contract.
For the sake of this example, let’s treat futures just like forwards,
i.e. ignore daily settlement and margins. Thus, entering the futures
costs us nothing. Second, invest the present value of F0 at the risk–
free rate, i.e. put F0 e−rT in the bank. At maturity T, you obtain F0
from your risk-free investment, which you use to honor your long
futures obligation, i.e. buy the underlying at a price F0 . In return,
you receive the underlying itself, which is worth ST .
Therefore, your cash flows are: (i) − F0 e−rT at t = 0, and (ii) ST at
t = T. What is the value of this investment? To determine that, you
should discount the future cash flow ST at a discount rate k which
accounts for the risk involved in this investment. The “fair” discount
rate, which perfectly compensates you for risk, sets the net present
value of the investment to exactly zero, i.e. − F0 e−rT + E(ST )e−kT = 0.
But then:
F0 = E(ST )e(r−k)T (3.6)

That means that whether F0 is equal to, larger than, or smaller than
E(ST ) depends on k, the risk–adjusted discount rate.
So what determines k? The simplest way to look at it is via the
CAPM:
k = r + β [E(r M ) − r ] (3.7)

where E(r M ) is the expected return on the market portfolio, and β

22 introduction to options and futures

is your investment’s exposure to market risk, which is related to its

correlation with the market return r M . If β = 0, your investment is
risk–free, and r = k. In that case (and only in that case), F0 = E(ST ).
If your investment has positive systematic risk (e.g. the underlying
asset has positive correlation with the market), k > r and F0 < E(ST ).
If systematic risk is negative instead, k < r and F0 > E(ST ).