Forwards and Futures

Pricing
Theory
• Arbitrage arguments can be used to value
the different types of financial futures
contracts in relation to the current value of
the underlying commodity.
Arbitrage Argument
• Two strategies equivalent in certain crucial
aspects should have the same price, otherwise
riskless arbitrage profits can be made.
• We are going to apply this powerful argument to:
1. Price currency, index and int. rate futures.
2. Construct arbitrage trading strategies should
actual contract prices deviate from those
calculated in (1).
Arbitrage strategy characteristics
• If we construct two investment strategies that are
equivalent in:
1. Risk (e.g., stock price- market risk)
2. Investment horizon (e.g., one year)
3. Incidence of cash flow (for simplicity we
construct strategies with cash flow only at the
beginning and end of the investment horizon)
Then ….
• Apply the Law of One Price (which states that
in efficient markets two equivalent investments
should have the same price).
• This law is sometimes called the no-arbitrage
equilibrium clearing condition.
• We first carefully consider the definition of each
futures contract; construct two equivalent
strategies (one has the contract and the other a
direct investment in the underlying); then apply
the Law of One Price to these two strategies.
INTEREST RATE FUTURES
• Underlying commodity is an interest rate
instrument (e.g. 3-month Treasury Bill).
• Either cash settled or interest-rate instrument
delivered.
• In LIFFE short-term interest rate futures are
cash settled contracts. Long-term futures are
delivered.
• In LIFFE, short-term interest-rate futures are
based on the interest rate on a 3-month deposit
(cash market offered rate e.g. ICE LIBOR or its
recent replacement e.g. SONIA).
• At the maturity date of the futures contract, say,
a T-Bill is delivered, or its cash equivalent (i.e.,
Exchange Delivery Settlement Price, EDSP).
• The underlying instrument often has its own
maturity date.
• Instruments Traded.
– Treasury Notes.
– Treasury Bills.
– Government Bonds.

• Face value typically $1,000,000/£500,000.

• Quoted at annualised discounts to face value.
• Quoted discount is NOT equal to T-Bill yield.

For US T-Bills,
Purchase price =
Face value x [1 - Quoted Discount x Days to
maturity/360].

For UK Sterling LIFFE products,

Days-to-maturity are divided by 365.
 Digression - interest rate notation
Spot versus forward interest rates.
• Let r01, r02, …, r07, …etc., denote spot rates
(interest rates starting today, 0, and apply for 1,
2 ….etc. periods into the future).
• Let r12, r13, …, r24,…, r39 etc., denote forward
rates (interest rates starting at end of period 1, 2
…etc. and apply for 1, 2, …etc. periods into the
future).
Two equivalent strategies
Strategy 1
§ Buy a T-Bill maturing at time T. Face value
$1 million, price S.
Strategy 2
§ Buy a futures contract maturing at t1, to
deliver a T-Bill maturing at T with face value
$1 million. Let the price of the contract be F.
AND
§ Buy a T-Bill maturing at t1 with face value F.
 Timeline of strategy cash flow

Strategy 1 (S1)
(Price of S1= S) $1 m

t=0 t=T

Strategy 2 (S2)
(F)

t=𝑡" $1 m
T-Bill Delivered

(Price of S2) F
Strategy 1 cash-flow
Pay S at t0 and get $1 Million at T. Therefore, S
should be the present value of $1 Million :
𝑆 = 1⁄ 1 + 𝑟)* = 1⁄(1 + 𝑟),- )(1 + 𝑟,-* )

Strategy 2 cash-flow
i. Nothing is paid or received at t0. F is paid at
delivery date of the futures contract, t1. $1
Million face value of T-Bill is received at T.
ii. Price of t1 T-Bill should be F/(1+𝑟),- ) paid at
t0. F is delivered at t1 to cover the payment
for the futures contract.
Strategy \ Time t=0 t = 𝒕𝟏 t=T
Cash flow table
Strategy 1
Buy long T-Bill (£S) £1m

Strategy 2
Buy futures maturity (F) £1m
t1 (face value of T-Bill
delivered)
Buy short T-Bill with (£price = F/(1+𝒓𝟎𝒕𝟏 )) F
face value = F
Net cash flow of (£F/(1+𝒓𝟎𝒕𝟏 )) £1m
strategy 2
• Note, both strategies are constructed to have
same horizon, end-of-period payoff (£1m) and
risk (interest rate risk).
• Therefore, applying the Law of One Price, an
efficient market where arbitrage is not possible
would require these strategies to have the same
price (initial investment):
F/(1+𝒓𝟎𝒕𝟏 ) = S, or
F = S(1+𝒓𝟎𝒕𝟏 )
• This is called the ‘cost of carry’ model. The
futures price is the spot price ‘carried forward’, in
this case compounded.
• Similar relationships will hold for other fixed
income futures.
Long-term bond futures
Valued similarly.
• The underlying asset is a coupon bond (bond
paying interest). The spot price of the
commodity has to be adjusted by the present
value of the coupon payments promised during
the life of the futures contract:
F = (S-PV(coupon))×(1+rt)
STOCK INDEX FUTURES
• Underlying asset is a stock index (usually
without the dividends).
• Contract is equivalent to a value weighted
basket of stocks in the index but without the
dividends.
• Quoted by index points - e.g. LIFFE ‘s
FTSE100 future attach £10 to every full index
point (e.g. if index level is 5000 points the Face
Value is £50,000).
• In general: Face value of futures = suitable
multiple x the index level.
• Delivery months. Normal cycle of March, June,
Sept and Dec maturity.
• On the delivery day, the contract is usually
settled by a cash payment equal to a multiplier
times the difference between the value of the
index at the specified time of the last trading day
and the purchase price of the futures contract.
 Two equivalent strategies

Strategy 1
§ Buy the index basket of stocks with an amount
equal to the face value of one index futures
contract. Call this value S.
§ Invest all interim dividends at a risk-less rate to
receive future value of div =FV(Div.).
Strategy 2
§ Buy one index futures contract valued at F.
§ Invest an amount of S to earn a risk-less rate
(e.g. a Treasury-Bill).
 Cash flow table
Strategy \ Time t=0 t=T
Strategy 1
Buy index (£S) ST
Invest dividends - FV(Div.)
Net cash flow of strategy 1 (S) S4 + FV(Div.)

Strategy 2
Buy futures contract maturity T S4 − F cash
settlement
Buy T-Bill with amount of £S (£S) S(1+𝒓𝟎𝑻)
Net cash flow of strategy 2 (S) S4 − F + S(1+𝒓𝟎𝑻)
• Note, both strategies have the same horizon,
risk (market and interest rate risks) and initial
investment (price).
• Applying the Law of One Price, their end-of-
period payoff should be the same.
S4 + FV Div. = S4 − F + S(1+𝒓𝟎𝑻 )
or F = S(1+𝒓𝟎𝑻 ) − FV Div.
• Which is, again, the cost of carry model.
Alternative expressions
• Can express future value of dividends as
present value compounded
FV Div. = PV(Div. )(1+𝒓𝟎𝑻 )

• Thus, pricing equation above can be written as :

F = (S − PV(Div.)(1+𝒓𝟎𝑻 )
• Often hard to calculate future or present value of
dividends, but dividend yield is widely available.
• Dividend yield throughout 0 to T is defined as
𝒅𝟎𝑻 = FV Div. / S
• So, can express pricing equation as
F = S(1+𝒓𝟎𝑻 ) − S𝒅𝟎𝑻 = S(1+𝒓𝟎𝑻 − 𝒅𝟎𝑻 )
• Thus price is spot compounded (carried forward)
by interest rate less dividend yield because
contract assumes no dividends
Assumptions made (crucial)
• Daily marking-to-market cash flows ignored.
Futures contract valued as a forward contract.
• No transaction costs.
• Dividends or coupons on underlying stocks
known with certainty till maturity.
… Assumptions made
• No differential tax effects. Tax timing option
ignored.
• Interest rates known with certainty till maturity.
• Margin requirements are met with fixed Interest
securities (T-Bills).
• No arbitrage window, i.e., markets are
frictionless.
CURRENCY FUTURES
• Pure currency futures usually through
international money market and Chicago
Mercantile Exchange (now CME Group and
CME Europe).
• Underlying commodity is currency.
• Currencies are delivered in the principal
financial centres in the country of issue.
• At CME, often priced as number of foreign currency per
US Dollar (USD), other way round elsewhere.
• Major currencies traded – denomination
1. British Pound – GBP 62,500
2. Euro – Euro 125,000
3. Japanese Yen – JPY12.5 million
4. Swiss Franc – CHF 125,000
5. Canadian dollar – CAD 100,000
6. Australian dollar – AUD 100,000
7. New Zealand dollar – NZD 100,000
8. Norwegian kroner – NOK 2 million
9. Swedish kroner – SEK 2 million
• Also ‘cross rates’ are quoted e.g., AUD/CAD or
EUR/JPY (i.e., not against USD)
• Many other ‘emerging market’ currencies are
traded, e.g., Brazilian reals, Chinese renminbi,
Czech koruna, Hungarian forint….etc.
• Usual cycle of delivery months (March, June,
Sept and Dec).
• Following pricing uses GBY/USD contract, but is
same for other currency pairs.
 Two equivalent strategies
Strategy 1
§ Convert pounds to dollars and invest in risk-
less bonds in USA,
§ Buy forward contract to deliver pounds
equivalent to known end of period value.
Strategy 2
§ Invest in risk-less bonds in UK.

In both cases let investment horizon coincide with

maturity of futures contract.
 Cash flow table
Strategy \ Time t=0 t=T
Strategy 1
Convert £1 to $S and invest in USD ($S) $
$S(1 + 𝑟)* )
$
deposit earning 𝑟)*
Buy forward to deliver GBP at - $
£[S(1 + 𝑟)* )/F]
forward rate F (in USD/GBP)
Net cash flow of strategy 1 ($S) $
£S(1 + 𝑟)* )/F

Strategy 2
Invest £1 in GBP-UK deposit (£1) £
£(1+𝑟)* )
£
earning 𝑟)*
Net cash flow of strategy 2 (£1) £
£(1+𝑟)* )
• Note, both strategies have same horizon, risk
(interest rate and exchange rate) and initial
investment (price) (since £1 = $S, where S is the
spot USD/GBP exchange rate).
• Applying the Law of One Price requires that the
end-of-period payoffs to also be the same
C $ £
£ 1 + 𝑟)* = £(1+𝑟)* ) or
D
$
1 + 𝑟)*
𝐹=𝑆 £
1 + 𝑟)*
Assumptions
1. Marking-to-market effect ignored.
2. No transaction costs.
3. No exchange controls, and no anticipated
controls.
4. No differential tax effects.
5. Futures contract valued as forward contract.
Riskless Arbitrage
• If actual forward/futures price in the market is
not = F, given our simplifying assumptions, then
arbitrage opportunity exists.
• We can conduct arbitrage strategies on this
basis.
• But note that we are conditioning on the
assumptions to hold in reality.
Arbitrage action

• If actual price > F, contract is overpriced.

• Arbitrage action: sell ENTIRE strategy
containing the forward AND buy ENTIRE
equivalent strategy – simultaneously.

• If actual price < F, contract is under-priced

– Arbitrage action: buy ENTIRE strategy
containing the forward AND sell ENTIRE
equivalent strategy – simultaneously.
Digression – what is a year?
• Sometimes financial markets assume 360 days
in a year (see CME contract specifications).
• When a year is taken as 360 days, then it is
divided into months of 30 days each and
quarters of 90 days each.
• When a year is taken as 365 days, then it is
divided into months of 30 days and quarters of
91 days (6-months = 182 days and 9-months =
273 days).
 Arbitrage Example – interest rate futures
• Assume a 360-day year. Observe the following
prices:
Contract Maturity Price in £ per £100
(days) face value
•Treasury
D Bill 90 96
• D
Treasury Bill 270 98
Futures
• D on 6-month 90 99
Treasury
• D Bills
• Are these prices out of line (i.e., is there an
arbitrage opportunity?)
• We price instruments relative to each other.
• Given the Treasury Bill prices, we need to check
if the futures is fairly priced.
• Recall: F = S(1+𝑟),- ), where S is the price of the
long Treasury Bill, and the maturity of the futures
contract (90 days) together with that of the
Treasury Bill it delivers (90 days) matches the
maturity of the long Treasury Bill.
• We can observe S, but we need to calculate
1+𝑟),- . This is the yield on the 90-day Treasury
Bill = Face value/ price
• = 100/96 = 1.0417
• ALWAYS KEEP ACCURACY TO 4 DECIMAL
POINTS.
• Therefore, F = 98(1.0417) = £102.0833 per £100
face value.
• Thus, at £99 the futures is actually under-priced
in the market.
• Accordingly, the strategy that contains the
futures, strategy 2, must be ‘cheap’ or under-
priced relative to the equivalent strategy,
strategy 1.
• The Law of One Price says these two strategies
must have the same price, otherwise a riskless
arbitrage opportunity exists.
• Arbitrage action: buy the cheap strategy and sell
the equivalent strategy.
Strategy \ Time t=0 t = 𝒕𝟏 t=T

Cash flow of arbitrage action

Selling Strategy 1
Sell long T-Bill £98 (£100)

Buying Strategy 2
Buy futures maturity t1 (£99) £100
(day 90) (face value of T-Bill
delivered)
Buy short T-Bill with (£price = F/(1+𝒓𝟎𝒕𝟏 )) F = 99
face value o= F, maturity = 99/1.0417 =
is t1 (day 90) (95.0370)
Net cash flow £2.9630 0 0
Cash flow from arbitrage action
• Thus, we gain an immediate (at t=0) riskless
profit of £2.9630 for every £100 face value
traded.
• This profit is riskless, because we bought a
strategy, which exposes us to certain risks, but
sold an equivalent strategy, which is an action
that sheds the same amount of risk. Risk
cancels out.
 Numerical Note - Annualisation
• Following market convention in annualisation
(markets often report annualised yields or rates
by simply multiplying daily rates by 360 or 365,
monthly rates by 12, quarterly rates by 4 and
semi-annual rates by 2.
• To calculate an annual rate from a daily rate for
example we are going to follow the convention:
1+annual rate = (1 + 𝑑𝑎𝑖𝑙𝑦 𝑟𝑎𝑡𝑒)LM) NO LMP .
• To de-annualise a rate that is quoted in annual
terms we are going to follow the convention: 1 +
QRRSQT OQ,U
𝑑𝑎𝑖𝑙𝑦 𝑟𝑎𝑡𝑒 = (1 + LM) NO LMP )
• Example: If you are quoted an annualised 3-
month rate, e.g., rate for 3-month deposits but
expressed in annual form, we de-annualise it
first (to undo the simplified market convention)
and then compound it to get the rate for 3
months:
𝑔𝑖𝑣𝑒𝑛 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 g) NO g"
1 + 3 month rate = (1 + )
360 𝑜𝑟 365
Quoted discount
• Money market instruments are usually sold at a
discount to face value. This ‘quoted discount’ is
DQhU iQTSU j kOlhU kOlhU
QD = DQhU iQTSU
= 1 − DQhU iQTSU .

It is NOT the same as the yield:

DQhU iQTSU jkOlhU DQhU iQTSU
Yield = kOlhU
= kOlhU
−1
• Thus, they are related by
1+ Yield = 1/(1-QD)
• Note, for instruments of maturity different than
one year (say maturity = n days)
𝑛
𝑃𝑟𝑖𝑐𝑒 = 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 1 − 𝑄𝐷×
360 𝑜𝑟 365
• Since 1+yield = Face value/Price Therefore, 1+
yield for such instruments is
𝑛
1s 1 − 𝑄𝐷×
360 𝑜𝑟 365
Uses of Financial Futures
• Speculation.
• Hedging.
• Arbitrage.
• Engineering synthetic securities.
Advantages of Financial Futures

• Low transaction costs.

• No buying and selling individual securities.
• Asset selection decision is kept independent of
risk exposure decision.
• Effective market timing possible.
END