OPTIONS, FUTURES AND

OTHER DERIVATIVES
Lecture 1: Using Futures
Prcing Futures and Forwards

Patrick PILCER
patrick@pilcer.fr
 Outline
• Forwards and Futures
What they are and how they trade
• Hedging strategies
Hedging with forwards
Hedging with Futures
• Pricing Forwards and Futures
The no arbitrage argument
Cash and Carry and Reverse Cash and Carry
Index, FX, Commodities Futures

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Forwards
• A private agreement between 2 parties to buy or sell
an asset for a certain price at a certain time in the
future
• All terms (price, traded good, quantities, delivery
date, delivery place) are negotiable
• There are no intermediate cash flows, the price at
which the trade will occur is locked in today
• At maturity, the buyer has the obligation to pay the
forward price against the delivery of the asset as the
seller has the obligation to deliver and receive the
forward price
• Risks?
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Futures
• A contract is a commitment to deliver (short) or to
receive (long) a given quantity of a given asset at a
future date at a price which is fixed today
• Futures are standardized, trade on exchanges, are
settled daily (marked to market)

• A Futures contract must specified the underlying

asset, the contract size, the delivery arrangements,
the maturity or delivery date
• Example

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 Let us compare
Forwards and Futures
Private contract / Exchange traded

Everything is negotiable / Standard Contract

Settled at end of contract / settled daily

Credit Risk / No credit Risk

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Links between the buyer
and the seller

BUYER SELLER

Clearing
BUYER SELLER
House

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 Margin / Futures
 For each new position, an initial margin is
deposited in a margin account
 At the close of every day, the position is
marked to market; the margin account is
adjusted to reflect the investor’s gain or loss
over the day
 If the investor cannot provide the variation
margin, the position is closed out

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 Margin / Futures
 Summing up the successive cash flows
F1-F0; F2-F1;…Fn-Fn-1
gives the total payoff of the strategy

 The margin is set up at a level at least equal

to the maximum loss expected over a day

 Marking to Market is like closing out and

reopening the position every day

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 Hedging Strategies
What is hedging?...Neutralizing the risk as far
as possible…

A perfect hedge completely eliminates the risk

A partial hedge reduces the risk

The basic principle is to find an asset that

delivers cash flows in the opposite direction of
those of the asset being hedged

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 Hedging Strategies
With Forward contracts

You simply need to find a counterpart and agree with

him on conditions and price

With Futures
You do not need to find a specific counterpart. You can
use standard futures contracts

Example

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 What is an Arbitrage
opportunity
A portfolio that costs nothing initially and delivers
futures payoffs that are never negative. For nothing, you
have a zero probability of loss and a positive probability
of future payment

Or

A portfolio with a positive sum of all the discounted

cash flows

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 No Arbitrage Rule
Under the No arbitrage rule, two assets delivering the
same cash flows must have the same value

If not, buy the cheaper and sell the most

expensive…there s an arbitrage opportunity

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 No Arbitrage Rule
At equilibrium on a financial market, there must be no
arbitrage

If not, the arbitrageurs will create arbitrage portfolios;

this will modify the price of the assets; arbitrageurs will
enter in this arbitrage until these operations remain
profitable

Thus prices are brought back to their no arbitrage values

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 Example of arbitrage
Assume the underlying is a stock index that delivers no
dividend, price is 3400, risk free rate is 1% annual

Consider a Futures contract with a one year maturity

What if the Futures price on this index is

3400
3500
3750
3200
3000
Can you arbitrage the stock index with the futures and
how?
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 Example of arbitrage
You buy the stock index at 3400 and borrow for it at 1%.
You sell the Futures at 3500
In one year you pay the interest and repay the capital:
-3434
You sold the Futures at 3500

Your final cash flow is +66, whatever the price of the

stock is at that date

You have built a cash and carry position

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 Example of arbitrage
You sell the stock at 3400 and invest the money at 1%.
You buy the Futures at 3300
In one year you receive the interest and the capital:
+3434
You bought the Futures at 3300

Your final cash flow is +134, whatever the price of the

stock is at that date

You have built a reverse cash and carry position

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 Example of arbitrage
Theoretically, you can sell, but you cannot short sell
what you want (banks,…) and there’s an extra cost to
borrow the security you do not have

Under the no arbitrage rule, the Futures price has to be

…3434

To calculate it you need today’s underlying asset price

and the risk free interest rate (cost of financing)

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 Theoretical Futures Price
Theoretically, with no storage costs, no cost of stock
borrowing, the Futures price is

F° = S° 𝑒 𝑟𝑇 with continuous compounding

F° = S° (1 + 𝑟)𝑇 with yearly compounded

If there is a cost of storing (insurance, storage…) add it

F° = S° (1 + 𝑟)𝑇 + K where K is the carrying

cost

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Futures Price when the underlying
assets provide a yield
Some assets provide a known yield (rather than a cash
income) for exemple, bonds, currencies…give a known
interest yield d

the Futures price is now F° = S° 𝑒 (𝑟−𝑑)𝑇

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 Futures Price when a stock pays a
known dividend D
When a stock pays a known dividend D at time t (t<T),
the short seller has to pay the dividend back to the stock
lender

What is the Futures price?

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 Futures Price when a stock pays a
known dividend D
You buy the Stock : -S°
You borrow to date T: S°-D’ (where D’is the
present value of D , D’=D 𝑒 −𝑟𝑡
You sell the Futures at F°
At date t, you receive the dividend D and repay D’x
𝑒 𝑟𝑡 = 𝐷
At maturity T, you repay (S°-D’) 𝑒 𝑟𝑇 and you deliver the
stock agaisnt F°

F° = (S°-D’) 𝑒 𝑟𝑇

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 Example
Futures on S&P 500 index

The dividend yield is d =3.5%

The Spot Value is S= 1045,20
The risk free rate is r= 2.5%

What should be the price of the futures contract for

delivery in 3 months?

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At 15€, you think that SocGen shares are likely to outperform
the CAC 40 in the next 6 months. You decide to buy 1 000 000
shares and to sell the June CAC 40 futures contract to hedge
your bet. Assuming that the CAC 40 June contract is at 3200
and that Soc Gen has an estimated beta of 1,4 with the CAC
index,

What is the number of contracts you would sell to hedge the

systematic risk of your position in SG? (value of a CAC 40
point 10€)

What if in June SocGen is at 30 and CAC40 at 3700 points?

What if SocGen is at 10 and CAC 40 at 2800?

What can go wrong?

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You are checking the news and hear that Citigroup shares have just crossed the
psychological barrier of $50 per share. You check the recent analysts reports and
conclude that the company is likely to outperform the S&P 500 in the next 6 months.
Hence this is an interesting buy opportunity.
You decide to buy 1 000 000 shares of Citigroup and to sell futures contracts on the
S&P 500 index expiring in 6 months , to hedge your position. Assuming that the 6
month futures price for the S&P index is 1300 and Citigroup has an estimated beta of
1,32 with the S&P 500 index.

a) What is the number of S&P Futures contracts you would sell to hedge the
systematic risk of your stocks?

b) List things that can go wrong with this strategy

c) If you had bought a forward contract on 1 000 000 shares, if the annual risk free
rate is 2%, what is the theoretical price for the forward contract if there is no
dividend during the next six months.
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How Many Contracts to Buy?
Hedge Ratio

• Suppose a portfolio has a value of 𝑉𝑝 and a beta of 𝛽𝑝 is to be hedged with an index future which
has a beta of 𝛽𝑖

𝑖0 × 𝑚 𝑁𝐹
𝑉𝑝 = 𝛽𝑖
𝛽𝑝
𝑉𝑝 × 𝛽𝑝
𝑁𝐹 =
𝑖0 × 𝑚 𝛽𝑖

• Suppose now the portfolio is worth £5𝑀 and has a beta of 1.3, the index is at 5,900 and it has a
beta of 0.97 then we need to buy
£5𝑀 × 1.3
𝑁= = 113.6
£10 × 5,900 × 0.97
• Need to round up/down

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 Forex Futures
Suppose you have 1000 € today, the spot FX rate against
the dollar is S°
You can change today, place this amount to date T at a
rate r
Or, you can place the euro amount to date T at rate rf
and change it at date T at the Futures FX rate F°

1000 F° 𝑒 𝑟𝑓𝑇 = 1000 S° 𝑒 𝑟𝑇

F° = S° 𝒆(𝒓−𝒓𝒇)𝑻

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You have 1 000 000€ on your account and you ‘d like to invest
it in Europe or in the US but you do not want any effect of the
exchange rate on the value of your investment.

Today’s spot FX rate: 1,34 $/€

6 month forward FX rate : 1,38
6 month US deposit interest rate: 0.75% p.a.
6 month € deposit interest rates: 1% p.a.

What is the fair price for the 6 month forward FX rate?

Is there any arbitrage opportunity?

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Currency Forwards
• Two ways of obtaining sterling in one period:
– Invest now in a UK account
– Convert to $, deposit at US rate, re-convert at (current) forward price

£100 £100.5 𝑮𝑨𝑰𝑵 = £𝟎. 𝟓

𝑟𝑈𝐾 = 0.5%
Spot: £100.5
£1=$1.5806 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 = £𝟏 = $𝟏. 𝟓𝟕𝟔𝟕
𝑟𝑈𝑆 = 0.25%
$158.06 $158,46

• Offers no arbitrage profit

– Borrow at UK rate, convert at spot, deposit at US rate and re-convert
• Only forward with no gain is
𝟏+𝒓𝒇 𝑻−𝒕
– Note exchange rate convention 𝑭𝒕 = 𝑺𝒕 𝟏+𝒓𝒅

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Your client asks for an advice on how to invest for five months £ 1 000 000 that
are on his account. Although the client lives in the UK, he is also keen to invest in
US deposits, but he does not want any exchange rate risk. You check your screen
and you find the following quotes:
FX spot rate: 1$ = 0,65£ 5 month forward rate 0,66
5 month UK deposit interest rates: 4% p.a.

a) What is the fair price for the FX contract expiring in 5 months?

b) Is there any arbitrage opportunity in this market? If so, how would you set up
a strategy to benefit from this arbitrage opportunity?

c) Given your results above, which investment would you advice the client to
make?

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 You buy a 2 years gold forward contract when the spot rate is 1700$
The risk free rate is 1%
The annual storage cost per ounce is 15$
a/ what is the price of one ounce of gold for this contract ?
b/ What is the value of the forward contract?
Now suppose it is one year later and the spot price of gold has risen to 1
800$
However, the risk free rate is still 1% and the cost of storage 15$
c/ what would be the 2 year gold forward price now
d/what should the value of the forward contract be now
e/ If the market price of the forward was 1850$, show how you could make
arbitrage profits

Formula : V(t,T)=St+storage(t,T)-F(0,T)(1+r)^(T-t)

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Forward Rate Agreement (FRA)
• An FRA is an agreement to pay/receive a 𝑘 − 𝑚 period money market
rate after 𝑘 periods, and receive/pay a fixed rate 𝑭𝑹𝑨𝒎,𝒌
– Seller of FRA pays floating (money market) rate and receives fixed FRA rate
– Buyer of FRA pays fixed FRA rate and receives floating (money market) rate

• FRA used to hedge interest rate risk over a specific forward time interval

• Example:
– Suppose 𝐹𝑅𝐴3,6 = 1% 𝑚 = 3 𝑎𝑛𝑑 𝑘 = 6
– Buyer of 𝐹𝑅𝐴3,6 agrees to lend money to seller of 𝐹𝑅𝐴3,6 , for a period of 3
months, starting 3 months from now, at the money market rate of 1%
– If the actual 3 months money market rate in 3 months time is 1.2% then the
seller of the FRA will pay 0.2% on an agreed notional amount

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 Arbitrage theory limits
 Market are not so efficient

 Transaction costs,

 bid and ask,

 differences between borrowing and lending rates

 Low liquidity

 Difficulties in replicating some assets such as indices

 Short selling constraints

 …

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