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1.2 - Forwards and Futures, Pricing
1.2 - Forwards and Futures, Pricing
Options
(& others)
Hedging
Financial with…
markets and
Swaps
corporate
applications
Pricing…
Forwards
and Futures
Determine the prices of forwards and futures
𝐹0 = 𝐹𝑉 𝑆𝑂
𝑆0 : spot price of the underlying asset (today)
𝐹0 : future price for transaction (set today)
𝐹𝑉: “Compute the future value” (just as PV is a present value)
Hedging portfolio
Value of a security = cost of hedging its risk
Replicating portfolio
Value of a security = cost of a portfolio of securities
that generates the same payoff
𝑡=0 𝑡=𝑇
𝑡=0 𝑡=𝑇
𝒕=𝟎 𝒕=𝑻
Settle futures:
Short futures $0 deliver gold at $425 − 𝑆𝑇
𝐹0
Buy gold −$390 Gold value 𝑆𝑇
Borrow +$390 Repay loan −$390 1 + 5%
Profit = Profit =
If 𝑭𝟎 > 𝑺𝟎 𝟏 + 𝒓 𝑻 , then arbitrage by going long
underlying and short the futures contract
𝒕=𝟎 𝒕=𝑻
Settle futures:
Short futures 0 deliver gold at 𝐹0 − 𝑆𝑇
𝐹0
Buy gold −𝑆0 Gold value 𝑆𝑇
Borrow +𝑆0 Repay loan −𝑆0 1 + 𝑟 𝑇
Profit = 0 Profit = 𝐹0 − 𝑆0 1 + 𝑟 𝑇
What if the quoted 𝐹0 is $390. What is the arbitrage
opportunity?
𝒕=𝟎 𝒕=𝑻
Settle futures:
Long futures $0 𝑆𝑇 − $390
pay 𝐹0 for gold
Shortsell gold +$390 Gold value −𝑆𝑇
Invest in 1-yr −$390 Get bond +$390
bond payoff × 1 + 5%
Profit = Profit =
If 𝑭𝟎 < 𝑺𝟎 𝟏 + 𝒓 𝑻 , then arbitrage by going short
underlying and long the futures contract
𝒕=𝟎 𝒕=𝑻
Settle futures:
Long futures 0 𝑆𝑇 − 𝐹0
pay 𝐹0 for gold
Shortsell gold +𝑆0 Gold value −𝑆𝑇
Invest in 1-yr Get bond 𝑇
−𝑆0 +𝑆0 1 + 𝑟
bond payoff
Profit = 0 Profit = 𝑆0 1 + 𝑟 𝑇 − 𝐹0
The spot price of an investment asset that
provides no income is $30; the 3-year forward
price is $40. What is the 3-year risk-free rate of
return?
𝑇
Start from 𝐹0 = 𝑆0 1 + 𝑟
𝐹0 𝑇
𝐹0
= 1+𝑟 ⇒ ln = 𝑇 ln 1 + 𝑟
𝑆0 𝑆0
1 𝐹0
⇒ ln = ln 1 + 𝑟
𝑇 𝑆0
1 𝐹0
⇒ exp ln − 1 = 𝑟 = 10.1%
𝑇 𝑆0
𝑇
What about 𝑟 = 𝐹0 /𝑆0 − 1?
Also correct…
3Com Palm
Cumulative Excess Return
0%
-50%
-100%
𝑇
Arbitrage pricing: 𝐹0 = 𝑆0 + 𝐶 1 + 𝑟
In our example:
If 𝐹0 = $425, then arbitrage by going long underlying
and short the futures contract
𝒕=𝟎 𝒕=𝑻
Settle futures:
Short futures $0 deliver gold at 𝐹0 − 𝑆𝑇
𝐹0
Buy gold −𝑆0 Gold value 𝑆𝑇
Borrow +𝑆0 Repay loan −𝑆0 1 + 𝑟 𝑇
Storage? $0 Pay storage −𝐶 1 + 𝑟 𝑇
Profit = Profit =
Quoted interest rates usually annualized, with
an implicit compounding convention
5% compounded semi-annually: a 2.5%
payment every 6 months
$1 invested at (annualized) 𝑟 with a
compounding frequency 𝑛 yields, after 1 year:
𝑟 𝑛
$ 1+
𝑛
Theoretical price:
2
2%−1% ×
𝐹0 = 1.0500𝑒 12 = 1.0518
The futures contract is undervalued! To make an
arbitrage, we should…
Futures price = Expected price in the future?
Futures Spot
Spot Futures
Time Time
Time
Backwardation
𝐹0
𝐹0 < 𝐸 𝑆𝑇
If speculators are long,
they require higher Expectations
hyp.
return
Backwardation
Time
Contango
𝐹0
𝐹0 > 𝐸 𝑆𝑇
If hedgers are long, they Contango
Time
Modern approach: Risk & return
Suppose you are a speculator, and expect 𝑆𝑇
to be greater than 𝐹0 at time 𝑇
What happens to 𝐹0 today?
Consider the following strategy:
▪ 𝑡 = 𝑇:
𝑆𝑇 − 𝐹0 + 𝐹0 = 𝑆𝑇
Long futures Risk-free
investment
Value of the investment?
−𝐹0 𝑒 −𝑟𝑇 + 𝐸 𝑆𝑇 𝑒 −𝑘𝑇
where 𝑘 = risk-adjusted discount rate.
No arbitrage: −𝐹0 𝑒 −𝑟𝑇 + 𝐸 𝑆𝑇 𝑒 −𝑘𝑇 = 0, or
𝑟−𝑘 𝑇
𝐹0 = 𝐸 𝑆𝑇 𝑒
Thus: depends on 𝑘 ≷ 𝑟.
CAPM
𝑘 = 𝑟 + 𝛽 𝐸 𝑟𝑀 − 𝑟
When is 𝑘 > 𝑟?