DETERMINATION OF FORWARD AND FUTURES

PRICES
DERIVATIVES AND RISK MANAGEMENT

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TOPICS
 Investment assets vs. consumption assets
 Short selling
 Assumptions and notation
 Forward price for an investment asset
 Known income
 Known yield
 Valuing forward contracts
 Are forward prices and futures prices equal?
 Futures prices of stock indices
 Forward and futures contracts on currencies
 Futures on commodities
 The cost of carry
 Delivery options
 Futures prices and the expected future spot price

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Pricing Forward and FUTURES

 Pricing forward contract is simple – end of maturity settlement

 Futures contract is complex – daily settlement

 Typically, forward and futures prices of contract tend to move closely when maturities are same

Investment versus Consumption assets

 Investment asset is solely held for investmentt purposes (intrinsic value is due to price appreciation)

 Stocks, bonds etc. [ what about real estate – Real estate investment trust]

 Consumption asset is primarily held for consumption (intrinsic value is due to its usability for the holder)

 Copper, corn, wheat, oil etc. [ what about the forwards/ futures in these commodities]

 Arbitrage arguments can be used for determining forward and futures prices of the investment assets
only

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Short Selling
Short selling or shorting refers to selling an
asset that is “not” owned at the time of sale
Shorting is possible only in select cases
Broker arranges for borrowing assets for a
fee
Short position should pay the interim
income received from the asset to the party
lending the asset ( dividends or interest)
Margin account to be maintained –initial
margin through cash or marketable
securities, if margin calls are not satisfied –
position is closed out
Regulation vary on short selling
- Short sale allowed only when share price
increased “uptick”
- Alternative uptick – no short sale if price falls
by 10%
- Ensuring short sale price is higher than best
current bid – aim to reduce volatility

John C Hull – Chapter 5 Table 5.1

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Assume that the following are all true for some market participants :
1. Are subject to no transaction costs when they trade
2. Are subject to same tax rate on all net trading profits
3. Can borrow and lend money at the same risk-free rate of interest ASSUMPTIO
4. Take advantage of arbitrage opportunities as they occur NS &
Need not be true for all but for a small portion of large dealers (viz. Market
Makers)
NOTATIONS
Notations used throughout this module
• T : Time until delivery date in a forward or futures contract (in years)
• S0 : Price of the asset underlying the forward or futures contract today
• F0 : Forward or futures price today
• r: Zero-coupon risk-free rate of interest per annum, expressed with
continuous compounding, for an investment maturing at the delivery date
DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Thursday, June 20, 2024 5
(i.e., in T years).
Forward Price for an Investment Asset

 Arbitrage opportunity - Non-dividend paying stock example

 To generalize consider a forward contract on an investment asset with price
𝑺𝟎 that provides no income.
 Using standard notation, T is the time to maturity, r is the risk-free rate, and F0 is
the forward price. The relationship between 𝑭𝟎 and 𝑺𝟎 is
𝑭𝟎 = 𝑺𝟎 𝒆𝒓𝑻
 𝑭𝟎 > 𝑺𝟎 𝒆𝒓𝑻 [arbitrageurs buy the asset -enter short forward contract]
 𝑭𝟎 < 𝑺𝟎 𝒆𝒓𝑻 [arbitrageurs short the asset - enter long forward contract]
 What is short sales are not possible? (Sell and buy back)
 Implicit cost : Forward prices being higher than spot prices – because of
funding the cost of spot purchase during the life of the contract
 Short selling in India – volatility and scams – SEBI/ RBI restrictions
 Securities Lending and Borrowing Mechanism (SLB)
 Lenders maximize yield – Borrowers avoid settlement failures
 Temporary transfer to borrowers – dividends, interest or voting rights stay with
lender
John C Hull – Chapter 5 Table 5.1
 Intermediary facilitates such transaction – collaterals are used to avoid defaults

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 Known Income
• Forward contract with “predictable” cash
income
Dividend paying stocks/ coupon bonds
• Investment provides income with a present
value of I
𝑭𝟎 = (𝑺𝟎 − I ) 𝒆𝒓𝑻
• 𝑭𝟎 > (𝑺𝟎 − I ) 𝒆𝒓𝑻 [arbitrageurs buy the asset -
enter short forward contract]
• 𝑭𝟎 < (𝑺𝟎 − I ) 𝒆𝒓𝑻 [arbitrageurs short the asset
- enter long forward contract

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Equivalence between continuous compounding and discrete
compounding rates (Chapter 4 – Interest Rates)
• 6-month forward contract
• Income at 2% of asset price once in 6
months
• Risk free rate is 10% per annum
• Asset price is $25
• Value of forward?
Known Yield
 Forward contract provides “Known Yield” as percentage of
asset’s price at the time income is paid.
 q is the average yield on the asset during time T
 The income is reinvested in the asset, the number of units
grow at the rate of q
 One unit of asset at time zero grows to 𝒆𝒒𝑻 at time T.
Strategy
 Borrow 𝑺𝟎 to buy one unit of asset at time zero
 Enter into forward contract to sell 𝒆𝒒𝑻 units of the asset at time T
for 𝑭𝟎
 Closed out the forward contract by selling 𝒆𝒒𝑻 units of the asset at
time T
 No arbitrage condition
 𝑺𝟎 𝒆𝒓𝑻 = 𝑭𝟎 𝒆𝒒𝑻
 𝑭𝟎 = 𝑺𝟎 𝒆(𝒓−𝒒)𝑻

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 f = (𝑭𝟎 −𝑲 )𝒆−𝒓𝑻
Valuing Forward Contracts
 Value of forward contract at the time of entering the contract is close to zero We know 𝑭𝟎 = 𝑺𝟎 𝒆𝒓𝑻

 Let's says 𝑲 is the delivery price of the contract entered with delivery in T years • Non-income paying asset
from now
f = 𝑺𝟎 − 𝑲 𝒆−𝒓𝑻
 r is the T-year risk free interest rate

 𝑭𝟎 is the forward price that would be applicable if the contract is negotiated today • Asset with “Known Income”

 f is the value of the original forward contract today f = 𝑺𝟎 − 𝑰 − 𝑲 𝒆−𝒓𝑻

 f = (𝑭𝟎 −𝑲 )𝒆−𝒓𝑻
• Asset with “Known Yield”
 Forward contract to buy asset for “K” at “T” – Payoff is (𝑆𝑇 − 𝐾 )
 Forward contract to sell asset for “𝐹0 ” at T – Payoff is (𝐹0 − 𝑆𝑇 ) f = 𝑺𝟎 𝒆−𝒒𝑻 − 𝑲 𝒆−𝒓𝑻
 Total pay off is (𝐹0 − 𝐾)

 The discounted value using risk free rate is the value of the forward contract today

 Value of long forward contract to buy asset at for K at T is (𝑭𝟎 −𝑲 )𝒆−𝒓𝑻

 Value of short forward contract to sell the asset for K at T is (𝑲 − 𝑭𝟎 )𝒆−𝒓𝑻

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ARE FORWARD PRICES and FUTURES PRICES EQUAL?
 If short-term risk-free interest rate is constant – theoretically – if the delivery dates of forward and futures
contracts are same, they will have similar prices.

 Similar results hold if interest rate path is known as a function of time (Certainty on interest rate curve)

 If Asset price is strongly correlated with interest rates ( rise in interest rates results in higher asset price)

 Party holding long futures contracts benefits immediately owing to “daily settlement”

 Party holding forward contract will not see the impact immediately

 Such cases long futures is more attractive than long forward hence prices will be more

 Opposite is true if the asset price is negatively correlated with interest rates

 Other factors at work which lead to differences between futures and forward prices

 Taxes, transaction costs, margin requirements, default risk (futures avoid them through exchanges), liquidity for futures
is higher

 However, the differences are often small and last only few months. Hence, are generally ignored.

 Therefore, 𝑭𝟎 is used to represent both forward and futures prices of an asset today
DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Thursday, 20 June 2024 10
FUTURES PRICES of STOCK INDICES
 Stock indices can be used for hedging purposes – How index futures prices are
3 month futures contract on
determined a index
 Index can be thought as portfolio of stocks that provide dividends at a known yield
Dividend yield on 1% pa
 Futures prices 𝑭𝟎 = 𝑺𝟎 𝒆(𝒓−𝒒)𝑻 where q is the dividend yield rate (assume continuous
compounding unless
 Futures prices increases at a rate of (r-q) with the maturity of the futures contract
specified otherwise)
 “q” should be the average annualized dividend yield during the life of the contract
Current value of index 1300
 Dividends used for estimating “q” should have ex-dividend date in the contract
period Risk free rate is 5% pa
 Index Arbitrage opportunities
𝑭𝟎 ?
 𝑭𝟎 > 𝑺𝟎 𝒆(𝒓−𝒒)𝑻 − buy now and enter short position to sell at T

 Banks and other financial institutions with short term view/ profits

 𝑭𝟎 < 𝑺𝟎 𝒆(𝒓−𝒒)𝑻 − Sell now and enter long position to buy at T

 Pension funds with long term view

 Program
DERIVATIVEStrading – automatic
AND RISK MANAGEMENT positioning using algorithms
:: ACV SUBRAHMANYAM Thursday, 20 June 2024 11
FORWARD AND FUTURES CONTRACTS on
CURRENCIES Consider 1000 units of
 Domestic currency is US Dollar (Perspective of US Investor) foreign currency and time
horizon of T
 Quote is USD per unit of foreign currency and underlying asset is 1 unit of foreign 𝒓𝒇 and 𝒓 are foreign and
currency domestic risk-free interest
 𝑺𝟎 = current spot price in USD for one unit of foreign currency ( 0.7500 USD per rates for T . 𝑭𝟎 is forward
AUD) exchange rate at T and 𝑺𝟎 is
the current spot rate.
 𝑭𝟎 = Forward or Futures price in USD for one unit of foreign currency

 Generally, FX quotes are given per USD ( ~84 INR for 1 USD) Except ( GBP, Two choices
EURO, AUD, NZD) Invest in foreign currency at
𝒓𝒇 for T and at maturity
 Foreign currency has the property that holder can earn risk free interest rate convert them to USD at 𝑭𝟎
prevailing in the foreign country
 Holder can invest in a foreign currency denominated bond for 𝑻 and earns a risk- Sell foreign currency in spot
free rate 𝒓𝒇 in foreign currency market at 𝑺𝟎 and investment
in domestic currency at 𝒓 for
 During the same period 𝑻 domestic risk-free interest rate is 𝒓 then relationship T
between 𝑭𝟎 and 𝑺𝟎 is given by
(𝒓−𝒓𝒇 )𝑻 No arbitrage equivalence
 𝑭DERIVATIVES
𝟎 = 𝑺𝟎 𝒆AND RISK MANAGEMENT
[ Interest parity relationship in international finance]
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Forex Forward Strategies
 2-year risk free rate in Australia is 3% and in USA is 1%
 Current spot exchange rate is 0.75 USD/ AUD
 2-year forward exchange rate should be?
 Consider case where 2-year forward exchange rate is 0.7000 USD / AUD what is the strategy to make profit
 In this case USD appreciated wrt to AUD ( borrow in weaker currency – AUD in this case)
 Consider case where 2-year forward exchange rate is 0.7600 USD/AUD what is the strategy to make profit
 In this case USD depreciated wrt to AUD ( borrow in weaker currency – USD in this case)

 𝑭𝟎 = 𝑺𝟎 𝒆(𝒓−𝒓𝒇)𝑻; and if 𝒓 > 𝒓𝒇 then 𝑭𝟎 is an increasing function of T “ futures price rise with maturity”

 A foreign currency can be regarded as an investment asset paying a known yield.

 The yield in the risk-free rate of interest in the foreign currency
 Currency features have been allowed for trading in India since August 2008 – volume are not commensurate
with market development
 Currency forwards are used by corporates for hedging purposes

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Futures on Commodities
Consider 1-year futures
 Investment assets – Like Gold and Silver [ intention is to make contract on an investment
asset that provides no income
money on price changes]
and has a storage cost of $2.
 No storage costs ; 𝑭𝟎 = 𝑺𝟎 𝒆𝒓𝑻 The payment is made at the
end of the year. Spot price of
 𝑭𝟎 = (𝑺𝟎 − I ) 𝒆𝒓𝑻 with a present value of Known Income I ; Treat $450 per unit and the risk free
storage costs as negative Income rate is 7% per annum for all
maturities
 U is the present value of all storage costs , net of income, during the What should be the futures
life of the forward contract. prices ?

 Let “U” be storage costs, then U = 2*e^(-0.07*1) = 1.865

𝑭𝟎 = (𝑺𝟎 − (−U )) 𝒆𝒓𝑻 => 𝑭𝟎 = (𝑺𝟎 +𝑼 ) 𝒆𝒓𝑻
F0 = (450+1.865)e^(0.07*1) =
 Alternatively, if storage costs are proportional to the spot price net of
484.63
any yield earned on the asset, it can be treated a known yield
(negative).

 𝑭𝟎 = 𝑺𝟎 𝒆(𝒓+𝒖)𝑻
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 Convenience Yield
 𝑭𝟎 > (𝑺𝟎 +𝑼 ) 𝒆𝒓𝑻
 Borrow 𝑺𝟎 + 𝑼 at risk free rate use it buy asset and pay storage Benefits of holding a physical asset is called
costs convenience yield.
 Short a futures contract on one unit of the commodity
If the dollar amount of storage costs is known
𝒓𝑻
 𝑭𝟎 − (𝑺𝟎 +𝑼 ) 𝒆 { is the profit from the transaction} and has a present value of U, then
 𝑭𝟎 < (𝑺𝟎 +𝑼 ) 𝒆𝒓𝑻 convenience yield y is defined such that

 Sell the asset at spot price 𝑺𝟎 and save on storage costs U 𝑭𝟎 𝒆𝒚𝑻 = (𝑺𝟎 +𝑼 ) 𝒆𝒓𝑻 or 𝑭𝟎 𝒆𝒚𝑻 = 𝑺𝟎 𝒆(𝒓+𝒖)𝑻
 Invest them in risk free asset
Convenience yield reflects market
 Enter into a long contract to buy asset at 𝑭𝟎 using the proceeds
expectations on future availability of the
 (𝑺𝟎 +𝑼 ) 𝒆𝒓𝑻 - 𝑭𝟎{ is the profit from the transaction} commodity.
 For consumption commodities
If the possibility of shortage higher is
There is a utility of holding the asset that is used during the contract convenience yield is higher.
maturity. Therefore, the holder will value future delivery at a lower
level than holding the asset consequently Inventories levels are inversely related to
convenience yield
𝑭𝟎 ≤ (𝑺𝟎 +𝑼 ) 𝒆𝒓𝑻 or 𝑭𝟎 ≤ 𝑺𝟎 𝒆(𝒓+𝒖)𝑻
High Inventories  low convenience yield
DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM
Low inventories  high convenience yield
Thursday, 20 June 2024 15
 Delivery Options
Carry Costs
 Forward contracts are delivered on maturity date.
 Relationship between spot and futures prices can
be summarized in terms of cost of carry Futures are complex as the they are settled

 This measures the storage cost plus the interest earlier.

that is paid to finance the asset less the income
earned on the asset  𝑭𝟎 = 𝑺𝟎 𝒆(𝒄−𝒚)𝑻 delivery options depend on

 Cost of carry for

 Short party has the option to choose the delivery
 Non dividend paying stock is ‘r’ (risk free rate)
 Known yield ‘q’ is ‘r-q’  𝒄 > 𝒚 => 𝑭𝟎 increases with Time

 Currency is ‘r- 𝒓𝒇  Delivery early as interest earned on cash received

 Income at rate ‘q’ and storage cost at rate ‘u’ is ‘r-q+u’ outweighs holding the asset

 𝑭𝟎 = 𝑺𝟎 𝒆(𝒄)𝑻 for an investment asset

 𝒄 < 𝒚 => 𝑭𝟎 decreases with Time
 𝑭𝟎 = 𝑺𝟎 𝒆(𝒄−𝒚)𝑻 for a consumption asset with
convenience yield of y  Delay delivery as it is beneficial to hold the asset

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Futures Prices and Expected FUTURE SPOT Prices
 Expected future spot price

 Risk should be reflected in the reward

 Systematic Risk (cannot be diversified) and Non-systematic risk (can be diversified) - CAPM Model

 Expected compensation of systematic risk

 Long position in futures 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑡ℎ𝑎𝑡 𝑙𝑎𝑠𝑡 𝑓𝑜𝑟 𝑇 𝑦𝑒𝑎𝑟𝑠

 A speculator puts the present value of the futures price into a risk-free investment and also take a long futures position ( proceeds
from risk free investment are used to buy the asset at maturity) and let K be the required return of investment on the asset

 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒑𝒐𝒔𝒊𝒕𝒊𝒐𝒏 𝒊𝒔 𝒕𝒐𝒅𝒂𝒚 𝒊𝒔 −𝑭𝟎 𝒆−𝒓𝑻 + E(St) 𝒆−𝑲𝑻

 They he is indifferent (net present value is zero) then 𝑭𝟎 = E(St)𝒆(𝒓−𝒌)𝑻

 If the investor is expected to be compensated only for systematic risk, then r = k and

 𝑭𝟎 = E(St) [futures price is the unbiased estimate of the expected futures spot prices]

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 𝑭𝟎 = E(St)𝒆(𝒓−𝒌)𝑻

Understate expected future spot price

Overstate expected future spot price

• When futures price is below the expected future spot price – situation is known as normal
backwardation
• When futures price is above the expected future spot price – situation is known as contango
• Sometimes it is also used for current spot price being higher or lower than futures prices
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