SEMINAR 5

FORWARDS AND FUTURES

1. Today's price of one AAA share is 1082.76. In six months, we expect AAA corporation to
distribute a dividend of 30 euros per share. The annual riskless interest rate is 4% for loans
with a maturity of 6 months. What is the no-arbitrage price of a forward contract on one AAA
share with maturity in 6 months? Explain how you would exploit an arbitrage opportunity if
the forward price is 1030. Describe the arbitrage strategy and its payoffs.

F_NA = St(1+r)T-t - Div

F_NA = 1082.76 x 1.04^0.5 – 30 = 1074.20

If F = 1030, it is too cheap. We want to buy the forward, short the share and lend the present
value of F + Div = 1030 + 30.

Position t=0 t=6 months

Long forward 0 S–F

= S – 1030

Short the share + 1082.76 – S – Div

= – S – 30

Lend PV of F+Div – 1060 / 1.040.5 + 1060

= – 1039. 4

Total 43. 36 0

2. What is the no-arbitrage futures price on one barrel of oil if the annual interest rate is 3%, the
underlying asset is worth today 100 USD, the contract matures in one year, and the storage cost
of the oil is 2 USD per barrel. Suppose the futures contract is trading at 107 USD. Describe an
arbitrage strategy.

F_NA = St(1+r)T-t + C = 100 x 1.03 + 2 = 105

If F = 108, it is too expensive. We want to short the futures, buy the spot (oil) and lend the
present value of F - C = 108 - 2.

Position t=0 t=6 months

Short futures 0 F–S

= 108 – S

Long oil - 100 S–C

 =S–2

Borrow PV of F-C + 106 / 1.03 - 106

= + 102.91

Total 2. 91 0

3. A stock index spot price is $13,500. The zero coupon interest rate is 2.6%. Describe
an arbitrage strategy and its payoffs if the 6-month futures contract on the index is
priced at $13,420. Note: assume there exists an ETF that tracks the index perfectly
(price of 1 ETF share = index price). Assume no dividends.

The index pays no dividends, so

F_NA = 13500 x 1.0260.5 = 13674

Since F = 13420, the futures is too cheap. We want to buy the futures, short the ETF and lend
the present value of F = 13420.

Position t=0 t=6 months

Long futures 0 S–F

= S – 13420

Short the ETF + 13500 –S

Lend PV of F – 13420 / 1.0260.5 + 13420

= -13249

Total 251 0

4. Consider a stock that pays no dividends with a price of 100. A futures contract on that
stock with maturity in 3 months is trading at 104. It is possible to enter a forward
contract on the same stock and with the same maturity and with a forward price of 103
euros. Describe a strategy that guarantees a positive payoff at maturity and no initial
investment (the initial margin is no investment). Specify the payoffs of the strategy.
Assume that no interest is paid on the futures account.

To exploit this arbitrage opportunity, we would go short in the futures contract and long
in the forward contract.

At maturity, the accumulated balance in the futures account is:

 (F0 -F1) +(F1 –F2) +(F2 –F3) + ··· FT-1 - ST = F0 – S T = 104 – S T

At maturity, the payoff of the forward contract for the buyer is:

S T – F = S T – 103

Therefore, the investor guarantees a final net payoff of 1 euro at maturity.

5. Suppose you own 200 shares of an ETF that tracks the S&P 500 with a price per
share of 5,000 USD. Given the current uncertainty about the evolution of markets, you
would like to limit your risk. The interest rate is currently 0%. There is a futures
contract on one ETF share with a futures price F = 5,000 USD and maturity in one year.
How would you use the futures contract to hedge the risk of half of your shares at the
end of one year? Compute the payoff of your overall position at the end of the year and
plot it as a function of the price of the ETF share at maturity. In the plot, display also the
value of the portfolio without positions futures. Discuss.

I would take a short position on 50% of my shares, 100.

In one year, I would have the following positions and payoffs:

Position Payoff at t = 1 year

Portfolio 200 ETF shares 200 x S

Short 100 Futures 100 x (5000 – S)

= 500,000 – 100 x S

Total 500,000 + 100 x S

By hedging 50% of my position I guarantee a minimum value of my portfolio of
500,000 USD. My partially hedged position will be worth more than the unhedged
portfolio for any price of the ETF share less than the futures price, 5,000. And it will be
worth more if the price is above 5,000. I therefore limit my losses, reduce the impact of
risk, but in doing so I also lose part of the upside potential.