Chapter 5

Determination of Forward &

Future Prices




R. Srinivasan
Introduction
Forwards contract are easier to analyse because,
Futures contracts have daily settlement and
Forwards contracts are settled only on maturity
Investment Vs. Consumption Assets:
Investment Asset: Are held for investment purposes by a
significant number of investors (e.g., stocks, bonds, gold,
silver etc). Hence arbitrage opportunity exists.
Consumption Asset: Are consumed over a period of time
(e.g., all commodities). No arbitrage opportunity, because,
manufacturers would like to hold the asset, so as not to
lose a business opportunity, due to out-of-stock situation.
Short Selling
Short selling involves selling securities you do
not own
Your broker borrows the securities from another
client and sells them in the market in the usual
way
At some stage you must buy the securities back
so they can be replaced in the account of the
client
Dividends and other benefits, the owner of the
securities receives
If the broker runs out of shares to borrow, the
investor is short-squeezed and is forced to
foreclose his position immediately
Margin Account
The investor maintains the account with the
broker
Margin money can be remitted in the form of
cash, marketable securities, and the broker
should guarantee that the investor does not walk
away from short position in case of rise in price
of shares leading to a loss.
Initial Margin and additional margins are
required to be maintained from time to time
Assumptions
(Is true for large FIs)
No transaction costs when they trade
Same rate of tax on all net trading profits
Market participants can lend & borrow
money at the same risk-free rate of
interest
Participants take advantage of the
arbitrage opportunities
Notation for Valuing Futures and
Forward Contracts
S
0
: Spot price today
F
0
: Futures or forward price today
T: Time until delivery date (in years)
r: Zero coupon risk-free interest rate per
annum for maturity in T years
Forward price of an Investment
Asset
It is easier to value an investment asset
without any intermediate income (e.g.,
non-dividend paying stocks, zero-coupon
bonds)
Analysis of Kidder Peabody (BS 5.1, page
125)
Business Snapshot 5.1
Kidder Peobodys (KP) Embarrassing Mistake
Investment banks have developed a way of
creating a zero-coupon bond, called a strip from a
coupon-bearing Treasury bonds by selling each of
the cash flows underlying the coupon-bearing
bond as a separate security. Joseph Jett, a trader
working for KP, had a relatively simple trading
strategy. He would buy strips and sell them in the
forward market. As the equation F
0
= S
0
e
rt
shows,
the forward price of a security providing no income
is always higher than the spot price. Suppose, for
example, that the 3-month interest rate is 4% p.a.
and the spot price of a strip is $70. The 3-month
forward price of the strip is 70e
0.40x(3/12)
= $ 70.70

Business Snapshot 5.1 (contd..)
KPs computer system reported a profit on each of
Jetts trades equal to the excess of the forward
price over the spot price ($0.70 in our example).
In fact this profit was nothing more than the cost of
finance the purchase of the strip. But, by rolling
his contracts forward Jett was able to prevent this
cost from accruing to him.
The result was that the system reported a profit of
$ 100 million on Jetts trading (and Jett received a
big bonus) when in fact there was a loss in the
region of $350 million. This shows that even large
FIs can get relatively simple things wrong!
Gold: An Arbitrage Opportunity?
Suppose that:
1. The spot price of gold is US$390 and the quoted
1-year forward price of gold is US$425
2. The spot price of gold is US$390 and the quoted
1-year forward price of gold is US$390
The 1-year US$ interest rate is 5% p.a.
No income or storage costs for gold
Is there an arbitrage opportunity in any of the 2
situations above?
Therefore forward price F
0
= S
0
X e
rT

Gold Arbitrage Opportunities
Forward Price = US$ 425
Borrow USD 390 @ 5%
Buy an ounce of gold
Short a forward contract for
selling gold @ USD 425

Position after 1 year
Sell Gold for USD 425
Repay loan = 390 x e
.05x1
=
390 x 1.05127 = USD 410
Gain = 425 410 = USD 15

Hence the Forward/Future price
should be higher than spot
price, which is nothing but cost
of financing
Forward Price = US$ 390
Short one ounce of gold in
deliveries market and realise
US$ 390 (If shares for shorting
are not available then holder of
investments sells his holding)
Invest the proceeds USD 390
@ 5% p.a.
Enter into a long forwards
contract @ USD 390/ounce

Position after 1 year
Buy Gold as per long forwards
contract and close short
position for USD 390
Return on investment = 390 x
e
.05x1
= 390 x 1.051 = USD 410
Gain = 410 390 = USD 20
Forward price with a known income
In case of investment assets with perfectly
predictable cash income to the holder (e.g.
stocks paying known dividends, coupon bearing
bonds). Then the Forward Price is:
F
0
= (S
0
I ) e
rT


where I is the present value of the income during
life of forward contract
Arbitrage opportunity exists when:
F
0
> (S
0
I ) e
rT
OR

F
0
< (S
0
I ) e
rT
Example
Problem
S
0
of coupon bearing bond = 900
Coupon due after 4 months = 40
Period of forward contract T = 9 months
Two different situations:
1. Forward price F
0
= 910
2. Forward price F
0
= 870
r for 4 months = 3%
r for 9 months = 4%
Solution of 1
Borrow Rs. 900 (Rs. 39.60 for 4 months & Rs. 860.40 for 9
months; because, coupon due after 4 months = Rs. 40. Hence,
PV of 40 (coupon payment) for 4 months = 40/e
.03x (4/12)
= Rs.
39.60)
Buy one bond; and enter into 9 month short forward contract at
(Strike Price) K = Rs. 910
After 4 months
Receive Rs. 40 cash income and repay 1
st
installment of loan with
interest
After 9 months
Sell bond as per forward contract @ Rs. 910
Repay amount owed on Rs. 860.40:
= 860.40 x e
.04x (9/12)
= Rs. 886.60
Risk free gain = 910 886.60 = Rs. 23.40
Example (contd)
Solution of 2
Short sell a bond for Rs. 900
Enter into long forward contract @ Rs. 870
Invest Rs. 39.40 for 4 months = 39.40xe
0.03x (4/12)

= Rs. 40/-
Invest Rs. 860.40 (900 39.60) for 9 months = 860.40 x e
0.04x (9/12)
=
Rs. 886.60
After 4 months
Receive coupon payment of Rs.40 and pass on to the lender of bond
After 9 months
Liquidate your investments and receive Rs. 886.60
Buy the bond at Rs. 870 as per terms of forward contract

Risk free gain = 886.60 870 = Rs. 16.60
Example (contd)
Investment Asset providing a
Known Yield
F
0
= S
0
e
(rq )T


where q is the average yield during the life of
the contract (expressed with continuous
compounding)
Example
6-month forward contract
Expected Income during the period @ 2%
Risk free rate of interest is 10%
Price of the Asset = $ 25.
Solution
S
0
= $ 25
Rate of income is 2% in 6 months; hence yield =
4% p.a. with semiannual compounding; giving us q
= 3.96% p.a. with continuous compounding.



r = 10% or 0.10
T = 0.5
F
0
= 25e
(0.10-0.0396)x0.5
= $ 25.77
( ) 1
1
=
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e m R
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Forward vs Futures Prices
Forward and futures prices are usually assumed
to be the same. When interest rates are
uncertain, in theory they are, slightly different:
A strong positive correlation between interest
rates and the asset price implies the futures
price is slightly higher than the forward price
A strong negative correlation implies the reverse