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Determination of Forward and Futures Prices
Determination of Forward and Futures Prices
Chapter 3
Chapter Outline
3.1 Investment assets vs. consumption assets
3.2 Short selling
3.3 Measuring interest rates
3.4 Assumptions and notation
3.5 Forward price for an investment asset
3.6 Known income
3.7 Known yield
Chapter Outline (continued)
3.8 Valuing forward contracts
3.9 Are forward prices and futures prices equal?
3.10 Stock index futures
3.11 Forward and futures contracts on currencies
3.12 Futures on commodities
3.13 Cost of carry
3.14 Delivery options
3.15 Futures prices and the expected future spot
price
Summary
3.1 Investment assets vs. consumption
assets
• Investment assets are assets held by significant
numbers of people purely for investment purposes
(Examples: gold, silver)
• Consumption assets are assets held primarily for
consumption (Examples: copper, oil)
• We will see later that we can use arbitrage
arguments to determine the forward and futures
prices of an investment asset from its spot price
and other observable market variables.
• We cannot do this for consumption assets.
3.2 Short Selling (Page 41-42)
Broker
$12,000
Sept 1 $8,000 100 shares 100 shares
October 1 October 1 September 1
Short Share
Seller holder
SEPTEMBER 1 OCTOBER 1
Stock Price $120 $80
3.3 Measuring interest rates
Define
Rc : continuously compounded rate
Rm: same rate with compounding m times per
year
Rm
Rc m ln 1
m
Rm m e Rc / m 1
3.4 Assumptions and notation
• Assumptions:
– No no transactions costs
– Homogeneous tax rates on net trading profits
– Everyone can borrow and lend at the same risk-
free rate
– Market participants can take advantage of
arbitrage opportunities.
3.4 Assumptions and notation
• Notation:
S0: Spot price today
F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate per annum,
expressed with continuous
compounding, for maturity T
3.5 Forward price for an investment asset
• For gold
F0 = S0(1 + r )T
(assuming no storage costs)
• If r is compounded continuously instead of
annually
F0 = S0erT
Extension of the Gold Example
(Page 46, equation 3.5)
0 T
S0 S0erT
• If F0 $307.59 there will be an arbitrage
Extension of the Gold Example
(Page 46, equation 3.5)
PV $30e .07.5 $30e .07.1 $30e .071.5 $30e .072 $1,030e .072.5
F0 $974.67 30e .07.5 $30e .07.1 e .071
F0 $984.27
F0 = (S0 – I )erT
where I is the present value of the
income
F0 $974.67 30e .07.5
$30e .07.1
e .071
F0 $984.27
3.7 Known yield
F0 = S0 e(r–q )T
where q is the average yield during the life of
the contract (expressed with continuous
compounding)
3.8 Valuing forward contracts
• Suppose that
K is delivery price in a forward contract
F0 is forward price that would apply to the
contract today
• The value of a long forward contract, ƒ, is
ƒ = (F0 – K )e–rT
• Similarly, the value of a short forward contract is
(K – F0 )e–rT
Valuing a Forward Contract
• Let us revisit our previous example of the
forward contract on the AMD bond.
• Suppose that we had taken a long position in
the contract on July 2, 2002 at $984.27
• Ten minutes later, interest rates have risen to
8% per annum.
• Have we made money or lost money?
The value of a long forward contract, ƒ, is
ƒ = (F0 – K )e–rT
Valuing a Forward Contract
PV $30e .08.5 $30e .08.1 $1,030e .081.5
PV $28.82 $27.69 $913.53
PV $970.05 $30 $30 $1,030
ƒ = (F0 – K )e–rT
= ($970.05 – 984.27 )e–.08 = $13.13
3.9 Are forward prices and futures prices
equal?
• Forward and futures prices are usually assumed to be
the same. When interest rates are uncertain they are,
in theory, 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
• In practice, we also must consider the probability of
counterparty default, taxes, transactions costs, and
the treatment of margins.
• For long-lived contracts like Eurodollar futures
contracts with maturities as long as ten years, it
would be dangerous to ignore the differences.
3.10 Stock index futures
• A stock index can be viewed as an
investment asset paying a dividend yield
• The futures price and spot price relationship
is therefore
F0 = S0 e(r–q )T
where q is the dividend yield on the
portfolio represented by the index
Stock Index
(continued)
F0 S0 e(r+u )T
where u is the storage cost per unit time as
a percent of the asset value.
Alternatively,
F0 (S0+U )erT
where U is the present value of the storage
costs.
3.13 The Cost of Carry (Page 60)
46
Futures Prices & Future Spot Prices
(continued)