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Determination of Forward and Futures
Determination of Forward and Futures
Futures Prices
RAVICHANDRAN
Pre requirements
• Time value of money
• Basics of Interest rates
• Continuous compounding Int rates
• Discreet compounding Int rates
• Nominal interest rates
Forward / Futures Prices
• we will examine how forward prices and
futures prices are related to the spot price
of the underlying asset.
• Forward contracts are easier to analyse
than futures contracts because there is no
daily settlement—only a single payment at
maturity.
Forwards Vs Futures
• Contract Specification
• Liquidity
• Marking to Market Process – reduces the
counterparty risk
• Margin ac – profit or loss daily
ASSUMPTIONS AND
NOTATION
1. The market participants are subject to no
transaction costs when they trade.
2. The market participants are subject to the
same tax rate on all net trading profits.
3. The market participants can borrow
money at the same risk-free rate of interest
as they can lend money.
4. The market participants take advantage of
arbitrage opportunities as they occur.
Assumption and Notation
﹡NOTATION:
S0: Price of the asset underlying the
forward or futures contract today
F0: Futures or forward price today
• F = S * e(r-y)t
• Incidentally, convenience yields are often implied from, or
backed out of observed market prices and not explicitly entered
in to a formula like other factors. They are something of a “fudge
factor” to make the equality between forward prices and their
other input factors hold true.
Forward price of currency
• When the underlier is a foreign currency, we
consider the domestic interest rate but also the
foreign rate.(rf)
• Foreign interest rate represents income to short
party and is just proportional income.
• F = S *e(rh-rf)t
• * Interest rate parity theory on forward rate calculation. * assume rate of int as Cont.
Compounding
Example:
r = 0.05 S0 = 1,300 T = 3/12 (0.25) q = 0.01
F0 = 1,300e(0.05-0.01)x0.25 = $1,313.07
• Direct Quote ?
• USD / INR : 74.28
• USD is the base currency OR foreign currency
• INR is the quoted currency OR domestic currency
• I unit of FC= some units of HC
• USD / GBP=0.72 Direct quote
• USD is the FC
• GBP is the HC
• Int rates of two currencies is required
• We need to determine HC int rate and FC
int rate?
Example
• Let us assume int rate in US 2% per annum and in UK int rate
is 4% per annum. (CC)
• Spot rate of USD/ GBP 0.73 (GBP)
• USD IS FC ; GBP is Home currency
• Calculate the 6 month forward rate of USD/GBP
• Forward rate of USD/ GBP=F = S *e(rh-rf)t
• Forward price= 0.73* exp((4%-2%)*0.5)
Forward price of currency - example
• X agrees to buy 5000 Tuluvian Krinkets from a
currency dealer Y in 9 months. Krinklets are currently
trading for $0.55. (when dealing foreign currency, just
think of each unit of other currency as a share of stock,
which is bought with some amount of local currency)
• One Krinklet =USD 0.55 (Krinklet FC & USD Is home
currency)
• The risk free int. rate in Tuluvia is 2 percent.. The risk
free int. rate at home is 6 per cent.
• This is exactly a forward underlier with proportional
income, replacing I with rf(foreign rate). Here’s what
we got:
Forward price of currency - example
• S = 5000 * 0.35 = 1750
• rh = 0.06
• rf = 0.02
• t=0.75
• Putting all together we have
• F = S* e(rh-rf)t
• F = 1750 * e(0.06-0.02)(0.75)
• F = 1750* e0.03
• F = 1803.30
• The fair –market delivery price for this contract is
$1803.30
Forward Price Summary
Description Forward Price formula
Basic Forward Price F = S* ert
With Proportional
F = S * e (r+U)t
Storage
With Fixed Income F= (S-I) * ert
With Proportional
F= S* e(r-i)t
Income
With Convenience
F = S * e (i-y)t
Yield
Foreign Currency
F = S * e(rd-rf)t
Forward
Forward Price - together
• Putting these all together:
• Forward Price = (S + U - I)* e(r+ u –i-y-rf)t
• Where S = Spot price , U –Fixed storage
cost
• I – Fixed Income, r – risk-free interest rate
• u- proportional storage cost ,
• i - proportional income, y - convenience
yield, rf – foreign interest rate
Forward vs Futures Prices
• 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
• Last only a few months are in most circumstances
sufficiently small to be ignored
• Forward and futures prices are usually assumed
to be the same. When interest rates are uncertain
they are, in theory, slightly different
Problem
• A share is currently selling at Rs 208.80.
Calculate the price of October Futures
contract on this share assuming the risk
free rate of 8 percent and the time to
maturity as 56 days.
• Take the market lot as 100.
Solution
• Here S0 = 208.80
• Continuously compounded rate of return =
ln(1.08) =0.77
• Time to maturity = 56/365= 0.1534
• F=S0*ert
• F= 208.80* e(0.077) * (0.1534)
• =208.80 * 1.012=211.281
• If Market lot is 100, value of futures
contract is Rs 211,281
Problem with dividend
• Re-work the value of futures contract in Prev.
Example assuming that a dividend of Rs 2.60 per
share is expected in the next 20 days from now.
• Present Value of the dividend = I = D*e-rt
• =2.60 * e-(0.077) (20/365)
• =2.59
• F= (S0-I)*ert
• = (208.80-2.59)* e(0.077) (56/365)
• = 208.661
• Futures value of the contract with lot size 100=
Rs 208,661