2 Itds

Determination of Forward and
Futures Prices
Chapter 5
Fundamentals of Futures and Options Markets, 8th Ed, Ch 5, Copyright © John C. Hull 2013 1
Introduction Forward & Futures
 Contractual agreement of a price
 Non-spot delivery: Agreeing on a price today (t) to buy (long) or sell (short) an
underlying asset at T (expiry)
 Why might this be useful?

 How would you relate this to time value of money?
 Note: we will mainly be using continuous compounding and discounting in this unit,
however you may also encounter discrete compounding
Definition
Long (buy) Short (sell)
 A forward contract is an obligation to  The expiration date of the contract and
buy (sell) an underlying asset at a the forward price are written when the
specified forward price on a known contract is entered into (t).
date.
Payoff of long position = ST – Payoff of short position = -(ST – f(St,T))
100
10 f(St,T)
0
Profit or Loss
Profit or Loss
50
50
Price of the 0
Price of the
0
50 100 150 200 underlier at T
50 100 150 underlier at T
- -
50 f(St,T) 50
-100 -100
Terminology: Consumption vs Investment
Assets
 Investment assets are assets held by significant numbers of people purely for
investment purposes (Examples: gold, silver)
 Although does not need to be exclusively for investment purposes
 Consumption assets are assets held primarily for consumption (Examples: copper,
oil)
 Important because arbitrage arguments (specifically “no-arbitrage”) can be used to
determine forward and futures prices of Investment assets from their spot prices
 But NOT for consumption assets
Notation for Valuing Futures and Forward
Contracts
 Notation
S0: Spot price today of e: Euler’s number

underlying asset ex: exponential function
F0: Futures or forward price
today
T: Time until delivery date
r: Zero Coupon Risk-free
interest rate for maturity T
Forward Pricing (Continuous vs Discrete)
 If using continuous compounding, then:
F0 = S0erT
 If using discrete compounding then:
F0 = S0(1+r)T
F0 is the futures or forward price today
S0 is the spot of underlying asset
I is income during the life of the contract
r is a continuously compounded risk free rate
T is the time to maturity
This equation relates the forward price and the spot price for any investment asset that provides no
income and has no storage costs. We will look at more variations later in the lecture…
The Forward Price
 If the spot price of an investment asset is S0 and the futures price for a contract
deliverable in T years is F0, then
F0 = S0(1+r)T OR F0 = S0erT
where r is the T-year risk-free rate of interest.
Thus, S0 =40, T=0.25, and r = 0.05 so that

F0 = 40(1.05)0.25 =40.491 Discrete compounding
F0 = 40e(0.05*0.25) =40.326 Continuous compounding
 What does the forward price represent? And how does it compare to $43 (previous slide)
Arbitrage Opportunity?
 Suppose that:
 The spot price of nondividend-paying stock is $40
 The 3-month forward price is US$39
 The 1-year US$ interest rate is 5% per annum
 Is there an arbitrage opportunity?
F0 = 40(1.05)0.25 =40.491 Discrete compounding

F0 = 40e(0.05*0.25) =40.326 Continuous compounding
When an Investment Asset Provides a Known
Dollar Income (page 111, equation 5.2)
 We adjust the generalized pricing formula for assets that provide predictable dollar income.
E.g. Bonds with coupons
F0 = (S0 – I )erT
Where:
I is the present value of the income during life of forward contract
When an Investment Asset Provides a Known
Yield (Page 112, equation 5.3)
 Similar to the previous equation we can also adapt this equation for assets which provide a
known yield instead of known cash flow. Income is expressed as a percentage of asset
price.
F0 = S0e(r–q )T
Where:
q is the average yield during the life of the contract (expressed with continuous compounding)
Valuing a Forward Contract Page 112-115
 A forward contract is worth zero  By considering the difference between
(except for bid-offer spread effects) a contract with delivery price K and a
when it is first negotiated contract with delivery price F0 we can
deduce that:
 Later it may have a positive or  The value, f, of a long forward contract
negative value is
(F0 − K)e−rT
 Suppose that K (or FT )is the delivery
price and F0 is the forward price for a
 The value of a short forward contract is
contract that would be negotiated
today (K – F0 )e–rT
Forward vs Futures Prices
 When the maturity and asset price are the same, forward and futures prices
are usually assumed to be equal
 (Eurodollar futures are an exception)
 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
Stock Index e.g. S&P (Page 116)
 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
q is the average yield during the life of the contract
 For the formula to be true it is important that the index represent an investment asset
 In other words, changes in the index must correspond to changes in the value of a tradable portfolio
 The Nikkei index viewed as a dollar number does not represent an investment asset (See Business
Snapshot 5.3, page 116)
Index Arbitrage (dual listed stocks)
 When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells
futures
 When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks
underlying the index
 Index arbitrage involves simultaneous trades in futures and many different stocks
 Very often a computer is used to generate the trades
 Occasionally simultaneous trades are not possible and the theoretical no-arbitrage
relationship between F0 and S0 does not hold (see Business Snapshot 5.4 on page 117)
 ..more on this later on in the lecture
Futures and Forwards on Currencies
 A foreign currency is analogous to a security providing a yield

 The yield is the foreign risk-free interest rate
 It follows that if rf is the foreign risk-free interest rate
Explanation of the Relationship
Between Spot and Forward (Figure
5.1, page 118)
1000 units of
foreign currency
(time zero)
1000S0 dollars
at time zero
1000S0erT
dollars at time T
Consumption Assets: Storage is Negative
Income
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.
The benefits from holding the physical asset is sometimes referred to as convenience yield.
Reflects the market’s expectations concerning the future availability of commodity
Higher shortage expectation = higher convenience
Lower shortage expectation = lower convenience
The Cost of Carry (Page 124)
 The cost of carry, c, is the storage cost plus the interest costs less
the income earned
 For an investment asset F0 = S0ecT
 For a consumption asset F0  S0ecT
 The convenience yield on the consumption asset, y, is defined so
that F0 = S0 e(c–y )T
Futures Prices & Expected Future Spot Prices
(Page 125-127)
 Suppose k is the expected return required by investors in an asset

 We can invest F0e–r T at the risk-free rate and enter into a long futures contract
to create a cash inflow of ST at maturity
 This shows that
Futures Prices & Future Spot Prices (continued)
No Systematic Risk k=r F0 = E(ST)

Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic k<r F0 > E(ST)
Risk
Positive systematic risk: stock indices

Negative systematic risk: gold (at least for some periods)
VALUATION AND ARBITRAGE
Arbitrage
 “A trading strategy that takes advantage of two or more securities being mispriced
relative to each other”
 Do we care if both are mispriced?
Theoretical Foundations: terminology
A pricing system where the elements of the system are priced
Relative value: in a way that is internally consistent. Derivatives are valued
relative to the price of the underlier and cash borrowing /
lending costs.
By copying derivatives’ end-of-period payoffs with a portfolio

Replication: consisting of the underlier and cash borrowing / lending, a
complex derivative is reduced to a portfolio of two simple
securities.
Two identical end-of-period payoffs must trade at the same

No-arbitrage: price. The value of the derivative must equal the known value
of the replication portfolio.
Derivatives can be valued as a discounted expectation, where

Risk neutrality: the expectation uses synthetic probabilities and the discount
rate is the riskless rate.
(more when we do the lecture on binomial)
Terminology Short Selling (Page 105-106)
 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 so they can be replaced in the account of
the client
 You must pay dividends and other benefits the owner of the securities receives
 There may be a small fee for borrowing the securities
 Why might you do this?
Example
 You short 100 shares when the price is $100 and close out the short position three
months later when the price is $90
 During the three months a dividend of $3 per share is paid
 What is your profit?
 What would be your loss if you had bought 100 shares?
Example
 Gain from the price depreciation: $100 - $90 = $10
 Required to “pay” the dividend back: -$3
 Total profit: $10 - $3 = $7 per share x 100 shares = $700
Example
 Gain from the price depreciation: $100 - $90 = $10
 Required to “pay” the dividend back: -$3
 Total profit: $10 - $3 = $7 per share x 100 shares = $700
 Loss from the price depreciation: $90 - $100 = -$10
 Received dividend back: $3
 Total profit: -$10 + $3 = -$7 per share x 100 shares = -$700
If Short Sales on assets Are Not Possible..
 Formula still works for an investment asset because investors who hold the asset
will sell it and buy forward contracts when the forward price is too low
 Think about what happens when things are priced too high or too low
Difference between the forward price and the
value of a forward contract?
 The forward price is the fixed price you agree to buy or sell that asset in the future:
 Essentially the current spot price S(t) at t=0 and accumulated over time er(T-t)
 This agreed on price never changes once specified in the forward contract as it is an
obligation
Difference between the forward price and the value of a forward
contract?
 The value of a forward contract is initially zero
 current spot price in the market
 forward price you found today at t=0
 discount factor you need to incorporate as the blue term is the amount at maturity or time = T
 must incorporate time value of money
Fundamentals of Futures and Options Markets, 8th Ed, Ch 5, Copyright © John C. Hull 2013
30
Difference between the forward price and the
value of a forward contract?
 After time has passed the value of a forward contract can be positive or negative
thereafter once time has elapsed
 Value of the forward contract compares the current trading spot price in the market
at any point in time with the locked in forward price found at the beginning of the
period
 (forward price may need to be discounted to compare like and like time values)
Valuation Example
 A) An asset is trading at $25. The risk free rate is 6% p.a continuously compounded.
What is the no-arbitrage three-month forward price for the underlying asset?
 B) What is the initial value of the contract?
S = $25 f(t;S(t),T) = ?
t=0 T = 3m
Valuation Example
 A) An asset is trading at $25. The risk free rate is 6% p.a continuously compounded.
What is the no-arbitrage three-month forward price for the underlying asset?
S = $25 f(t;S(t),T) = ?
t=0 T = 3m
 The no-arbitrage forward price is:
Valuation Example
 B) What is the initial value of the contract?
 The no-arbitrage forward price was 25.37783 and the current spot price is $25
Valuation Example
a) A bank enters into a three month forward contract on an underlier that is trading at
$100, and the continuously compounded riskless rate is 6% p.a. What is the initial
value of the forward contract?
b) What was the initial forward price?
c) After one month has elapsed, the underlier is trading at $110, and the two month
continuously compounded riskless rate is 5.2% p.a. What is the value of the
forward contract?
Valuation Example
a) A bank enters into a three month forward contract on an underlier that is
trading at $100, and the continuously compounded riskless rate is 6% p.a.
What is the initial value of the forward contract?
Valuation Example
b) What was the initial forward price?
If the initial value of the contract = 0 then the forward price is the agreed upon
price today that makes the initial value 0.
S(t)=100
t T
F(t)=0
Valuation Example
 After one month has elapsed, the underlier is trading at $110, and the two
month continuously compounded riskless rate is 5.2% p.a. What is the value
of the forward contract?
S(t)=100 S(t+1)=110
t t+1 T
F(t)=0
Valuation Example
 At expiry, the underlier is trading at $97. What is the value of the forward
contract?
S(t)=100 S(t+1)=110 S(T)=97
t t+1 T
F(t)=0
Arbitrage Example
 Suppose that:
 Spot price of gold is US$1,390
 1-year forward price of gold is US$1,425
 1-year $US interest rate is 0.5% p.a.

 No income or storage costs for gold
 Is there an arbitrage opportunity?

 What if the forward price is US$1,390?
Arbitrage Example
 If spot price of gold is S & futures price for a contract deliverable in T years is
F, then
F = S (1 + r)T
where r is the 1-year (domestic currency) risk-free rate of interest
S = 1,390, T = 1, and r = 0.005

F = 1390(1 + 0.005) = $1,396.95
Quoted price is too high! (1,425)
Arbitrage Example
 Arbitrage strategy:
Now After 1 year

Borrow US$1,390 Sell Gold under Forward
Buy Gold Receive US$1,425
Short Forward Repay US$1,396.95
Initial cost of portfolio = 0

CF after one year = US$28.05 (riskless profit)
Arbitrage Example
 If forward price is US$1390, reverse strategy:
Now After 1 year
Sell Gold Investment pays $1,396.95
Invest US$1,390 Buy Gold under Forward
Long Forward Pay US$1,390
Initial cost of portfolio = 0

CF after one year = US$6.95 (riskless profit)
Index Arbitrage
 When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and
sells futures
 When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks
underlying the index

2 Itds

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2 Itds

Uploaded by

Copyright:

Available Formats

Determination of Forward and

 Why might this be useful?

S0: Spot price today of e: Euler’s number

Thus, S0 =40, T=0.25, and r = 0.05 so that

F0 = 40(1.05)0.25 =40.491 Discrete compounding

 Can be viewed as an investment asset paying a dividend yield

 ..more on this later on in the lecture

 A foreign currency is analogous to a security providing a yield

where U is the present value of the storage costs.

 Suppose k is the expected return required by investors in an asset

No Systematic Risk k=r F0 = E(ST)

Positive systematic risk: stock indices

 Do we care if both are mispriced?

By copying derivatives’ end-of-period payoffs with a portfolio

Two identical end-of-period payoffs must trade at the same

Derivatives can be valued as a discounted expectation, where

 Short selling involves selling securities you do not own

 Why might you do this?

 The value of a forward contract is initially zero

 current spot price in the market

 forward price you found today at t=0

 B) What is the initial value of the contract?

b) What was the initial forward price?

S(t)=100 S(t+1)=110 S(T)=97

 1-year $US interest rate is 0.5% p.a.

 Is there an arbitrage opportunity?

where r is the 1-year (domestic currency) risk-free rate of interest

S = 1,390, T = 1, and r = 0.005

Quoted price is too high! (1,425)

Now After 1 year

Initial cost of portfolio = 0

Initial cost of portfolio = 0

You might also like