MFIN6003 Derivative Securities

Lecture Note Three

HKU Business School

University of Hong Kong

Dr. Huiyan Qiu

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 Outline
Derivation of forward pricing formula using prepaid
forward
Synthetic forward
• Forward pricing
• Hedging a forward position
• Arbitraging of mispriced forward

Uses of forward and futures: asset allocation; cross

hedging

Reading: McDonald Chapter 5

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 Forward and Futures
Forward contract: a binding agreement
(obligation) to buy or to sell an underlying asset in
the future, at a price set today

Futures contracts are the same as forwards in

principle except for some institutional and pricing
differences.

In this note, stock or stock index is used as the

underlying asset of the contract.
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 Alternative Ways to Buy a Stock
A share of stock has price S0 at time 0. The continuously
compounding interest rate is r.
At time 0 you agree to a price, which is paid either today or at
time T. The shares are received either today or at time T. 
Four combinations.

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 Alternative Ways to Buy a Stock
Four different ways to buy a stock:

Outright purchase: ordinary transaction

Fully leveraged purchase: investor borrows the full

amount

Prepaid forward contract: pay today, receive the share

later

Forward contract: agree on price now, pay/receive

later
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 Pricing Prepaid Forwards
If we can price the prepaid forward (FP), then we can
calculate the price for a forward contract
F = future value of FP
Pricing by no arbitrage argument
For now, assume that there are no dividends
• In the absence of dividends, the timing of delivery is
irrelevant
• Price of the prepaid forward contract should be the same
as current stock price

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Pricing Prepaid Forwards (cont’d)
Arbitrage: any trading strategy requiring no cash input
that has some probability of making profits, without any
risk of a loss  free money!!!
If at time t = 0, the prepaid forward price somehow
exceeded the stock price, i.e.,

an arbitrageur could: buy stock and sell prepaid forward

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 Pricing Prepaid Forwards (cont’d)
Cash flows of arbitrage strategies when the prepaid
forward price exceeds the stock price:

Since, this sort of arbitrage profits are traded away quickly, and
cannot persist, in equilibrium we can expect:

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 Prepaid Forwards with Dividends
What if there are dividends? Is still valid?
• NO, because the holder of the prepaid forward will not
receive dividends that will be paid to the holder of the
stock  .
• The price difference should reflect exactly the dividends
from time 0 to time T.
• If the stock pays discrete dividends Dti at times ti, i = 1,
…., n, the prepaid forward price:

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 Prepaid Forwards with Dividends
Example: XYZ stock costs $100 today and is expected
to pay a quarterly dividend of $1.25. If the risk-free rate
is 10% compounded continuously, how much does a 1-
year prepaid forward cost?
Solution: the buyer of the prepaid forward will not
receive the quarterly dividend of $1.25.

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 Prepaid Forwards with Dividends
Instead of discrete dividend in cash, many underlying
assets have dividend yield rate.
For example, for stock indexes containing many stocks,
it is common to model the dividend as being paid
continuously at a constant annual rate of δ.
What should be the prepaid forward price then? In other
words, how much should be paid now for one share at
time T? Or what is the present value of one share at time
T?

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 Continuous Dividend Yields
Suppose an asset pays dividend at an annual
continuously compounding yield rate of δ. Instead of
receiving cash dividend, number of shares is
accumulated at the rate δ.
• Same as continuously compounding of interest, 1 share
today will become shares at time T.
• Therefore, one share at time T is equivalent to shares at
time 0.

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Prepaid Forwards with Continuous
Dividends
Buying prepaid forward is paying now for one share at
time T. Thus, the price should be the same as the price
for shares now, that is .
The prepaid forward price:

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Pricing Prepaid Forwards (cont’d)
Example: The current index level is 1,250 and the
dividend yield is 3% continuously compounding. How
much does a 1-year prepaid forward on the index cost?
Solution: given the index is yielding 3%, buying share
of the index now will result in exactly one share of the
index 1 year later. Thus, the 1-year prepaid forward
should pay the same price as buying share of the index
now.

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 In-Class Exercise
Stock A and stock B are both trading at $85 per share.
It’s expected that stock A will pay dividend semi-
annually, with $1.5 six months later and growing at 2%
every six months. For stock B, the continuously
compounding dividend yield is 3.5% per year.
If the continuously compounding risk-free rate is 5%,
which 2-year prepaid forward is more expensive? On
stock A or on stock B?

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 In-Class Exercise
Solution:

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 Forward Pricing Formula
Forward price is the future value of the prepaid forward
price.
• No dividends

• Discrete dividends

• Continuous dividends

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 Forward Price
Forward / futures price converges to spot price as the
expiration date is approached.
• When the delivery time is reached, the forward price
equal – or is very close to – the spot price.

If the forward price is higher, arbitrage:

• Short the forward contract
• Buy the asset
• Make delivery
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 Outline
Derivation of forward pricing formula using prepaid
forward
Synthetic forward
• Forward pricing
• Hedging a forward position
• Arbitraging of mispriced forward

Uses of forward and futures: asset allocation; cross

hedging

Reading: McDonald Chapter 5

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 Synthetic Forward
Synthetic contract (also called replicating portfolio) is a
portfolio which duplicates the cash flows and value of
the contract under consideration.
How to create a synthetic forward?
• Note that long forward has zero cost and payoff at
expiration: ST – F0,T
• Synthetic forward using stocks (underlying asset) and
bonds: borrow to buy  same zero cost and the same
final payoff.

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 Creating a Synthetic Forward
The following cash flow table demonstrates that
borrowing S0e-T to buy e-T shares of the underlying
replicates the cash flows to a forward contract: 0 at time
0 and ST – F0,T at time T.

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Creating a Synthetic Forward (cont’d)
No-arbitrage  the forward price is

The idea of creating synthetic forward leads to following

(LHS is the actual contract and RHS is the synthetic
contract)
• Forward = Stock – Zero-coupon bond
• Stock = Forward + Zero-coupon bond
• Zero-coupon bond = Stock – Forward
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 Use of Synthetic Forward Contract
Synthetic forward can be used to hedge a position in the
actual forward contract.
• For example, a short forward position faces the risk of
future price being high. Taking a long position in the
synthetic forward (borrow to buy) can offset the risk.
Synthetic forward can also be used to arbitrage mis-
priced forward contract. For example, if the forward
price is higher than , then cash-and-carry arbitrage:
short the forward and long the synthetic forward

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 Cash-and-Carry Arbitrage
Transactions and cash flows for a cash-and-carry
arbitrage:

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 In-Class Exercise
A $50 per share stock pays a 4% continuous dividend.
The continuously compounding risk-free rate is 6%.
a) What is the price of a forward contract that expires 1 year
from today?
b) Suppose you observe a one-year forward price of $52. What
arbitrage would you undertake?
c) Suppose you observe a one-year forward price of $50. What
arbitrage would you undertake?

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 In-Class Exercise
Solution:

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 Arbitrage with Transaction Cost
Cash-and-carry arbitrage with transaction costs
(arbitrage is harder)
• trading fees
• bid-ask spreads
• different borrowing/lending rates
• the price effect of trading in large quantities

No-arbitrage bounds: F – < F0, T < F +

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Arbitrage with Transaction Cost (cont’d)
Suppose
• Bid-ask spreads: for stock Sb < Sa, and for forward Fb < Fa
• Cost k of transacting forward or stock
• Interest rates for borrowing and lending are rb > rl
• No dividends and no time T transaction costs for
simplicity
Arbitrage possible if 𝑏
𝑎 𝑟 𝑇
𝑏 +¿=(𝑆 +2 𝑘)𝑒 ¿
𝐹 0 ,𝑇 >𝐹 0

𝑙
𝑎 − 𝑏 𝑟𝑇
𝐹 0 ,𝑇 <𝐹 =(𝑆 − 2 𝑘)𝑒
0 3-28
Arbitrage with Transaction Cost (cont’d)
If , then cash and carry strategy: borrow to buy the
stock and short the forward. At time T, net payoff is

If, then reversed cash and carry strategy: buy the

forward and short the stock and lend the net proceeds at
the lending rate. At time T, net payoff is

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 In-Class Exercise
Jack is searching for arbitrage opportunity related to
one-year forward on non-dividend paying Zink stock.
Suppose Jack can (1) trade Zink stock at ask price of
$40.5 and bid price of $40 and (2) borrow money at 7%
and lend at 5%. The bid-ask forward prices are $43.5
and $44. Jack has to pay $20 per 100 shares for taking
stock position or forward position at time 0. No time-1
transaction costs. Is there any arbitrage opportunity? If
yes, how to make money?

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 In-Class Exercise
Solution:

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 Outline
Derivation of forward pricing formula using prepaid
forward
Synthetic forward
• Forward pricing
• Hedging a forward position
• Arbitraging of mispriced forward

Uses of forward and futures: asset allocation; cross

hedging

Reading: McDonald Chapter 5

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 Forward and Futures: Speculation
Forward and futures can be used as alternative to direct
investment to speculate on price movement of an asset.

Payoff / Profit Payoff / Profit

Short Forward

ST ST
Long Forward
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 Quanto Index Contracts
There exists index futures with settlement of the contract
in a different currency than the currency of
denomination for the index.
Example: Nikkei 225 Futures

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 Nikkei 225 Futures
Anything special about Nikkei 225 Futures?
• The currency of denomination for the index: Yen
• The currency for settlement: US dollar
Purpose of such futures
• Dollar-based investor to speculate on the change of
Nikkei 225 index
• Currency risk (exchange risk, the risk that the yen/dollar
exchange rate will change) is avoided
Quanto index contracts allow investors in one country
to invest in a different country without exchange rate
risk
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Forward to Reallocate Investment
Forward can be used to manage risk by creating
synthetic security to switch investment among different
asset categories – asset reallocation.
Example: Effect of owning the stock and selling
forward, assuming that S0 = $100 and F0,1= $110.

← Risky Investment

← Riskfree Investment
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Forward to Reallocate Investment
Asset A – Forward on Asset A = Risk-free Asset
Forward / Futures overlay: the use of multiple
forward/futures to convert a position from one asset
category to another
Asset A Asset A
– Forward on Asset A
+ Forward on Asset B
– Forward on Asset A = Asset B

+ Forward on Asset B
T-bill Asset B 3-37
 Futures to Cross-Hedge
Forward and futures are often used for hedging risk.
• Problem: may not be able to find a contract based on the
same asset that you wish to hedge.
• Solution: use a contract on another asset which is highly
correlated with the asset concerned  cross-hedging.
E.g.: hedge jet fuel with crude oil futures
Index futures can be used to cross-hedge stock portfolio
that are not exactly the index but correlated with the
index

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 Cross-Hedging: Example
Example: Cross-hedging with perfect correlation
• we own $100 million of stocks with a beta relative to the
S&P 500 of 1.3, our portfolio is perfectly correlated with
S&P 500 index.
• Suppose S&P 500 is 3,100 with 0 dividend yield;
effective risk-free interest rate is 3%

Stock investing is risky. If we want to hedge the risk in

the stock portfolio investment, and there is no existing
derivatives on our stock portfolio, how can we hedge the
risk for a year?
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 Cross-Hedging (cont’d)
With perfect correlation and beta of 1.3, $100 million
investment in stock portfolio is equivalent to $130
million investment in S&P 500 index.
• Hedging $100 million investment in stock portfolio is the
same as hedging $130 million investment in S&P 500
index.
Use S&P 500 index futures! Short futures!
Question: how many futures contracts to short for a
perfect hedge?

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 Cross-Hedging (cont’d)
By contract specification, one S&P 500 futures contract
covers $250 x 3,100 = $0.775 million investment in
S&P.
The number of S&P 500 futures to short in order to
cross-hedge:

• Note: For illustration purpose, we assume that taking fractional

number of contracts is feasible.

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 Cross-Hedging (cont’d)
Two positions:
• $100 million invested in stock portfolio
• Shorting 167.74 index futures. The price of one-year
futures = 3,100x1.03 = 3,193
Suppose the index value one year later is 2,950:
• Profit on shorting 167.74 futures:

• What is the value of stock portfolio?

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 Cross-Hedging (cont’d)
The return on S&P 500 index over the year is

The risk-free rate is 3%. The rate of return

corresponding to the risk in S&P 500 index is thus .
(Market risk premium.)
The stock portfolio is perfectly correlated with S&P 500
with beta of 1.3. The rate of return corresponding to the
risk in stock portfolio is thus .

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 Cross-Hedging (cont’d)
Together with risk-free rate of 3%, the return on the
portfolio is

* Note: this rate can be directly calculated by using

CAPM:
Portfolio value is thus
$100m × (1 – 7.19% ) = $92.81 million

Combined: 10.19 + 92.81 = $103 million

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 In-Class Exercise
Verify that the hedged position earns risk-free rate of 3%
if S&P 500 index value one year later is 3,200.
Solution:

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 Cross-Hedging (cont’d)
Table Results from shorting 167.47 S&P 500 index futures
against a $100 million portfolio with a beta of 1.3.
S&P 500 Index Gain on Futures Portfolio Value Total
2,950 10,190,323 92,809,677 103,000,000
3,000 8,093,548 94,906,452 103,000,000
3,050 5,996,774 97,003,226 103,000,000
3,100 3,900,000 99,100,000 103,000,000
3,150 1,803,226 101,196,774 103,000,000
3,200 -293,548 103,293,548 103,000,000
3,250 -2,390,323 105,390,323 103,000,000
3,300 -4,487,097 107,487,097 103,000,000

Cross-hedging with imperfect correlation

Risk management for stock-pickers 3-46
End of the Notes!

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