Chapter 5

Financial Forwards and Futures

Question 5.1

Four different ways to sell a share of stock that has a price S0 at time 0.

Description
Outright Sale
Security Sale and
Loan Sale
Short Prepaid Forward
Contract
Short Forward
Contract

Get Paid at
Time

Lose Ownership of
Security at Time

0
T

0
0

S0 at time 0
S0 erT at time T

? erT

Receive Payment of

Question 5.2

1.

The owner of the stock is entitled to receive dividends. As we will get the stock only in one year, the
value of the prepaid forward contract is todays stock price, less the present value of the four dividend
payments:
4

F0,PT = $50 $1e 0.06 12 i

3

i =1

= $50 $0.985 $0.970 $0.956 $0.942

= $50 $3.853 = $46.147

2.

The forward price is equivalent to the future value of the prepaid forward. With an interest rate of 6%
and an expiration of the forward in one year, we have:
F0,T = F0,PT e0.06 1 = $46.147 e0.06 1
= $46.147 1.0618 = $49.00

Note that this is equivalent to taking the future value of the initial stock price and subtracting the
future value (at 6%) of the dividends received, as in Equation (5.6) of the text.

60

McDonald Fundamentals of Derivatives Markets

Question 5.3

1.

The owner of the stock is entitled to receive dividends. We have to offset the effect of the continuous
income stream in form of the dividend yield by tailing the position:
F0,PT = $50e 0.08 1 = $50 0.9231 = $46.1558

We see that the value is very similar to the value of the prepaid forward contract with discrete
dividends that we have calculated in Question 5.2. In Question 5.2., we received four cash dividends,
with payments spread out through the entire year, totaling $4. This implies a total annual dividend
yield of approximately $4 $50 = 0.08.
2.

The forward price is equivalent to the future value of the prepaid forward. With an interest rate of
6% and an expiration of the forward in one year we thus have:
F0,T = F0,PT e0.06 1 = $46.1558 e0.06 1
= $46.1558 1.0618 = $49.01

We could also use Equation (5.7) of the text, i.e.,

F0,T = $50e(.06 .08) = $49.01.

Question 5.4

1.

We use the continuously compounded interest rate and the time to expiration in years (6 months is
0.5 year) in Equation (5.7). We have:
F0,T = S0 er T = $35 e0.05 0.5 = $35 1.0253 = $35.886.

2.

The annualized forward premium is calculated as:

annualized forward premium =

F 1
1
$35.50
ln 0,T =
ln
= 0.0284
T
S0 0.5 $35

Notice this is less than the interest rate, hence the index must pay a dividend.
3.

We could use F0,T = S0 e( r )T and solve for . However, it is easier to use the previous result concerning
the annualized forward premium. The forward premium is simply the difference between the risk-free
rate and the dividend yield:
F
S e ( r ) T
annualized forward premium = 1 ln 0,T = 1 ln 0

T S0 T
S0

= 1 ln (e(r )T ) = 1 (r )T
T
T
= r

Therefore, we can solve:

0.0284 = 0.05

= 0.0216
The annualized dividend yield is 2.16%.

Chapter 5 Financial Forwards and Futures

Question 5.5

1.

We use the valuation formula, F0,T = S0 e( r )T , with a continuously compounded interest rate
of r = 5%, a dividend yield of = 0, and time to expiration T = 0.75. Remember time is in years,
hence 9 months is 3/4 of a year. We have:
F0,T = S0 er T = $1,100 e0.05 0.75 = $1,100 1.0382 = $1,142.02.

2.

We engage in a reverse cash and carry strategy. In particular, we do the following:

Description
Long forward, resulting
from customer purchase
Sell short the index
Lend + S0
Total

Today

In 9 months

0
+ S0
S0
0

ST F0,T
ST
S0 erT
rT
S0 e F0,T

Specifically, with the numbers given in the exercise, and assuming the forward price is the no
arbitrage price we determined in Part (1), we have:
Description
Long forward, resulting
from customer purchase
Sell short the index
Lend $1,100

Today
0
$1,100
$1,100

Total

In 9 months
ST $1,142.02
ST
0.05 0.75
$1,100 e
= $1,142.02
0

Therefore, the market maker is perfectly hedged. She does not have any risk in the future, because
she has successfully created a synthetic short position in the forward contract.
3.

Now, we will engage in cash and carry arbitrage:

Description
Short forward, resulting
from customer purchase
Buy the index
Borrow + S0
Total

Today
0
S0
+ S0
0

In 9 months

F0,T

F0,T ST
ST
S0 erT
S0 erT

61

62

McDonald Fundamentals of Derivatives Markets

Specifically, with the numbers of the exercise, we have:

Description

Today

Short forward, resulting

from customer purchase
Buy the index
Borrow $1,100

0
$1,100
$1,100

In 9 months
$1,142.02 ST
ST
0.050.75
$1,100 e
= $1,142.02

Total

Again, the market maker is perfectly hedged. He does not have any index price risk in the future,
because he has successfully created a synthetic long position in the forward contract that perfectly
offsets his obligation from the sold forward contract.

Question 5.6

1.

We use the valuation formula, F0,T = S0 e( r )T , with a continuously compounded interest rate
of r = 5%, a dividend yield of = .015, and time to expiration T = 0.75. We have:
F0,T = S0 e( r ) T = $1,100 e(0.05 0.015) 0.75 = $1,100 1.0266 = $1,129.26.

2.

We engage in a reverse cash and carry strategy. We must tail our short index position to
e T = e .015.75 = 0.9888. Notice shorting the index requires paying the continuous dividends
Hence shorting 0.9888 units requires having to buy back more (i.e., 1 unit) of the index. The
specifics of the reverse cash and carry are:
Description
Long forward, resulting
from customer purchase
Sell short tailed position
of the index
Lend S0 e T
Total

Today
0
+ S0 e T
S0 e T
0

In 9 months
ST F0,T
S

T
( r ) T

S e
S0 e
F0,T
0
( r ) T

Using the given numbers, we have:

Description
Long forward, resulting
from customer purchase
Sell short tailed position
of the index
Lend $1,087.69
Total

Today

In 9 months

0
$1,100 .9888
= 1087.69
$1,087.69
0

ST $1,129.26
S

$1,087.69 e

T
0.05 0.75

= $1,129.26
0

Therefore, the market maker is perfectly hedged. He does not have any risk in the future, because he
has successfully created a synthetic short position in the forward contract.

Chapter 5 Financial Forwards and Futures

3.

63

With dividends reinvested, buying e T units today will grow to 1 unit in T years. The cash and carry
table is:
Description

Today

Short forward, resulting

from customer purchase
Buy tailed position in index
Borrow S0 e T
Total

In 9 months

0
S0 e
S0 e T
0
T

F0,T

F0,T ST
ST
( r ) T
S0 e
S0 e( r )T

Specifically, we have:
Description

Today

Short forward, resulting

from customer purchase
Buy tailed position
in index
Borrow $1,087.69

In 9 months
0

$1,129.26 ST

$1,100 .9888
= $1,087.69
$1,087.69

ST
$1,087.69 e0.050.75

= $1,129.26
0

Total

Again, the market maker is perfectly hedged. He does not have any index price risk in the future,
because he has successfully created a synthetic long position in the forward contract that perfectly
offsets his obligation from the sold forward contract.

Question 5.7

We need to find the fair value of the forward price first. With the numbers given, we have:
F0,T = S0 er T = $1,100 e0.05 0.5 = $1,100 1.02532 = $1,127.85

1.

If we observe a forward price of 1135, we know that the forward is too expensive, relative to the fair
value weve determined. Therefore, we will short the forward contract at 1135, and create a long
position in a synthetic forward (which has an implied price of 1,127.85). The synthetic long position
is created by cash and carry. We should make a sure profit of $7.15. We verify this with the following
table:
Description

Today

In 9 months

Short forward
Buy position in index
Borrow $1,100
Total

0
$1,100
$1,100
100

$1,135.00 ST
ST
$1,127.85
$7.15

This position requires no initial investment, has no index price risk, and has a strictly positive payoff.
We have exploited the mispricing with a pure arbitrage strategy.

64

2.

McDonald Fundamentals of Derivatives Markets

If we observe a forward price of 1115, we know that the forward is too cheap, relative to the fair
value we have determined. Therefore, we will buy (i.e., go long) the forward at 1115, create a
synthetic short forward at 1127.85, and make a sure profit of $12.85. The synthetic short forward is
achieved by engaging in a reverse cash and carry:
Description

Today

Long forward
Short position in index
Lend $1,100
Total

0
$1,100
$1,100
0

In 9 months
ST $1,115.00
ST
$1,127.85
$12.85

This position requires no initial investment, has no index price risk, and has a strictly positive payoff.
We have exploited the mispricing with a pure arbitrage strategy.

Question 5.8

We need to find the fair value of the forward price first. With the numbers given, we have:
F0,T = S0 e( r ) T = $1,100 e(0.05 0.02) 0.5 = $1,100 1.01511 = $1,116.62

1.

If we observe a forward price of 1120, we know that the forward is too expensive, relative to the fair
value we have determined. Therefore, we will sell the forward at 1120, and create a synthetic forward
for 1116.82, making a sure profit of $3.38. Our cash and carry has a tailed position due to the positive
dividend yield:
Description
Short forward
Buy tailed position
in index
Borrow $1,089.055
Total

Today

In 9 months

0
$1,100 .99
= $1,089.055
$1,089.055
0

$1,120.00 ST

ST
$1,116.62
$3.38

This position requires no initial investment, has no index price risk, and has a strictly positive payoff.
We have exploited the mispricing with a pure arbitrage strategy.
2.

If we observe a forward price of 1110, we know that the forward is too cheap, relative to the fair
value we have determined. Therefore, we will buy the forward at 1110, and create a synthetic short
forward for 1116.62, thus making a sure profit of $6.62. As we buy the real forward, we engage in a
reverse cash and carry arbitrage (remembering to tail the position in order to cover dividends):
Description
Long forward
Sell short tailed position
in index
Lend $1,089.055
Total

Today
0
$1,100 .99
= $1,089.055
$1,089.055
0

In 9 months
ST $1,110.00
ST
$1,116.62
$6.62

This position requires no initial investment, has no index price risk, and has a strictly positive payoff.
We have exploited the mispricing with a pure arbitrage strategy.

Chapter 5 Financial Forwards and Futures

65

Question 5.9

1.

A money manager could take a large amount of money, travel back to 1981, invest it at 12.5%, and
instantaneously travel forward to 1982 to reap the benefits, i.e., the accrued interest. Then repeat the
process as many times as possible. Our argument of time value of money breaks down.

2.

If many money managers undertook this strategy, the large amount of funds theyd want to invest
at 12.5% would drive the 1981 interest rates down.

3.

Unfortunately, these arguments mean that costless and riskless time travel will not be invented. The
same point can be made using almost any other financial asset.

Question 5.10

We plug the continuously compounded interest rate, the forward price, the initial index level, and the time
to expiration in years into the valuation formula and solve for the dividend yield:
F0,T = S0 e(r )T
F0,T
S0

= e( r )T

F
ln 0,T = (r ) T
S0

F
1

ln 0,T
T
S0
1
1129.257
= 0.05
ln

0.75 1100
= 0.05 0.035 = 0.015

=r

Remark: Note that this result is consistent with Exercise 5.6., in which we had the same forward prices,
time to expiration, etc.
2.

With a dividend yield of only 0.005, the fair forward price would be:
F0,T = S0 e( r ) T = 1,100 e(0.05 0.005) 0.75 = 1,100 1.0343 = 1,137.759

Therefore, if we think the dividend yield is 0.005, we consider the observed forward price of
1129.257 to be too cheap. We will therefore buy the forward and create a synthetic short forward,
capturing a certain amount of $8.502. We engage in a reverse cash and carry arbitrage:
Description
Long forward
Sell short tailed position
in index
Lend $1,095.88
Total

Today

In 9 months

0
$1,100 .99626
= $1,095.88
$1,095.88
0

ST $1,129.257
ST
$1,137.759
$8.502

Of course, if we were wrong and the dividend yield was higher than we thought (0.5%), we might
lose money as covering our short position would require buying more than one unit in 9 months.

66

3.

McDonald Fundamentals of Derivatives Markets

With a dividend yield of 0.03, the fair forward price would be:
F0,T = S0 e( r ) T = 1,100 e(0.05 0.03) 0.75 = 1,100 1.01511 = 1,116.62

Therefore, if we think the dividend yield is 0.03, we consider the observed forward price of 1,129.257
to be too expensive. We will therefore sell the forward and create a synthetic long forward, capturing
a certain amount of $12.637. We engage in a cash and carry arbitrage:
Description
Short forward
Buy tailed position
in index
Borrow $1,075.526
Total

Today

In 9 months

0
$1,100 .97775
= $1,075.526
$1,075.526
0

$1,129.257 ST
ST
$1,116.62
$12.637

If the dividend yield turned out to be lower than we thought (i.e., lower than 3%), we will have less
than 1 unit from our initial index purchase. This could lead to losing money in 9 months.

Question 5.11

1.

The notional value of 4 contracts is 4 $250 1200 = $1,200,000, because each index point is worth
$250, and we buy four contracts.

2.

The margin protects the counterparty against default. In our case, it is 10% of the notional value of
our position, which means that we have to deposit an initial margin of:
$1,200,000 0.10 = $120,000.

Question 5.12

1.

The notional value of 10 contracts is 10 $250 950 = $2, 375, 000, because each index point is worth
$250, we buy 10 contracts and the S&P 500 index level is 950.
With an initial margin of 10% of the notional value, this results in an initial dollar margin of
$2,375,000 0.10 = $237,500.

2.

We first obtain an approximation. Because we have a 10% initial margin, a 2% decline in the futures
price will result in a 20% decline in margin. As we will receive a margin call after a 20% decline in
the initial margin, the smallest futures price that avoids the maintenance margin call is 950 .98 = 931.
However, this calculation ignores the interest that we are able to earn in our margin account.
Let us now calculate the precise answer. We have the right to earn interest on our initial margin
position at a continuously compounded interest rate of 6%. Hence, after one week, our initial margin
grows to:
$237, 500e0.06 52 = $237, 774.20
1

Chapter 5 Financial Forwards and Futures

67

We will get a margin call if the initial margin falls by 20%. Hence we will get a margin call when our
account has a balance less than 80% of the initial margin:
$237, 500 0.8 = $190, 000

The 10 long S&P 500 futures contracts obligate us to pay $2,500 times the futures price at the end of
the week, call it F1.
Therefore, we will get a margin call if:

$237, 774.20 + ( F1 950) $2, 500 $190, 000

( F1 950) $2, 500 $47, 774.20

2500 F1 950 $2, 500 $47, 774.20

F1 950 47774.2 / 2500 = 930.89

Therefore, the greatest S&P 500 index futures price at which we will receive a margin call is 930.89.

Question 5.13

When you go long a forward contract, you do not own the stock until you take delivery at the expiration of
the contract. Hence you do not receive any of the dividends paid during the life of the contract. So regardless
of dividends, your payoff/profit from the long position is ST F0,T . If you lend the present value of F0,T ,
which is e rT F0,T , you will receive F0,T in T years. Hence your aggregate payoff is ST F0,T + F0,T = ST .
Hence spending e rT F0,T today (our lending amount, as the long forward position is costless) gives us a
payoff of ST regardless of dividends. We could also show this using our forward pricing formulas for the
given dividend cases, as follows:
1.
Description

Today

At expiration of the contract

Long forward
Lend S0
Total

0
S0
S0

ST F0, T = ST S0 erT
S0 erT
ST

In the first row, we made use of the forward price equation if the stock does not pay dividends.
We see that the total aggregate position is equivalent to the payoff of one stock.
2.

In the case of discrete dividends, we have:

Description

Today

Long forward

At expiration of the contract

0

ST F0,T = ST S0 erT + er (T ti ) Dti

i =1

Lend S0 e rti Dti

i =1

Total

S0 + e rti Dti
i =1
n

S0 + e rti Dti
i =1

+ S0 erT er (T ti ) Dti
i =1

ST

68

3.

McDonald Fundamentals of Derivatives Markets

In the case of a continuous dividend, we have to tail the position initially. We therefore create a
synthetic share at the time of expiration T of the forward contract.
Description

Today

Long forward
Lend S0 e T
Total

0
S0 e T
S0 e T

At expiration of the contract

ST F0, T = ST S0 e(r )T
S0 e(r )T
ST

In the first row, we made use of the forward price equation if the stock pays a continuous dividend.
We see that the total aggregate position is equivalent to the payoff of one stock at time T.

Question 5.14

The following table presents the payoffs, at delivery T, from cash-and-carry and reverse cash-and-carry for
the 4 different delivery dates.
Delivery (months)

12

T (years)

1/12

1/4

1/2

Buy Index
ST
Borrow $1200 @7%
1207.02
Go short at F (0, T )
F (0, T ) ST
Total
F (0, T ) 1207.02

ST
1221.18
F (0, T ) ST
F (0, T ) 1221.18

ST
1242.74
F (0, T ) ST
F (0, T ) 1242.74

ST
1287.01
F (0, T ) ST
F (0, T ) 1287.01

ST
1206.02
ST F (0, T )
1206.02 F (0, T )

ST
1218.14
ST F (0, T )
1218.14 F (0, T )

ST
1236.55
ST F (0, T )
1236.55 F (0, T )

ST
1274.20
ST F (0, T )
1274.20 F (0, T )

Short Index
Invest $1200 @ 6%
Go long at F (0, T )
Total

Since these strategies have zero initial cost, the payoffs must be less than or equal to zero. These provide
upper and lower bounds for the respective forward prices. For example, the 3-month futures price must be
between $1218.14 and $1221.18.

Question 5.15

1.

As in exercise 5.14, the upper bound is determined by the borrowing rate and the lower bound is
determined by the lending rate. Let F + denote the upper bound and let F denote the lower bound.
We have
F + = 800e0.055 = 800 1.05654 = 845.23
F = 800e0.05 = 800 1.051271 = 841.02

2.

Now, we will incur an additional transaction fee of $1 for going either long or short the forward
contract. Stock sales or purchases are unaffected. We calculate:
F + = (800 + 1)e0.055 = 801 1.05654 = 846.29
F = (800 1)e0.05 = 799 1.051271 = 839.97

Chapter 5 Financial Forwards and Futures

3.

69

Now, we will incur an additional transaction fee of $2.40 for the purchase or sale of the index,
making our total initial transaction cost $3.40. We calculate:
F + = (800 + 3.40)e0.055 = 803.40 1.05654 = 848.82
F = (800 3.40)e0.05 = 796.60 1.051271 = 837.44

4.

We also have to take into account as well the additional cost that we incur at the time of expiration.
We can calculate:
F + = (800 + 3.40)e0.055 + 2.40 = 803.40 1.05654 = 851.22
F = (800 3.40)e0.05 2.40 = 796.60 1.051271 = 835.04

5.

Let us make use of the hint. In the cash and carry arbitrage, we will buy the index, which has a
expiration payoff of ST . However, we have to pay a proportional transaction cost of 0.3% on it,
so that the position is only worth 0.997 ST . However, we need ST to set off the index price risk
introduced by the short forward. Therefore, we will initially buy 1.003 units of the index, which
leaves us exactly ST after transaction costs. Additionally, we incur a transaction cost of 0.003 S0
for buying the index today, and of $1 for selling the forward contract.
F + = (800 1.003 + 800 0.003 + 1)e0.005 = 805.80 1.05654 = 851.36

The boundary is slightly higher, because we must take into account the variable, proportional cash
settlement cost we incur at expiration. The difference between Parts (4) and (5) is the interest we have
to pay on $2.40, which is $.14.
In the reverse cash and carry arbitrage, we short the index and have to pay back, at expiration, ST .
However, we have to pay a proportional transaction cost of 0.3% on it, so that we have exposure
of 1.003 ST . However, we only need an exposure of ST to set off the index price risk introduced
by the long forward. Therefore, we will initially only sell 0.997 units of the index, which leaves
us exactly with ST after transaction costs at expiration. Additionally, we incur a transaction cost
of 0.003 S0 for buying the index today, and $1 for selling the forward contract. We have as a new
lower bound:
F = (800 0.997 800 0.003 + 1)e0.05 = 794.20 1.051271 = 834.92

The boundary is slightly lower, because we forego some interest we could earn on the short sale,
because we have to take into account the proportional cash settlement cost we incur at expiration.
The difference between Parts (4) and (5) is the interest we are foregoing on $2.40, which is $.12
(at the lending rate of 5%).

Question 5.16

1.

The one-year futures price is determined as:

F0,1 = 875e0.0475 = 875 1.048646 = 917.57

2.

One futures contract has the value of $250 875 = $218, 750. Therefore, the number of contracts
needed to cover the exposure of $800,000 is: $800,000 $218,750 = 3.65714. Furthermore, we need
to adjust for the difference in beta. Since the beta of our portfolio exceeds 1, it moves more than the
index in either direction. Therefore, we must increase the number of contracts. The final hedge
quantity is: 3.65714 1.1 = 4.02286. Therefore, we should short-sell 4.02286 S&P 500 index future
contracts.

70

McDonald Fundamentals of Derivatives Markets

As the correlation between the index and our portfolio is assumed to be one, we have no basis risk
and have perfectly hedged our position and transformed it into a riskless investment. Therefore, we
expect to earn the risk-free interest rate as a return over one year.

Question 5.17

It is important to realize that, because we can go long or short a future, the sign of the correlation does not
matter in our ranking. Suppose the correlation of our portfolio in Question 5.16 with the S&P 500 is
minus 1. Then we can do exactly the same calculation, but would in the end go long the futures contract.
It is thus the absolute correlation coefficient that should be as close to one as possible. Therefore, the
ranking is 0, 0.25, 0.5, 0.75, 0.85, 0.95, with 0 having the highest basis risk.