Textbook Reference Lecture outline

‰ This lecture: Chapter 5 – Pricing forwards and futures
‰ Next lecture: Chapter 3 – Hedging using futures
‰ Determination of forward prices: no arbitrage argument
‰ Forward prices for investment assets with known
income/yield
‰ Forward prices on currencies
‰ Forward prices on commodities
‰ Value of forward contract vs. forward price
‰ Equivalent of forward and futures prices

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 1 forwards & futures Management Techniques 2

What determines the forward price: No-

Assumptions arbitrage argument

‰ No transaction costs ‰ There are two ways to acquire an asset for some date in the
‰ Same tax rate on all net trading profits future
‰ Borrowing rate is the same as lending rate (i.e., rate-free rate ‰ For example:
of interest ƒ Purchase it now and store it
‰ Taking advantage of arbitrage opportunity as they occur ƒ Take a long position in a forward contract

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 3 forwards & futures Management Techniques 4

What determines the forward price: No- What determines the forward price: No-
arbitrage argument (cont’d) arbitrage argument (cont’d)

Portfolio A:
Let’s look at a non-dividend-paying stock initial (t) at time T
Portfolio A: Buy the stock now and hold it until time T. Borrow St -St e r(T-t)
Portfolio B: Take a long forward position on the same asset Buy stock –St ST
today for delivery at time T with delivery price of Ft Total for A 0 ST - St e r(T-t)
(determined today)
Portfolio B:
initial (t) at time T
Long forward 0 –Ft
Receive asset ST

Total for B 0 ST - Ft
Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 5 forwards & futures Management Techniques 6

1
What determines the forward price: No-
arbitrage argument (cont’d) What if the relationship does not hold?

Since portfolios A & B can both acquire the same asset at time
T, if there is no arbitrage opportunity, the cash flow either at F t ≠ St e r (T – t)
time t or T must be the same: Can we profit from mispricing?

Ft = St e r(T – t) ƒ Suppose that Ft =$43, St =$40, r=5%, and T-t = 3 months.

where: ƒSt e r (T – t) = 40e 5% *3/12 = $40.50, hence Ft >St e r (T – t)
r is risk-free rate of interest per annum at time t with
continuous compounding for an investment maturing at T
ƒAction: Sell futures and buy stock
ƒCash flows?

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 7 forwards & futures Management Techniques 8

Cash flows when Ft > St e r(T – t) Action and Cash flow when Ft < St e r(T – t)

Position time t time T Position time t time T

Borrow St –St e r(T – t) Short sell stock St –ST
Buy stock –St ST Invest –St St e r(T – t)
Short forward 0 F t – ST Long forward 0 ST – F t

Net position 0 Ft – S t e r(T – t) > 0 Net position 0 St e r(T – t) – Ft > 0

This is known as Cash and Carry Arbitrage This is known as Reverse Cash and Carry Arbitrage

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 9 forwards & futures Management Techniques 10

What is the forward price for a dividend-paying stock

(an investment asset with known income)? Why Ft = (St – I)e r(T – t) ?

Suppose that dividends of stock are predictable (i.e., an Portfolio A:

investment asset provides a perfectly predictable cash income). initial (t) td at time T
The forward price is given as Borrow St -St e r(T-t)
Buy asset –St D (dividend) ST + D e r(T - td)

Ft = (St – I)e r(T – t) Total for A 0 ST - St e r(T-t) +D e r(T - td)

where I is the present value, using the risk-free rate r, of Portfolio B:

dividends to be received during the life of the forward contract. initial (t) at time T
• Investor forgoes I when using a forward contract. Long forward 0 –Ft
• I reduces the cost of buying the stock. Receive asset ST

Total for B 0 ST - Ft
Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 11 forwards & futures Management Techniques 12

2
Homework Solution

Step 1: Calculate I
A stock is expected to pay a dividend of $1 per share in two
PV of dividend in 2 months: $1e–0.08 ×(2/12)
months & five months. The stock price is $50 and the risk-
PV of dividend in 5 months: $1e–0.08 ×(5/12)
free rate of interest is 8% per annum with continuous
compounding for all maturities. An investor has just taken a I = $1e–0.08 ×(2/12) + $1e–0.08 ×(5/12) = $1.95
short position in a six-month forward contract on the stock.
Step 2: Calculate F
What is the forward price if there is no arbitrage opportunity?
F = (S – I) er(T – t) = ($50 – $1.95)e0.08×0.5 = $50.01

HWQ: What if F is $51.01? Is there an arbitrage opportunity?

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 13 forwards & futures Management Techniques 14

What is the forward price for an investment asset

Solution with known yield?

Transaction now 2 mths 5 mths T=6 mths Suppose that an investment asset provides a perfectly
predictable (dividend) yield. The forward price is
Short forward 0 0 0 $51.01 – ST
Buy stock –$50 $1 $1 ST Ft = Ste(r – q)(T – t)
Borrow (for 2mths) $1e-r(2/12) –$1 0 0
Borrow (for 5mths) $1e-r(5/12) 0 –$1 0 q is the average (dividend) yield per annum on asset during
Borrow (for 6mths) $50 – 1e-r(2/12) – 1e-r(5/12) 0 0 -(50-1.95)er(6/12)= - $50.01 the life of the contract.
Net CF 0 0 0 $1.00

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 15 forwards & futures Management Techniques 16

Value of a forward contract vs. forward price

Value of a forward contract vs. forward price (cont’d)

Forward price “F” refers to the price to be paid for the Note that the forward price is chosen so that f = 0 at
underlying asset at contract maturity. When a contract is initiation of the contract. This is what the no arbitrage
entered into, this becomes the delivery price (“K”) arguments accomplish.

contract, denoted f, represents the

The value of a forward contract Th value
The l off a contract
t t is
i the
th difference
diff b
between
t th
the
present value of the expected payoff of the contract. payoff of the new forward contract and the payoff of the
old contract, discounted back from maturity.
Value of a forward contract ≠ forward price
For a long position: (Ft – K)e–r(T – t) = (Ster(T – t) – K)e–r(T – t)
= St – Ke–r(T – t)

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 17 forwards & futures Management Techniques 18

3
 What happens when interest rate is not
Are forward prices and futures prices equal? constant?

when risk-free interest rate is constant and the same for all
maturities, the forward price for a contract with a certain
delivery date is the same as the futures price for a contract
with the same delivery date.
This is proven using a parity argument, i.e., if the payoffs of
two portfolios are the same, the costs must be the same.
Reference: Ch. 5 Appendix (p. 126 of Hull, 2008)
“When interest rates vary unpredictably, (as they do in the
real world) forward and futures prices are no longer the
same. When the price of the underlying asset is positively
(negatively) correlated with the interest rate, futures
prices tend to be higher (lower) than forward prices
because futures (forward) contract is more attractive
attractive.
The theoretical differences between forward and futures
prices for contracts that last only a few months are in most
circumstances sufficiently small to be ignored.” (Hull, page
110). So, in this subject, we assume that futures
prices and forward prices are equal.

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 19 forwards & futures Management Techniques 20

Futures Price of Stock Index Homework

Suppose that the S&P 500 stock index is at $295 and the six-
A stock index can be regarded as the price of an month forward contract on that index is at $300. If the risk-
investment asset that pays dividend yield. The futures free interest rate is 7% and the dividend rate is 5%
(continuous compounding).
price is
• Is there an arbitrage g opportunity?
pp y
F = Se(r – q)(T – t)
Ft = Ste(r – q)(T – t) Fmodel = $295×e(0.07-0.05)×0.5 = $297.96
Fmarket = $300
• If yes, how can you make an arbitrage profit?
q is the average (dividend) yield per annum on asset
during the life of the contract.
Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 21 forwards & futures Management Techniques 22

What is the forward/futures price on

Solution currencies?
Transaction now T
ƒConsider forward and futures foreign currency contracts from the perspective
Short 0 $300 - IndexT of a US investor.
forward ƒThe underlying asset is one unit of the foreign currency
ƒSt is current spot price in dollars of one unit of the foreign currency
Buy index, -$295×e-qT=-$295×0.9753 IndexT
ƒFt is current futures price in dollars of one unit of the foreign currency
reinvest =-$287.72
$287.72
ƒConsider foreign currency as an asset that pays a known dividend yield of rf
dividends
Borrow at r $287.72 (=$295×e-qT) -$287.72erT
(=-$295×e(r – q)T) No arbitrage relationship between forward/futures and spot prices:
=-$297.96 Ft = Ste(r – rf)(T – t)
where rf is the value of foreign risk-free interest rate with continuous
Sum of cash 0 $ 2.04 compounding. Note: in International Finance this is called interest
rate parity
flows

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 23 forwards & futures Management Techniques 24

4
 What is the forward/futures price on commodity
(investment or consumption asset)? Concept of
Currency futures arbitrage convenience yield

What if the Aussie forward/futures price exceeds ‰Costs: borrowing cost and storage cost
Se(r – rf)(T – t)? ‰ benefits (consumption asset): ownership of a commodity
which may provide (difficult to quantify) benefits, for
example
e a pe
ƒ Short
Sh i off Ft
ffutures ((sellll AUD) @ price
ƒ ability to profit from temporary local shortages
ƒ Borrow USD @ interest rate of r
ƒ ability to immediately supply a production process
ƒ purchase AUD and receive interest payment @ rf
ƒ These benefits are referred to as the convenience
yield of the commodity
ƒConvenience yield is negatively related to the level of
inventories. For example, cruel oil
Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 25 forwards & futures Management Techniques 26

What is the forward/futures price on

commodity? (cont’d) A general pricing: cost of carry

Forward/futures price is given as

Ft = Ste(r+u– y)(T – t)
Cost of carry refers to the cost (benefit) of holding the asset
asset,
including:
ƒ Interest rate forfeited on funds used to purchase asset r
ƒ Storage costs u expressed in continuous
compounding rate
ƒ convenience yield y (continuous compounding rate)
generated from ownership of the commodity.
In words, if there are no arbitrage opportunities, the
forward/futures price at time t equals the spot price of the
underlying at time t compounded forward at the cost of carry
to the maturity date of the forward/futures contract
ƒ add costs to the spot price or to the interest rate (they
increase how much you would have to borrow to arbitrage)
ƒ subtract benefits from the spot price or from the interest
rate (they decrease how much you would have to borrow to
arbitrage)
Ft = S t e ( c −b )(T −t ) − Ie r (T −t ) + Ue r (T −t )

Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 27 forwards & futures Management Techniques 28

Impact of Delivery Options on Futures Prices Summary

ƒ There are multiple delivery dates for a futures ƒ (1) Determining forward price
contract. ƒ Forward price is the net cost of carrying the underlying asset
from current time to maturity when there is no arbitrage
ƒ Seller of futures contract chooses a specific date opportunity, more specifically,
d i the
during th delivery
d li monthth a few
f days
d before
b f the
th ƒ
ƒ
Price of forward
Price of forward
on
on
non
non-dividend-paying
dividend paying stock
cash-dividend-paying stock
delivery takes place. ƒ Price of forward on stock index paying dividend yield
ƒ Price of forward on foreign currency (similar to stock index)
ƒ This introduces a complication into the ƒ Price of forward on commodity (investment commodity and consumption
determination of futures prices. commodity)
ƒ Identify arbitrage opportunity
ƒ When market forward price is too high (low), i.e., higher (lower) than the
net cost, it implies that forward contract is overpriced (underpriced) and
there is arbitrage opportunity.
Week 2 - Pricing FINS3635 Options, Futures and Risk Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 29 forwards & futures Management Techniques 30

5
Summary
ƒ Construct strategies
ƒ When forward is overpriced, sell forward and buy the underlying (make sure that
you know that how much you need to borrow and how many units of underlying
you need to buy)
ƒ When forward is underpriced, buy forward and short sell the underlying (again,
make sure that you know how many units of underlying asset you need to sell)
ƒ Calculate
C l l t risk-free
i k f profit
fit
ƒ Risk-free profit = difference between market forward price and net cost of carry.

ƒ (2) Value of a long forward contract

ƒ Need to know how to calculate the value of a forward contract
ƒ (3) Relationship between forward price and futures price
ƒ When the interest rate is constant, forward price = futures price
‰Suggested problems and questions:
5.1-5.15, 5.17-5.18, 5.24, 5.26
Week 2 - Pricing FINS3635 Options, Futures and Risk
forwards & futures Management Techniques 31