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ADVANCED FINANCIAL THEORY

5. Forwards and futures

A forward / a futures contract is a commitment made at


time t concerning buying or selling an asset at time T at
price F t,T (the forward rate).

The cash flows of a forward contract


• No cash flows when the deal is made (but: collateral (forward) or
safety deposit (future))
• Value at maturity for the buyer of the contract S T - F t,T
• Ways to settle the contract
• Physical delivery => the asset is bought / sold (and delivered) at price F t,T
• Cash settlement => settlement in local currency, for the value of S T - F t,T

The value of a forward contract is therefore


Zero when deal is made (since the price is "fair" => gains & losses equally
likely)
Later (at time t+n) the gain / loss to the buyer of the contract:
F t+n, T - F t, T
At maturity, FT,T = ST holds, and the gain / loss to the buyer is
then S T - F t,T
Va lue at mat urity

The value of a forward


contract
Bought forwards

0 S T
F F
1 2
Sold forwards

@ EVA LILJEBLOM 60
ADVANCED FINANCIAL THEORY

Futures: Marking-to-market

Exchang
rate Mark-to-market
t+1 Mark-to-market
EUR / t+2
100 USD
Profit

90

The profit from a future The profit from


a forward is
is gained on a daily obtained at
basis the end
t t+2
June Time September
t+1

How forward / futures prices are determined:

• Expectations theory :
F t,T = E ( S T)
• Price given by a no-arbitrage condition,
Extended Cost-of-Carry
F t,T = S t + I + C - B
where
Ft,T = price now(at time t) for a forward contract with maturity T
St = today's spot rate
I = interest gained (during T-t) if we buy using a forward contract (instead of
now)
C = other costs saved by a forward transaction (e.g. storage costs during T-t)
B = gain which is lost if a forward transaction is made instead of a spot
• lost dividend (stock and index futures)
• lost interest coupon payment (bond futures)
• lost currency deposit rate as compared to buying at once, in which case you

@ EVA LILJEBLOM 61
ADVANCED FINANCIAL THEORY

could depositing foreign currency and earn an interest rate (currency futures)
• Convenience yield (futures on physical assets) => the gain from "having oil".

Arbitrage = to buy, and sell at once in order to create a


riskless profit.
No-arbitrage condition = A condition which has to hold so
that there is no arbitrage.

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ADVANCED FINANCIAL THEORY

Prices of various forwards / futures


• Bond and interest rate futures

By means of a futures contract, you can buy a bond now but


pay for it (and obtain it) later => but you pay a compensation
for the right to pay later. The market interest rate influences
the price of bond futures. =>
F t,T = S t - PV (interest coupons) (1 +r)T-t
Or
(r * (T-t)
F t,T = S t - PV (interest coupons) (1 + )
365

• FRA - interest rate forwards

FRA-interest rate forwards are forward contracts based on forward rates on the
money market (which can be Computed from existing money market spot
rates).

(1 + r t1 ) t1 *(1 + f t1,t2 ) t2 = ( 1 + r t1+t2 ) t1+t2 or


1 + (rt1+t2 *t1+t2 )
ft1,t2 = 360 - 1 * 360
1 + (rt1 * t1 ) t2
360

• Stock (1) and stock index (2) forwards:

1. F t,T = ( S t - PV(Div)) * (1 + r ) T-t

where PV(Div) = the present value of


expected dividends.

@ EVA LILJEBLOM 63
ADVANCED FINANCIAL THEORY

N
2. F t,T = S t - PV(Divi ) * (1 + r )T-t =>
i=1
N
Divi
F t,T = S t - * (1 + r )T-t
i=1 (1 + rti )ti

• Currency forwards
Covered interest parity (a no-arbitrage condition) gives:

( 1 + rdom) = 1 * (1 + rfor ) * Ft,T => F t,T = S t * 1 + rdom


St 1 + rfor

@ EVA LILJEBLOM 64
ADVANCED FINANCIAL THEORY

6. Options
An option gives a right, but no obligation, to buy (a call
option) or sell (a put option)
- a fixed amount (contract size) of the underlying asset
- at a settled price (strike price, excercise price)
- during a time (American options) or at maturity (on expiration
day=> Euroopean options).

You can either • BUY or


• WRITE an option.

Call options (C)


- Option buyer can buy the asset at strike price X
- Writer must sell when buyer wants to buy
C = Max (S T - X, 0)

Put options (P)


- Option owner (the one who bought a put) can sell at strike price X
- Writer must buy when so needed
P = Max (X - S T, 0)

Option cash flows


- A premium transferred from option buyer to option writer at
once (time t)
- Later, writer delivers something to the buyer if the option
expires "in-the-money"
- Physical delivery (asset itself) or cash settlement (money)
=> The intrinsic value of the option = its value at expiration
day.

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ADVANCED FINANCIAL THEORY

• The intrinsic value of a call increases with lower strike price:

C(X1) C (X2) if X1 < X2


Intrinsic value Intrinsic value
Value for buyer Value for writer
at at
maturity maturity

X1 S S
X2 T X X T
1 2

• The intrinsic value of a put increases with higher strike price:

P(X1) P (X2) if X1 < X2

Intrinsic value Intrinsic value


Value Value
at for buyer at for writer
maturity maturity

X1 X2

X1 X2 S S
T T

Calls Puts
S>X In-the-money Out-of-the-money
S=X At-the-money At-the-money
S<X Out-of-the-money In-the-money

@ EVA LILJEBLOM 66
ADVANCED FINANCIAL THEORY

• Option premiums before expiration


Option value = Intrinsic value + Time value
=> time value highest when the option is at the money

Value Value
now now

S S
t t
Time value
Intrinsic value

How are option premia exactly defined?


1.) Option values are restricted by boundary conditions (no-
arbitrage conditions).
2.) Pricing models give final values (the exact value within
the boundary condition).

@ EVA LILJEBLOM 67
ADVANCED FINANCIAL THEORY

6.1. Boundary Conditions for Options

Compare two ways to buy a stock so that you own it at time T:

Cash-Flow now Value at T


A. Buy the stock now - St ST
B. Buy a call option and - Ct MAX(ST- X, 0)
deposit PV(X) - X / (1 + r) +X

Value of strategy B at • ST- X+X = ST if ST X (i.e. the same


time T: as for strategy A).
• X when ST< X (which is higher than for
A!!)

If in the future B A => B must now cost than A

=> Ct + X / (1 + r) St (and since Ct 0)


=> Ct MAX (St - X / (1 + r), 0)
=> A boundary condition!

@ EVA LILJEBLOM 68
ADVANCED FINANCIAL THEORY

• A boundary condition for a European option on a non-


dividend paying stock

) )

Value Value
now now

S S
t t

• A boundary condition for a European option on a


dividend paying stock

( )
)

),
)

• A boundary condition for a European currency option

) )

) )

@ EVA LILJEBLOM 69
ADVANCED FINANCIAL THEORY

• American options

- An American option (C or P) always as valuable as a


European

In fact: the value of an American option the highest of the


Europeans that have an expiration day between today and T:

CTA,t = MAX(CtE,t, Ct+1E,t,.... CTE,t)

Example 1: Two dividend days t1 and t2 during the life of an American call
option.

• Since time always increases the value of a call option if no dividends are paid
out, we can eliminate many of these alternative European options to value. What
will be left is the options used just before an ex-dividend day, and the one held
t1- t2- T
to expiration, i.e. C E,t , C E,t , and :C E,t :

• CA,t Max 0
S - X /(1+r)t1
S - Div1/(1+r)t1 - X /(1+r)t2
S - Div1/(1+r)t1 - Div1/(1+r)t2- X /(1+r)T

Example 2: Two ex-dividend days during the life of an American put. Div1
is the lowest possible dividend.

• PA, t Max 0
X-S
X /(1+r)t1 - S + Div1/(1+r)t1
X/(1+r)t2 - S + Div1/(1+r)t1+ Div1/(1+r)t2

@ EVA LILJEBLOM 70
ADVANCED FINANCIAL THEORY

The boundary condition for an American call on a dividend-paying


instrument can be used to analyze when it can be optimal and when
not optimal to exercise an American option early:

• If you exercise an option on the last cum-dividend date t, you get: St


-X

• On the first ex-dividend date, the option value C must be:


C St - D - PV(X)

=> It is never optimal to exercise early if

St - D - PV(X) St – X => if D X - PV(X).

(See e.g. Hull, 5th ed., page 254.)

@ EVA LILJEBLOM 71
ADVANCED FINANCIAL THEORY

• Another no-arbitrage condition:


Put-call parity:
Stock options C + X/ (1+rdom) = P + S
Currency options C + X/ (1+rdom) = P + S / (1+rfor)
Based on the idea of being able to create a perfectly similar position at
maturity either by
1.) Buying a call and depositing the present value of the exercise price,
or
2.) By buying the underlying asset, and a put option on it, at once.

Since cash flows at maturity are equal => both strategies must cost the
same now, initially.

(Otherwise arbitrage!)
90
80
70
60 C
50
X
40
30 Kok.pos.

20
10
0
50 60 70 80 90

90
80
70
60 P
50
S
40
30 Kok.pos.

20
10
0
50 60 70 80 90

@ EVA LILJEBLOM 72
ADVANCED FINANCIAL THEORY

6.2.Factors affecting option premiums:

1. Value of the underlying asset St


2. Strike price X
3. Risk-free (domestic) interest rate rdom
4. Asset's expected volatility
5. Time-to-maturity T-t
6. Cash flows dropping out of the asset (before opt. Int.coup., Div,
expiration) rfor
- interest coupons, dividends, foreign interest rate

Directions of influence for (1) to (6):


• Price of the underlying asset (1) and the strike price (2)
- Good to buy something worth much for calls (St, C), bad to
sell something more valuable at a fixed cost for puts (St, P)

- Bad to buy at high cost for calls (X, C), good to sell at high
cost for puts (X, P)

• The domestic risk-free rate (3)


• When you purchase by means of a call => you pay only the
premium now, the strike price X later => you get time for your
payment as compared to a spot purchase, where the whole
price is paid at once

=> you save the time value of money for the strike price X

@ EVA LILJEBLOM 73
ADVANCED FINANCIAL THEORY

=> Option would dominate spot deal unless the saved interest
rate on X would be included in its price
=> no-arbitrage restriction requires that the call is worth more,
by an amount equaling the time value of money otherwise
saved!

• Puts => you sell, but obtain the price X later => loose the
time value of money on X => puts worth less.

Interest rates up => time value of money up =>C, P

@ EVA LILJEBLOM 74
ADVANCED FINANCIAL THEORY

• The expected volatility of the underlying asset (4)

- An option gives a nonlinear payment profile (restricted loss,


unrestricted gain)

- Increased volatility raises the probability of large gains (=>


the expected value of the option)

=> Increases option premiums (for C and P)

- By means of options we then also can "price" uncertainty

Calls

25

20 std. 0.1

std. 0.3
15
std. 0.5
10
std. 0.7

5
std. 0

0
50 60 70 80 90

Assumptions: interest rate 6%,


time-to-maturity 3 months.

Puts

25

20 std. 0.1

std. 0.3
15
std. 0.5
10
std. 0.7

5 std. 0

0
50 60 70 80 90

Assumptions: interest rate 6%,


time-to-maturity 3 months.

@ EVA LILJEBLOM 75
ADVANCED FINANCIAL THEORY

• Time-to-maturity (5) affects through volatily and interest


rate

- Effect through volatility

Time
t0 t1 t2 t3

If the volatility of one period (t0 => t1) is 1, the volatility of two
periods (t0 => t2) is 1* 2 , and of n periods (t0 => tn) is 1 * n.

=> The volatility "grows" with the square of the number of


periods

=> If the volatility per unit of time stays the same => when
longer time passes, even large stock price changes can occur
with higher probabilities

=> Since increased volatility "good" for option premia =>


time has a positive (increasing) affect through this channel.

@ EVA LILJEBLOM 76
ADVANCED FINANCIAL THEORY

Effect of time through interest rates


=> Time increases the importance of lost / gained time value
of money
Example. If the interest rate is 6% p.a., and the term structure of interet rates is
flat:

- 1 month of payment time affects the profitability by 0.5% (+ is gained, - if lost)

- 6 months of payment time affects the profitability by 3% (+ is gained, - if lost).

=> For stock options


The effect of time through the interest rate is pos. for C, neg.
for P.

=> For currency options, time increases the importance of


the interest rate
difference (rdom - rfor)
- If rdom- rfor > 0 ( eli F > S): time pos. for Calls, neg. for Puts
- If rdom - rfor < 0 ( eli F < S): time neg. for Calls, pos. for Puts

• Summary of the effects of time

Stock Options Currency Options


C P C C P P
F> F<S F>S F<S
S
Thr. volatility + + + + + +
Thr. interest rate + - + - - +
Total effect + ? + ? ? +

@ EVA LILJEBLOM 77
ADVANCED FINANCIAL THEORY

Osto-optiot

30

25 aika 3 kk

20 aika 6 kk

15 aika 9 kk

10 aika 12 kk

5 aika 0

0
50 60 70 80 90

Oletukset: Korko 8%, volat. 30% p.a.

Myynti-optiot

20
18
16 aika 3 kk
14
aika 6 kk
12
10 aika 9 kk
8
aika 12 kk
6
4 aika 0
2
0
50 60 70 80 90

Oletukset: Korko 8%, volat. 30% p.a.

• Things dropping out of the underlying asset during time-


to-maturity (6)
- Things dropping out of the underlying asset (dividends, bond
interest rate coupons etc.) reduce the values of Calls, and
increase the values of Puts.

Summary of factors affecting option prices


Stock Options Currency Options
C P C P
1. Underlying asset price S + - + -
2. Exercise price X - + - +
3. Interets rate (or int.difference + - + -
dom.-for.)
4.Volatility + + + +
5. Time-to-maturity + ? ? ?
6. Cash flows dropping - + (rfor -) (rfor +)

@ EVA LILJEBLOM 78

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