Fin4003 - Lecture04 - Determination - of - Forward - and - Futures - Prices 14 Sep 2019
Fin4003 - Lecture04 - Determination - of - Forward - and - Futures - Prices 14 Sep 2019
Fin4003 - Lecture04 - Determination - of - Forward - and - Futures - Prices 14 Sep 2019
Lecture 4
Determination of Forward
and Futures Prices
Learning Outcomes
2
Consumption vs Investment Assets
4
Short Selling
5
Short Selling
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
6
Example
7
Notation for Valuing Futures and
Forward Contracts
8
Cost-of-Carry Model
The common way to value a futures
contract is by using the Cost-of-Carry
Model. The Cost-of-Carry Model says
that the futures price should depend
upon two things:
⚫ The current spot price.
⚫ The cost of carrying or storing the
underlying good from now until the futures
contract matures.
9
Cost-of-Carry Model
The Cost-of-Carry model can be expressed as:
F0 = S0(1+C)T or F0 = S0ecT
Where:
C (c) = the percentage (rate of) cost
required to store/carry the asset from today until
time T.
The cost of carrying or storing includes:
⚫ 1. Financing costs
⚫ 2. Income earned (negative cost)
⚫ 3. Storage costs
⚫ 4. Other: Insurance costs, transportation costs
10
No-Arbitrage Forward Price
In this lecture, we will use no-arbitrage
pricing principle together with the cost-
of-carry model to derive forward price.
Assumptions:
⚫ There are no transaction costs or margin
requirements.
⚫ There are no restrictions on short selling.
⚫ Investors can borrow and lend at the same
rate of interest.
11
Motivation
Suppose today, time 0, you know you will need
to purchase an asset at a future date, time T.
And you want to lock in the price.
One thing you can do is to enter into a forward
contract today with delivery date T.
Alternatively, you can purchase in the current
spot market and then “carry” the asset forward
to time T.
No arbitrage will require that the contractual
forward price must be the same as the spot
price plus the cost of carrying the asset forward.
12
Arbitrage Strategies
Cash-and-carry arbitrage:
⚫ F0 > S0ecT , you can borrow the money,
buy it at the spot market and open a short
forward contract
0 T
13
Arbitrage Strategies
Reverse cash-and-carry arbitrage:
⚫ F0 < S0ecT , you can short sell at the spot
market, invest the proceeds, and open a
long forward contract
0 T
14
An Arbitrage Opportunity?
Suppose that:
⚫ The spot price of a non-dividend-paying
stock is $40
⚫ The 3-month forward price is $43
⚫ The 3-month US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?
15
Another Arbitrage Opportunity?
Suppose that:
⚫ The spot price of non-dividend-paying
stock is $40
⚫ The 3-month forward price is US$39
⚫ The 3-month US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?
16
The Forward Price
Assumptions: (1) zero costs for storage,
delivery and transactions; (2) zero income
associated with the underlying assets during
the period.
F0 > S0erT , you can borrow the money, buy it
at the spot market and open a short forward
contract
F0 < S0erT, you can short sell at the spot
market, invest the proceeds, and open a long
forward contract
17
The Forward Price
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Summary: Arbitrage Transactions
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If Short Sales Are Not Possible..
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When an Investment Asset Provides a
Known Income
rT
F0 = (S 0 -I )e
21
Example
Consider a 10-month forward contract on a
stock with a price of $100 in the stock
exchange. We anticipate the dividends of $2
per share after 3 months, 6 months, and 9
months. Given 5% interest rate, what is the
forward price?
The present value of dividends during this
period is:
I = 2e −0.050.25 + 2e −0.050.5 + 2e −0.050.75 = 5.852
The forward price is
F0 = (100 − 5.852)e0.0510 /12 = 98.154 22
When an Investment Asset Provides a
Known Yield
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Index Arbitrage
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Index Arbitrage (continued)
Index arbitrage involves simultaneous
trades in futures and many different
stocks
Very often a computer is used to
generate the trades. We call it program
trading.
Occasionally simultaneous trades are
not possible and the theoretical no-
arbitrage relationship between F0 and S0
does not hold.
26
Futures and Forwards on Currencies
27
Explanation of the Relationship
Between Spot and Forward
1000 units of
foreign currency
(time zero)
r T
1000e f units of 1000S0 dollars
foreign currency at time zero
at time T
1000F0 e f
r T 1000S0erT
dollars at time T dollars at time T
28
Futures Prices on Consumption Assets:
Storage Costs
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Futures Prices on Consumption Assets:
Storage Costs (continued)
30
Futures Prices on Consumption Assets:
Storage Costs (continued)
32
Futures Prices on Consumption Assets (continued)
The convenience yield on the consumption
asset, y, measures the benefits from the
ownership of an asset that are not obtained
by the holder of a long futures contract.
Then we have S0 e(c–y )T F0 S0ecT
If c > y (c < y), holders would like to deliver as
early (late) as possible
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Backwardation vs. Contango
Futures
Spot Price
Price
Time Time
34
Valuing a Forward Contract
35
Valuing a Forward Contract
By considering the difference between a
contract with delivery price K and a
contract with delivery price F0 we can
deduce that:
⚫ the value of a long forward contract, ƒ,
is:
(F 0 -K )e -rT
⚫ the value of a short forward contract is:
(K − F 0 )e -rT
36
Example
On June 30, an investor opens a long 9-
month forward contract on a stock that pays
no dividend. The delivery price set at that
time is $24. On September, the stock price is
$25. The interest rate is 10% per annum.
What is the value of the forward contract?
⚫ The six-month forward price is
F0 = $25e0.16 /12 = $26.28
⚫ The value of the 9-month forward contract opened
on June 30 is
f = (26.28 − 24)e−0.16 /12 = $2.17
37
Futures Prices & Expected Future Spot Prices
or
F0 = E ( ST )e( r −k )T
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Futures Prices & Future Spot Prices (continued)
39