FIN 4003 Financial Derivatives

Lecture 4

Determination of Forward
and Futures Prices
Learning Outcomes

After this class, you should be able to

 Understand the determination of
forward prices of investment assets
and consumption assets
 Calculate the value of forward/futures
contracts

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Consumption vs Investment Assets

 Investment assets are assets held by

significant numbers of people purely for
investment purposes (Examples: gold, silver,
securities)
 The storage and delivery costs for
investment assets are usually small
 With a large amount put in the warehouse,
investment assets can be borrowed at a
small cost
 Hence the basis risk is small
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Consumption vs Investment Assets

 Consumption assets are assets held

primarily for consumption (Examples:
copper, oil, soybean, livestock)
 The basis risk is relatively larger, due to
higher storage and delivery costs and
inconvenience for borrowing

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Short Selling

 Short selling involves selling

securities you do not own
 Borrow the securities from another
client through your broker and sell
them in the market in the usual way

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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

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Example

 You short 100 shares when the price is

$100 and close out the short position
three months later when the price is $90
 During the three months a dividend of $3
per share is paid
 What is your profit?
 What would be your loss if you had
bought 100 shares?

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Notation for Valuing Futures and
Forward Contracts

S0: Spot price today

F0: Futures or forward price today for
delivery at time T
T: Time until delivery date
r: Risk-free interest rate for maturity T

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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.

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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
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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.

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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.

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 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

1. Borrow money 4. Deliver the commodity against

2. Buy commodity the forward contract
3. Sell forward contract 5. Recover money & payoff loan

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 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

1. Sell short the commodity 4. Accept delivery from forward

2. Lend money received from short contract
sale 5. Use commodity received to
3. Buy forward contract cover the short sale

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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?

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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?

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 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
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 The Forward Price

 Forward price must be F0 = S0erT

 In our examples, S0 =40, T=0.25, and r=0.05

so that
F0 = 40e0.05×0.25 = 40.50

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Summary: Arbitrage Transactions

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If Short Sales Are Not Possible..

Formula still works for an investment

asset because investors who hold the
asset will sell it and buy forward
contracts when the forward price is too
low

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When an Investment Asset Provides a
Known Income

 If there is an income with a present value of I

associated with the underlying assets, then
the forward price is

rT
F0 = (S 0 -I )e

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 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 −0.050.25 + 2e −0.050.5 + 2e −0.050.75 = 5.852
 The forward price is
F0 = (100 − 5.852)e0.0510 /12 = 98.154 22
When an Investment Asset Provides a
Known Yield

 If the underlying assets have a known

yield of q, its value at time T is S0eqT
 If we only consider time 0 and time T, it is
the same as with a known income of
S0(eqT-1)
 The present value of the income is:
S0 (e qT -1 ) e -qT
 So the forward price is:
F0 = [S 0 -S0 (e qT -1 ) e -qT ] e rT= S 0 e(r-q)T
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Stock Index
 A stock index can be viewed as an
investment asset paying a dividend yield
from the portfolio represented by the index.
 The futures price and spot price relationship
is therefore
F0 = S 0 e(r-q)T
where q is the average dividend yield on the
portfolio represented by the index during life
of contract

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Index Arbitrage

 When F0 > S0e(r-q)T an arbitrageur buys the

stocks underlying the index and sells
futures
 When F0 < S0e(r-q)T an arbitrageur buys
futures and shorts or sells the stocks
underlying the index

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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.
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Futures and Forwards on Currencies

 A foreign currency is analogous to a

security providing a yield
 The yield is the foreign risk-free interest
rate rf
 It follows that
( r −rf ) T
F0 = S0e

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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

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Futures Prices on Consumption Assets:
Storage Costs

 Storage costs can be regarded as negative

income; Storage costs are significant to
consumption assets
 Usually, storage costs are based on the
quantity of the commodity stored, instead of
its values. Let U denote the present value of
storage costs.

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 Futures Prices on Consumption Assets:
Storage Costs (continued)

 If F0 > (S0+U )erT or > S0 e(r+u )T you can borrow

an amount at the risk-free rate to buy the
asset, open a short position in the futures,
and pay the storage fee.
 If F0 < (S0+U )erT or < S0 e(r+u )T the holders can
sell the asset, deposit the money, open long
positions in the futures and save the storage
fee.

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 Futures Prices on Consumption Assets:
Storage Costs (continued)

 If most of the commodities are for production

or consumption purposes, holders will not
arbitrage. So the equality may not hold in this
case.
 The futures price for consumption assets:
F0  (S0+U) erT
 Alternatively, if the storage cost is as a
percentage of the asset value, then
F0  S0 e(r+u )T
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 Futures Prices on Consumption Assets

 The cost of carry, c, is the storage cost plus

the interest costs less the income earned
⚫ For an investment asset F0 = S0ecT

⚫ For a consumption asset F0  S0ecT

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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

Spot Price Futures

Price

Time Time

(a) Contango (F>S) (b) Backwardation (F<S)

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Valuing a Forward Contract

 A forward contract is worth zero (except

for bid-offer spread effects) when it is
first negotiated
 Later it may have a positive or negative
value

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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

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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 = $25e0.16 /12 = $26.28
⚫ The value of the 9-month forward contract opened
on June 30 is
f = (26.28 − 24)e−0.16 /12 = $2.17
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Futures Prices & Expected Future Spot Prices

 Suppose k is the expected return required by

investors in an asset
 We can invest F0e–r T at the risk-free rate and enter
into a long futures contract to create a cash inflow
of ST at maturity
 This shows that
− rT
F0e e kT
= E ( ST )

or
F0 = E ( ST )e( r −k )T

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Futures Prices & Future Spot Prices (continued)

No Systematic Risk k=r F0 = E(ST)

Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic Risk k<r F0 > E(ST)

Positive systematic risk: stock indices

Negative systematic risk: gold (at least for some
periods)

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