Session 3

Forward and Futures Prices

Chapter 5

1
 Objectives
• Relation between spot & forward prices
– Cost of carry model
– Arbitrage
– Calendar spread arbitrage
– Stock index, currencies arbitrage
– Consumption assets
• Valuation of Futures position
• Bond, Note and Eurodollar futures
– Features & quotations

2
Relation Between Spot and Forward
Prices
• Relation is enforced by arbitrage.
• Arbitrage involves
– investing in (short selling) an asset at spot while
– fixing the price it can be sold (repurchased) in the forward
market.
• Ability to arbitrage is affected by:
– opportunity cost of invested funds and storage costs
– income from investment assets
– storability of consumption assets
3
 Short Selling
• Short selling involves selling securities you do
not own.
– Your broker borrows the securities from another
client and sells them in the market.
– At some stage you must buy the securities back to
replace them in the client’s account.
– You must pay dividends and other benefits that the
owner of the securities is entitled to.

4
 Cost of Carry Model
• For an investment asset that provides no
income and has no storage costs
r .T
F=
0 S0 × e (Equation 5.1, p.106)

F0 : forward price at t=0

S0 : spot price at t=0,
r : T -year rate of interest (continuously compounded)

• For an investment asset with dividend yield q

reduces holding cost r:
( r − q )T
F=
0 S0 × e (Equation 5.3, p.110)

5
 Carrying cost: interest with no income
• Suppose gold trades at $1060 at spot, while the three-
month forward rate is $1120. The risk-free rate is 6% p.a.
r .T 0.06×0.25
S0 .e 1060 × e
= $1076
=
Thus: F0 > S0 × e r .T
• Based on 100oz of gold:
– At t=0
Borrow $106,000, purchase 100 oz at spot, sell 100 oz three months forward.
– At t=3 months
Deliver 100 oz of gold under forward contract and receive $112,000. Repay
$107,600 on loan.
• Profit = 112,000-107,600=$4,400
6
 Carrying cost: interest with income at rate q
• Same principle as with ‘no income’ except that to
arbitrage:
– borrow enough to buy e-qT of the asset at spot
– receive income from holding the asset
– simultaneously sell (all of) the asset forward

• Alternatively, short sell e-qT of the asset at spot

• Note:
– if e-qT of an asset earns at rate q over period T, with
reinvestment it will grow to (e− qT ) × eqT =e0 =1
– the holder of the asset receives the income
– the short seller must pay this in compensation.
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 Example - Cash and Carry Arbitrage
• If S0=$100, F0= $105, r=0.12, q=0.09, T=1 year:
such that: F0 > S0 e(r–q )T

• Based on one asset forward contract:

– At t=0
• Borrow $100 x e-0.09x1=$91.39,
• Purchase 91.39% of the asset at spot.
• Sell (100% of) asset one year forward.
– At t=1 year
• With reinvestment, the borrowed asset has grown to 1.
Deliver this under the forward contract and receive $105.
• Repay 91.39xe0.12x1=$103.05 on loan.
• Profit = 105.00-103.05=$1.95 8
 Reverse Cash and Carry Arbitrage
• If F0=$102,
S0=$100, r=0.12, q=0.09, T=1 year, (as before)
such that: F0 < S0 e(r–q )T
– At t=0
• Short sell e-0.09x1=0.9139 of the asset at spot
• Invest the proceeds ($100 x 0.9139 = $91.39) at 12% p.a..
• Buy the asset 1 year forward.
– At t=1 year
• Pay $102 to receive the asset under the forward contract.
• Use asset to close out short position AND compensate lender of asset
for lost income.
• Receive 91.39xe0.12x1=$103.05 from investment.
• Profit (t=1) =103.05-102=$1.05
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 Equilibrium Pricing

• S0=$100, r=0.12, q=0.09, T=1 year

• If F0=$103.05,
such that: F0 = S0 e(r–q )T

• Then there is no arbitrage opportunity.

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 Calendar Spreads
• The cost of carry model applies to contracts of any
maturity. Futures prices are therefore linked.

• Since F1 = S e(r − q)T1 and F =Se

2
(r − q )T2

it follows that:

( r − q )( T2 −T1 )
F2 = F1e

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 Calendar Spread Arbitrage
( r − q )( T2 −T1 )
• If F2 > F1e
– take a long forward position in F1 and a short
forward position in F2.

( r − q )( T2 −T1 )
• If F2 < F1e
– take a long forward position in F2 and a short
forward position in F1.
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 Stock Index Futures
• Can be viewed as an investment in a portfolio of stocks
asset paying a continuous dividend yield q.
F0 = S0 e(r–q )T (Equation 5.3, p. 110)
• Arbitrage opportunity if equality does not hold:
– If F0>S0 e(r-q)T
• buy stocks underlying the index and sell index futures.
– If F0<S0 e(r-q)T
• buy index futures and short sell stocks underlying the
index.
– automated simultaneous trades in futures and many stocks
– changes in the index must correspond to changes in value of
tradable portfolio. 13
 Futures on Currencies
• A foreign currency is analogous to a security
providing a continuous dividend yield.

• The continuous dividend yield is the foreign risk-free

interest rate.

• It follows that if rh and rf are the home and foreign

risk-free interest rates, respectively:
( rh − rf ) T
F0 = S0 e
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 Futures on Consumption Assets

( r + u )T
• F0 ≤ S 0 e (Equation 5.16, p.121)

where ‘u’ is the storage cost per unit time as a

percent of the asset value.

• Alternatively:
rT
F0 ≤ ( S 0 + U )e
where ‘U’ is the present value of the storage
costs. 15
 The Cost of Carry
• The cost of carry: c=r+u-q
where:
r = interest costs
u = storage cost
q = income earned

cT
• For an investment asset F0 = S 0 e
• For a consumption asset cT
F0 ≤ S0e
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 Convenience Yield
• Futures on consumption assets may be less than full
carry.
• Occurs when current consumption is high relative to
the supply of goods
– or a future over-supply of goods is anticipated.
• The convenience yield on the consumption asset, ‘y’,
is defined so that
( c − y )T
F0 = S 0 e (Equation 5.19, p.122)

17
 Futures Prices & Expected Future Spot
Prices
• Hedgers seek to transfer risk to speculators.
– Hedgers with long positions in the asset
• need to SELL (short) futures
• are prepared to accept a price lower than the ‘expected’
future spot price to remove risk
• That is, will accept F0 < E(St).
– Speculators will take a short futures position only if
F0 > E(St).
• If more speculators than hedgers have short positions,
F0 > E(St).
• The converse also holds. 18
 Valuing a Forward Contract

• The value of a forward contract is the difference

between the contracted forward price K and the
current forward price Ft for contracts maturing at time
T, all discounted back to t=0.

• For a long forward contract, the value (at time ‘t’) is:
ƒ = (Ft – K )e–r T

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 Valuation Example
• In January
– the spot price of gold was $1092.
– 100oz of gold were sold forward for $1120 with June delivery.
• In April
– the gold spot price was $1128 and contracts for June delivery were
priced at $1140 per oz.
– Interest rates are unchanged at 6% p.a.
• Value of short forward contract (in April) is:
−( FApril − K ).e − rT
f =
2
−0.006×
= −100 (1140 − 1120).e 12

= −$1980 20
 Bond, Note and Eurodollar Futures

Australian Futures Quotations

• Bank bill futures:
– Quoted in exactly the same way as physical bank bills.
– Standardised on one contract having
• face value of $1 million,
• term to maturity of exactly 90 days,
– Settled by
• cash
• physical delivery of 85-95 day bills.

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 Australian Futures Quotations
• Treasury bond futures:
– Quoted in exactly the same way as physical
T-bonds.
– Standardised, contracts are traded on
• Exactly 3-year and 10-year T-bonds
• One contract covers bonds with a face value of
$100,000, coupon 6% p.a. paid semi-annually.
– Cash settled.

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 US Futures Quotations
T-bills (13 week) & 3-month Eurodollar futures:
• Based on instruments with face value of $1 million.
• On the CME, both are cash settled,
– T-bill settlement based on highest discount rate accepted at
the 91-day US T-bill auction that is contemporaneous with the
last trade date.
– Eurodollar futures settlement based on 3-month libor
determined by British Bankers’ Association survey 2 days
prior to expiry.
• Both are quoted as an ‘index’ equal to 100 minus the
annualised discount rate expressed in percent.

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 US Futures quotations
• Recall from lecture 2 that for T-Bills with ‘n’ days to
maturity the cash price per $100 is:
n
Cash Price = 100 − × Discount Rate
360

• T-Bill Futures on:

– 90 day instrument
– Face value = $1m
Contract Price = 10,000(100 – 0.25 x Discount Rate)
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 Example:
• At settlement of a T-bill futures contract:
– the index on the futures contract is quoted as 93.05
– therefore the discount rate on physical T-bills is 6.95%.
• Contract settlement calculated as follows:

Contract Pr ice = 10000(100 − 0.25 × 6.95) = $982,625

(Note the similarity to the cash price of the
instrument.)

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 Bonds: Cash Price vs Quoted Price in
the US

• Treasury Bonds:
– cash price = quoted price + accrued interest

• Treasury Bond Futures:

– cash price = quoted futures price × conversion
factor + accrued interest

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 Bonds: Cash Price vs Quoted Price in
the US

The conversion factor:

• Arises because settlement occurs with the physical
delivery of a bond within certain parameters.

• The conversion factor is approximately equal to the

value of this bond on the assumption that the yield
curve is flat at 6% with semi annual compounding.

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