INTRODUCTION AND VALUATIONS OF FORWARDS
AND FUTURES
Session 4
GROUP PROJECTS
▷ BUSINESS OF THE ENTITY
▷ OBJECTIVE OF THE DERIVATIVE STRATEGY
EMPLOYED. HEDGING OR ARBITRAGE OR ANY
OTHER COMPLEX STRATEGY?
▷ DERIVATIVE INSTRUMENTS USED IN THE
STRATEGY. WAS IT APPROPRIATE FOR THE
OBJECTIVE AND LIKELY RISKS?
GROUP PROJECTS
▷ ANALYSES OF THE OUTCOME AND WHY IT
FAILED? WHAT ARE THE KNOWN UNKNOWNS
AND FINALLY WAS THERE ANY UNKNOWN
UNKNOWNS?
▷ PUT YOURSELF IN THE CEO/CFO SHOES AND
STATE WHAT WOULD YOU DO TODAY IN THAT
SITUATION AND WHY? OUTLINE EXPECTED
OUTCOME AND COGENT ARGUMENTS FOR THE
SAME. WHAT ARE THE RISKS TO YOUR
ASSESSMENT?
SESSION PLAN
▷ FORWARD AND FUTURES CONTRACT
INVESTMENT/ CONSUMPTION ASSET
SHORT SELLING
▷ A COMPARISON FORWARD AND FUTURES
▷ THEORETICAL PRICE OF FORWARDS AND FUTURES
MODELS WITH NO INCOME
KNOWN INCOME
YIELDS
▷ PRICING FORWARDS WITH RESIDUAL MATURITY
▷ FUTURE AND EXPECTED SPOT PRICES
LEARNING
▷ WHAT ARE FORWARD AND FUTURES CONTRACTS
AND HOW ARE THESE USED FOR RISK
MANAGEMENT.
▷ DIFFERENCE BETWEEN THE TWO
▷ RELATIONSHIP WITH SPOT PRICES
▷ PRICING FORWARDS UNDER ARBITRAGE AND NO
ARBITRAGE MODELS
▷ FOR VARIOUS ASSETS LIKE DEBT HAVING INCOME,
STORAGE COSTS AND CONVENIENCE YIELDS
FORWARDS AND FUTURES?
INVESTMENT/ CONSUMPTION ASSETS
1 INVESTMENT ASSETS
EQUITY/BONDS/FC/GOLD/SILVER
2 CONSUMPTION ASSETS
COPPER/ OIL/WHEAT/CORN
SHORT SELLING
▷ SELLING AN ASSET NOT OWNED
Interest is not paid on margin account unless collateral is in
the form of interest-bearing securities
EXAMPLE SHORT SELLING
▷ You anticipate poor oil demand and hence lower
crude oil prices.
▷ Short 1000 shares of ONGC @Rs.100 and close out
short position in 3 month when price is Rs. 90.
▷ ONGC paid a dividend of Rs. 3 during these 3
months
▷ What is your profit?
FORWARD CONTRACT
▷ A forward contract is a COMMITTMENT to purchase at
a future DATE a given amount of a commodity or an
ASSET at a PRICE agreed TODAY
A FORWARD CONTRACT
▷ CUSTOMISED 2 PARTIES
▷ OTC
▷ NO MONEY CHANGES HANDS TILL MATURITY
▷ NON-TRIVIAL COUNTERPARTY RISK
EXAMPLE
▷ SOYFIT A SOYA MANUFACTURER NEEDS 1000
TONNES OF SOYABEAN 3 MONTHS FROM NOW SAY
OCTOBER 2020.
▷ SPOT PRICE IS RS. 37600 PER TONNE
▷ FORWARD OCT CONTRACT RS. 38000
▷ THERE IS A SUDDEN POSITIVE SHIFT EXPECTED IN
SOYA DEMAND AND COMPETITION IS TOUGH.
VIRTUALLY ZERO PRICING POWER.
PROBLEMS OF FORWARDS
▷ ILLIQUIDITY
▷ COUNTER PARTY RISK
FUTURES CONTRACT
▷ A FUTURES contract is an exchange traded,
STANDARDISED, forward like contract that is
MARKED TO MARKET on a daily basis. Can be used
to take long or short position on the underlying asset.
FUTURES CONTRACT
▷ STANDARISED
UNDERLYING
QUANTITY
EXPIRY
▷ EXCHANGE TRADED
▷ GAINS OR LOSSES ARE SETTLED DAILY
▷ UPFRONT MARGIN
▷ NO COUNTERPARTY RISK AS CLEARING
CORPORATION PROVIDES GUARANTEE
COMPARISON OF FUTURE/FORWARD
FUTURES FORWARDS
REGULATED UNREGULATED
ORGANISED EXCHANGE TRADINHG TRADES IN OTC MARKET
STANDARISED CONTRACTS CUSTOMISED
LIQUIDITY HIGH ILLIQUID AND NO SECONDARY MARKET
RANGE OF DELIVERY DATES SINGLE DELIVERY DATE
NO COUNTER PARTY RISK CREDIT RISK PRESENT
DAILY SETTLED ON MATURITY
ANONYMOUS TRADING KNOWN TRADERS
RISK MANAGEMENT IS ONLINE REALTIME COLLATERAL ONLY
LOW TRANSACTION COST HIGH COSTS
THEORETICAL PRICE OF
FORWARDS AND FUTURES?
FORWARDSARE EASIER TO PRICE
THAN FUTURES DUE TO NON MTM
ASSUMPTIONS
1. NO ARBITRAGE WORLD
2. SIMPLE COST OF CARRY MODEL
ASSUMPTIONS OF PERFECT COMPETITION
TRANSACTION COST IS ZERO
COST OF BORROWING IS SAME
COST OF STORAGE IS KNOWN
ALL PARTICIPANTS FACE SAME TAX RATE
NOTATIONS
▷ S(0)=PRICE OF THE ASSET UNDERLYING THE
CONTRACT TODAY
▷ F(0)=FORWARD OR FUTURES PRICE TODAY
▷ T= TIME UNTIL DELIVERY IN YEARS
▷ r = ZERO-COUPON RISK-FREE RATE OF INTEREST
PER ANNUM
PRICE MODEL 1: COST OF CARRY
▷ CREATE 2 EQUIVALENT PORTFOLIOS OF STOCK XYZ
▷ LONG STOCK IN FORWARD MARKET
▷ ALTERNATIVELY BUY STOCK IN SPOT BY
BORROWING AND CARRY IT FOR FUTURE. PAY THE
LENDER BACK.
COST OF CARRY MODEL
DATE PORTFOLIO A PORTFOLIO B
LONG FORWARD LONG STOCK
1/1/20 0 BORROW S(0) = +100
BUY THE STOCK = -100
31/12/20 PAY BACK –100*(1+.06)^1
106
CASH 106 100* (1+06)^1
FLOW
106 = 100 (1+06)^1
S(0)/ (1+r)^T =F(0)
COST OF CARRY MODEL
DATE PORTFOLIO A PORTFOLIO B
LONG FORWARD LONG STOCK
0 PAY RS 0 WITH A BORROW S(0) = +S(0)
FORWARD PRICE F(0) BUY THE STOCK = -S(0)
T PAY F(0) PAY BACK S(0)(1+r)^T
OWN ASSET OWN ASSET
CASH F(0) S(0)(1+r)^T
FLOW
F(0) = S(0)(1+r)^T
F(0)/ (1+r)^T =S(0)
MODEL WITH NO INCOME
▷
Where F(0)= Futures Price today
S(0) = Spot Price Today
r= risk free interest rate
T= time period of future or forward contract
EXAMPLE 5.1
▷
CONSIDER A 4 MONTH FORWARD CONTRACT TO BUY
A ZERO-COUPON BOND THAT WILL MATURE 1 YEAR
FROM TODAY. CURRENT PRICE OF THE BOND IS
Rs.930.
RISK FREE RATE 7.5%
COMPUTE THE FORWARD PRICE
F(0) = Rs. 953.54
PORTFOLIO A AND B WITH
BONDS: MODEL 2
▷ PORTFOLIO A
LONG MARKET TRADED FORWARD
▷ PORTFOLIO B
LONG STOCK AND SHORT BONDS
TWO DATES
THREE SECURITIES
CONTRACT ENDS ON DELIVERY CASH SETTLED
BORROW OR LEND FUNDS AT RISK FREE RATE WHATEVER
MODEL ASSUMPTIONS
1. NO MARKET FRICTIONS
2. NO CREDIT RISK OR DEFAULT RISK
3. COMPETITIVE AND WELL FUNCTIONING MARKETS
4. NO INTERMEDIATE CASH FLOWS
5. NO ARBITRAGE OPPORTUNITIES
VALUATION WITH BONDS
DATE PORTFOLIO A PORTFOLIO B
LONG FORWARD LONG STOCK AND SHORT
BOND
0 PAY RS 0 WITH A PAY S(0) BUY THE STOCK = (-)
FORWARD PRICE F(0) S(0)
SHORT ZERO COUPON BOND
TO BORROW
PAY NOW F(0)/(1+r)^T
0 -S(0)+ F(0)/(1+r)^T
0 = - S(0)+F(0)/(1+r)^T
VALUATION WITH BONDS
DATE PORTFOLIO A PORTFOLIO B
LONG FORWARD LONG STOCK AND SHORT
BOND
0 PAY RS 0 WITH A PAY S(0) BUY THE STOCK = (-)
FORWARD PRICE F(0) S(0)
SHORT ZERO COUPON BOND
TO BORROW
PAY NOW F(0)/(1+r)^T
T S(T)- F(0) S(T) - F(0)
S(T)- F(0) -S(0)+ F(0)/(1+r)^T+S(T)- F(0)
S(T) - F(0) = -S(0) + F(0)/(1+r)^T + S(T) – F(0)
0 = - S(0)+F(0)/(1+r)^T
ARBITRAGE WORLD
ARBITRAGE MODEL
▷
Where F(0)= Futures Price today
S(0) = Spot Price Today
r= risk free interest rate
t= time period of future or forward contract
MARKET SCENARIO
▷
SCE 1 F(0) >
SCE 2 F(0) <
SCE 3 F(0) =
SITUATION
Spot Price of a stock A is Rs. 100
Risk free Interest rate, Zero coupon bond yield 6%
Contract is Annual
Transactions costs are Rs. 0.05%
Statutory levies like STT etc. NIL
Anuj placed a forward buying order at Rs. 107.9
What would you like to do?
ASSETS WITH PREDICTABLE INCOMES
1 A DIVIDEND PAYING STOCK
2 INTEREST YIELDING BONDS
EXAMPLE 5.5
A FORWARD CONTRACT TO BUY A COUPON BEARING
BOND, CURRENT PRICE IS Rs. 900. CONTRACT
MATURES IN 9 MONTHS. COUPON PAYMENT OF RS. 40
IS EXPECTED AFTER 4 MONTHS. INTEREST RATES FOR
4/9 MONTHS ARE 3% AND 4 % RESPECTIVELY.
ASSUME FORWARD PRICE IS Rs. 910 or Rs. 870
PV OF INTEREST IS RS. 39.60
EXAMPLE 5.5
SUPPOSE FORWARD PRICE IS HIGHER AT RS. 910: BUY
THE BOND, SELL FORWARD
PV OF COUPON 39.60
BORROW 39.60 AT 3% FOR 4 MONTHS AND 860.40 AT 4%
FOR 9 MONTHS
AMOUNT OWED BY INVESTOR IS
RS. 886.60 i.e., 860.40*e^0.04*0.75
PROFIT = 910-886.60 = 23.40
EXAMPLE 5.5
SUPPOSE FORWARD PRICE IS LOW AT RS. 870: SELL
THE BOND, BUY FORWARD
GET RS. 900 BY SELLING THE BOND
PV OF COUPON 39.60
INVEST 39.60 AT 3% AND 860.40 AT 4% FOR 9 MONTHS
BUY THE BOND AND SELL FORWARD
RS. 886.60 i.e., 860.40*e^0.04*0.75
PROFIT = 886.60-870 = 16.60
ASSETS WITH KNOWN INCOME
▷
Where F(0) = Futures Price today
S(0) = Spot Price Today
I = Present value of cash flow or income
r = risk free interest rate
T = time period of future contract
F(0) = (900-39.60)
= 886.603
ASSETS WITH KNOWN YIELDS
1 INTEREST YIELDING BONDS
INCOME IS KNOWN AND EXPRESSED AS A
PERCENTAGE OF THE ASSET PRICE AT THE TIME
THE INCOME IS PAID. FOR EXAMPLE
BOND YIELD
STOCK INDEX YIELD (DIVIDEND YIELD)
EXAMPLE 5.6
▷
CONSIDER A 6 MONTH CONTRACT ON AN ASSET THAT
IS EXPECTED TO PROVIDE INCOME EQUAL TO 2% OF
THE ASSET PRICE DURING A 6 MONTH PERIOD. RISK
FREE RATE r is 10% AND ASSET PRICE Rs. 250 AND 4%
SEMI ANNUAL RATE IS 0.0396 CONTINUOUS
COMPOUNDING
F(0) WORKS OUT TO RS. 257.6652
ASSETS WITH KNOWN YIELD
▷
Where F(0) = Futures Price today
S(0) = Spot Price Today
q = yield per annum
r = risk free interest rate
T = time period of future contract
EXAMPLES ARE FUTURE PRICES OF STOCK INDICES
THEORETICAL PRICE OF FORWARDS
WITH RESIDUAL MATURITY?
VALUING FORWARD CONTRACT
▷
Where f = Value of the forward contract today
F(0) = Forward price of the contract today
K = Delivery price of the contract at the time
of negotiation
r = t year risk free interest rate
T= delivery date t years from today
VALUING FORWARD CONTRACTS
DATE SECURITY A SECURITY B
LONG FORWARD FORWARD CONTRACT TO
CONTRACT AT T SELL ASSET FOR F(0) AT TIME
T
0 0 0
T S(T)-K F(0) -S(T)
S(T)-K F(0)-S(T)
TOTAL CERTAIN CASH FLOWS AT TIME T = F(0)-K
TODAY’S VALUE = (F(0)-K)
EXAMPLE 5.4
A▷ LONG
FORWARD CONTRACT ON NON-DIVIDEND
PAYING STOCK HAS 6 MONTHS TO MATURITY. R IS
10%, STOCK PRICE RS. 25 AND DELIVERY PRICE RS. 24.
S(0)=25, r= 0.10, T=0.5, and K=24
F(0) WORKS OUT TO RS. 26.28
Value of Forward Contract= (26.28-24)
or Rs. 2.1688 or 2.17
VALUING FORWARD CONTRACT
▷
BY SUBSTITUTING VALUE OF F(0) IN THE EQUATION
f = (F(0)-K)
CONTRACT KNOWN INCOME
▷
WHERE f = Forward Price
S(0)= Spot Price today
I = Known Income
K = Forward price at intermediate time
ARE FUTURES AND FORWARD
PRICES SAME?
YES
NO
MAYBE
RELATION
BETWEEN FUTURE AND SPOT PRICES IS COST OF
CARRY
STOCK = r
INCOME = r–d
COMMODITY = r – q + u
D= Dividend or bond income
q = Convenience yields
u= Storage Costs
RISK TRANSFER HYPOTHESIS
KEYNES HICKS HYPOTHESIS
CELEBRATED THEORY OF NORMAL
BACKWARDATION AS HEDGERS ARE SHORT AND
TRANSFERRING RISK TO SPECULATORS, MUST
COMPENSATE THEM FOR ASSUMING THE RISK
APPLICATIONS
FUTURES AND FORWARDS
1. HEDGING
2. ARBITRAGE
3. SPECULATION
“
▷ KIDDER PEABODY STRIPS AND BONDS
FUTURE TRADING-JOSEPH JETT A
TRADER
FUTURE PRICES AND EXPECTED
SPOT PRICES
MARKET’S AVERAGE OPINION ABOUT WHAT SPOT
PRICES AT FUTURES TIME WILL BE AS EXPECTED
SPOT PRICE
“
▷ KEYNES AND HICKS ARGUED THAT
FUTURE PRICES WOULD BE BELOW THE
EXPECTED SPOT PRICE AS A
COMPENSATION FOR ASSUMPTION OF
RISK
KEY TAKEAWAY
1. AT TIMES EVEN LARGE INSTITUTIONS CAN GET THE
SIMPLE CONCEPTS WRONG.
2. FORWARD AND FUTURES PRICES DIVERGE IN REAL
LIFE THOUGH SAME IN THEORY. THIS PRESENTS AN
OPPORTUNITY.
3. KEY IS UNDERSTANDING COUNTER PARTY OR
CREDIT RISK IN FORWARDS
CONCEPT FOR THE DAY
VALUATION OF DERIVATIVES IS BASED ON
BUILDING RISKLESS PORTFOLIOS WITH SAME
CASH FLOWS
