Options, Futures, and Other Derivatives

Tenth Edition

Chapter 5
Determination of
Forward and
Futures Prices

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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)
• Consumption assets are assets held primarily for consumption
(Examples:copper, oil)

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Short Selling (Page 108--109) (1 of 2)
• Short selling involves selling securities you do not own
• Your broker borrows the securities from another client and sells them
in the market in the usual way

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Short Selling (2 of 2)
• 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

T: Time until delivery date

r: Risk-free interest rate for maturity T

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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 nondividend-paying stock is $40
– The 3-month forward price is US$39
– The 1-year US$ interest rate is 5% per annum (continuously
compounded)
• Is there an arbitrage opportunity?

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The Forward Price
If the spot price of an investment asset is S0 and the futures price for a
contract deliverable in T years is F0, then

F0 = S0erT

where r is the T-year risk-free rate of interest.

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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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 (page 113, equation 5.2)
F0 = (S0 – I )erT

where I is the present value of the income during life of forward

contract

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When an Investment Asset Provides a
Known Yield (Page 115, equation 5.3)
F0 = S0 e(r–q )T

where q is the average yield during the life of the contract (expressed
with continuous compounding)

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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

• Suppose that K is the delivery price and F0 is the forward price for a
contract that would be negotiated today

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Valuing a Forward Contract (pages 115-117)
• 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 is
(F0 – K )e–rT
– the value of a short forward contract is
(K – F0 )e–rT

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Forward vs Futures Prices
• When the maturity and asset price are the same, forward
and futures prices are usually assumed to be equal.
(Eurodollar futures are an exception)
• In theory, when interest rates are uncertain, they are
slightly different:
– A strong positive correlation between interest rates and the asset
price implies the futures price is slightly higher than the forward
price
– A strong negative correlation implies the reverse

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Stock Index (Page 118-120) (1 of 2)
• Can be viewed as an investment asset paying a dividend yield
• The futures price and spot price relationship is therefore
F0 = S0 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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Stock Index (2 of 2)
• For the formula to be true it is important that the index represent an
investment asset
• In other words, changes in the index must correspond to changes in
the value of a tradable portfolio
• The Nikkei index viewed as a dollar number does not represent an
investment asset (See Business Snapshot 5.3, page 119)

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Index Arbitrage (1 of 2)
• 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 (2 of 2)
• Index arbitrage involves simultaneous trades in futures and many
different stocks
• Very often a computer is used to generate the trades
• Occasionally simultaneous trades are not possible and the theoretical
no-arbitrage relationship between F0 and S0 does not hold (see
Business Snapshot 5.4 on page 120)

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Futures and Forwards on Currencies
(Page 120-123)

• A foreign currency is analogous to a security providing a yield

• The yield is the foreign risk-free interest rate

• It follows that if rf is the foreign risk-free interest rate

( r  r f )T
F0 S 0 e

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Figure 5.1: Explanation of the
Relationship Between Spot and Forward
1000 units of
foreign currency
(time zero)

rf T
1000e units of
1000S0 dollars
foreign currency at time zero
at time T

rf T 1000S0erT
1000 F0 e
dollars at time T
dollars at time T

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Consumption Assets: Storage is Negative
Income
F0 ≥ S0 e(r+u )T
where u is the storage cost per unit time as a percent of the asset value.
Alternatively,
F0 ≥ (S0+U )erT
where U is the present value of the storage costs.

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The Cost of Carry (Page 126-127)
• 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

• The convenience yield on the consumption asset, y, is defined so that

F0 = S0 e(c–y )T

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Futures Prices & Expected Future Spot
Prices (Page 127--129) (1 of 2)
• 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 kT
F0 e e  E ( ST )
or
F0 E ( ST )e ( r  k )T

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Futures Prices & Future Spot Prices
(2 of 2)

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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Copyright

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