Chapter 5 Determination of Forward and Futures Prices

Short Selling
Short Selling is the sale of a security that is not owned by the seller, or that the
seller has borrowed. Short selling is motivated by the belief that a security's price will
decline, enabling it to be bought back at a lower price to make a profit.
Investors need to maintain a margin account with the broker that they borrow
money from. The margin account guarantees that the investor will not walk away
from the short position if the share price increases.
Forward Contracts
The easiest forward contract to value is one written on an investment asset that
provides the holder with no income. A forward price is the predetermined delivery
price for an underlying commodity, currency or financial asset decided upon by the
long (the buyer) and the short (the seller) to be paid at predetermined date in the
future. At the inception of a forward contract, the forward price makes the value of the
contract zero.
Consider a forward contract on an investment asset with price S
0
. The
relationship ship between the forward price, F
0
, risk free rate r, and S
0
is
0
=
0

.
When there is a known income I (which includes dividendsetc), the forward
contract price is
0
= (
0
)

.
Consider the situation where the asset underlying a forward contract provides a
known yield rather than a known cash income. This means that the income is known
when expressed as a percentage of the assets price at the time the income is paid.
Define q as the average yield per annum on an asset during the life of a forward
contract with continuous compounding. It can be shown that
0
=
0

()
.
Valuing Forward Contracts
The value of a forward contract at the time it is first entered into is zero. At a
later stage, it can be positive or negative. It is important for banks and institutions to
value the contract each day, also known as marking to market.
At the beginning of the life of the forward contract, the delivery price, K, is set
equal to the forward price The delivery price is the price at which one party agrees to
deliver the underlying commodity and at which the counterparty agrees to accept
delivery. In forward contracts, the forward price and the delivery price are identical
when the contract begins, but as time passes, the forward price will fluctuate and the
delivery price will remain constant. A general result, applicable to all long forward
contracts, is = (
0
)

. To see why this is correct, compare a long forward

contract that has a delivery price of F
0
versus another with delivery price K. The
difference between the two is only in the amount that will be paid for the underlying
asset at time T. For contract one, this is F
0
. For the second contract , this is K. Thus,
there is a cash outflow difference of F
0
K at time T, which translates to a difference
of (
0
)

today. The contract with delivery

0
is this less valuable than
contract with delivery K by (
0
)

. Since the value of a contract with

delivery price of F
0
must be zero, it follows that the value of a contract with a delivery
price K equals (
0
)

. Similarly, the value of a short forward contract with

delivery price K is (
0
)

.
Since
0
=
0

and = (
0
)

, substituting gives the value of a

forward contract as =
0

.
If the long forward contract provides a known income with present value I, the
value of the contract is =
0

.
If the long forward contract on an investment asset provides a yield rate of q, the
value of the contract is =
0

.
When the underlying asset S is strongly positively correlated with interest rates,
futures prices will tend to be slightly higher than forward prices since they are settled
daily. When they are negatively correlated, forward prices will be higher.
Futures Prices of Stock Indices
A stock index can be regarded as the price of an investment asset that pays
dividends. The investment asset is the portfolio of stocks underlying the index, and
the dividends paid by the investment asset (each specific portfolio/stock) are the
dividends that would be received by the holder of this portfolio. If q is the dividend
yield rate, the futures price is given by
0
=
0

()
.
Index Arbitrage
If
0
>
0

()
, profits can be made by buying the stocks underlying the
index at the spot price (i.e. for immediate delivery) and shorting the futures contracts.
These strategies are known as index arbitrage.
Forward and Futures Contracts on Currencies
Consider forward and futures foreign currency contracts from the perspective of
a US investor. The underlying asset is one unit of the foreign currency. Define the
variable S
0
as the current spot price in US dollars of one unit of the foreign currency
and F
0
as the forward or futures price in US dollars of one unit of the foreign currency.
A foreign currency has the property that the holder of the currency can earn interest at
the risk-free interest rate prevailing in the foreign country. For example, the holder
can invest the currency in a foreign-denominated bond. Define r
f
as the value of the
foreign risk-free interest rate when money is invested for time T. The variable r is the
US dollar risk-free rate when money is invested for this period of time.
The relationship between F
0
and S
0
is
0
=
0

()
. The reason this is true
can be understood by arbitrage. Suppose that an individual starts with 1,000 units of
the foreign currency. There are two ways it can be converted to dollars at time T. One
is by investing it for T years at r
f
and entering into a forward contract to sell the
proceeds for dollars at time T. This generates

0
dollars. The other is by
exchanging the foreign currency for dollars in the spot market and investing the
proceeds for T years at rate r. This generates
0

dollars. In the absence of

arbitrage opportunities, the two strategies must give the same result, which means

0
=
0

, so
0
=
0

)
.
The equation for forward price of a foreign currency is identical to the one for
dividends, with dividends q replaced by r
f
. A foreign currency can be regarded as an
investment asset paying a known yield. The yield is the risk-free rate of interest in the
foreign currency. For instance, suppose the interest rate on British pounds is 5% per
annum. To a US investor the British pound provides an income equal to % of the
value of the British pound per annum. In other words it is an asset that provides a
yield of 5% per annum.
Futures Prices and Expected Future Spot Prices
The spot price and futures price are expected to converge at maturity. Thus, if the
expected spot price is less than the futures price, currently, then the market must be
expected the futures price to decline, which means traders with short positions gain
and traders with long positions lose. The opposite occurs for then the expected spot
price is greater than the futures price.