Q&A on Forward/Futures NCE 05 Anal Prolesos Dasa Haag 1 The Value of a Forward Contract as Time Passes Recall that the forward price of asset, that does not pay any dévidends duving the life of he contract, Js specified at time @ and for maturity T is Fy= Sw’ o where Sp is the t ne D price of the asset and + isthe rise free i forest rate with continwons com We the forward price at any time after time 0 und belore maturity same arguinent as before gives us the more general formula for the forward price based on the enrrent price Si, Fase, co) Question: What is Pp at time T? Solution: Using the formula, Fr = Spe? T= reduces to a spot contract So a forward contract with maturity 0 Example: A one-year ong forward contract on a non-dividend paying stock is entered into when the stock price is $10 and the -free interest rate is 10% per annum with continous compounding, What are the forward price and the initial value of the forward eoutra Solution: The forward price is given by iy = 40 x eM = 44.21 But il value of the forward co O because it costs toenter a forward. Question: Assume that six 1s Inter, the price of the stock is $15 and the risk-free still 10%, What are the current forward price for the same maturity and the value of the forward contract’? Answer: at 1 = 6/1 = 0.1.50 Fag oho Regarding the value of the contract at ¢ = 0.5, let’s compare our position in a long forward with a newly initiated long forward at time ¢ = 0.5 years. Using the numbers from our example, we get that the original long forward obligates us to buy the asset at maturity for Fy = $44.21 but someone who enters a long forward at time f for the same maturity T is obligated to buy the asset at time T for more, say Fi) = $47.31, s0 the holder of the original long forward would buy the assetcheaper by 47.81 —44.21 = 3.10 co date T. eel to the current (time f) forwaed deal for the: The difference F; ~ Fy represents the value of the original forward at time T because this is exactly +r would have to pay for the existing long forward so as to be equivalent lv higher forward price. ‘The value of the forward contract at how much a time ¢ ing. a new long forward wi its T-value 1 we get by dise Ses (Fi~ Fie XP) = (4731 — 44. 21)e-1 9 = 9.95, Question: What happens if we also enter a short position at time # with maturity Z7 Answer: Adding a short forward position at time, with the same maturity as the original long position fom time 0, is equivalent to elosing our original long forward position. Questi What is the totad payo|f at maturity T of this portfolio of tong and short forwards? Answer: We know the payoff at matn forward with delivery price F v T ofa long forward with delivery price Fy and a short Total payolf at time T = (Sr — Fa) +(Fi- Sr) = Fi- Fru. The total payoff t value of the forward at maturity T, ie. the time t-value we get by discounting. up with if we close onr original long, forward position is again the ‘To summarize: The t-value of a long forward with maturity T is given by i= Fi Fe T9 (Se TO — Gye" Je TO = $,— Seer, Cheek the above example, 45 — Ae?" = 2.95, So the time O-valuc is fy = $i ~ Sye™* = 0, and the time T-value is Fr = Sp ~ Sve" 2 Forwards on Assets with Continuously Paid Dividends 1d q be the asset price at time 4, the ni),and the isk-free interest rate (assumed ‘vield, respectively Dividend yield ¢ refers to the faet that over the time interval [I,t + Ad), the dividend paid by the asset at time t is Sight Question: What happens if we reinvest the dividends immediately back into the asset? Answer: If we have 1 share of the asst at time f, we can buy gAf more shares of the asset at Lime t using the dividend. So at ¢+ At, we have (1 +gA2) shares of the asset. ity T. Let’s equally split the matu ‘Now suppose the forward has a mat ity into NW subintervals, ie, ALS T/N,Question: How can we use the same strategy to find the forward price when the asset pays dividends continvonsly’? Answer: Ii we start withe shares of the asset, which will grow to 1 shaxe after time T. Again, buy now e units of the asset for a total cost of Sye and enter a short forward to sell 1 share of the asset at time T for a price of Fj, To avoid arbitrage, the cost today 1 hie of the known eash ist be equal to th present v y received at time TP! Soe T= PVE) = Fue" + Fy Suppose at time 0, wehave 1 share of the asset, Then with yield, at time At, weave 1 + gat shares, at time 2A¢, we have (I+ qAf)(1 + qf) = (1+ 4At)*, and at time T. we have (1+ qAO(L + gt) x x (1+ gAt) = (14 9d = (1+ gd) oP, as AL 90. To generalize, ifat time 0, we have e % shar of the asset, With reinvesting all the yields back in the asset, we have e-% x 7 = 1 share at time P. 3 The Forward Price for Continuous Dividends ‘fine the forward priee in the ease of continuons dividends. The strategy is to bny 1 share of asset at time 0 for Sy and enter into a short forward to sell this asset at time T for the forward price Fy, which is specified at time 0. so it isa known cash received at time T. In sum, at time 0 wehavea cost of §) (for obtaining 1 share of the asset) because it costs nothing to enter a forward contract and at time T we receive certain cash Fy. This strategy does not lead to any arbitrage only if the cost today is equal to the present vahwe (PV) of the known cash Fg received at time T: Sq = PV(Fy) = Foe ‘7 > Fa = Soe Question: How can we use the sau dividends continuously? strategy to find the forward price when the asset pays € wres of the asset, which will grow to 1 time T. A a Answer: If we siart with buy now e@ of the asset at time T for a price of Fj). To avoid arbitrage, the cost today must be equal to the present vah ‘of the asset for a total cost of Se enter a short forward to sell 1 share of the kuown cash Fy received at time T Soe = PV (Fa) = Foe "7 Fy= Soe!” 17.4 Homeworks for Weeks 1-2 1, A urader enters into a one: short forward contract to sell an asset for SLO when the spot price is $90. The spot price in one-year proves to be $95. (a) What is the trader's gain or loss from the forward on the matwity date? Draw the sgain/loss diagram for the trader. () What is the gain or loss of the buyer of this forward on the maturity date? Draw the sgain/loss diagram for the buyer. Solutions: (a) The undedying price incroases but is still less than the forward price 100, so the seller benefits. She can buy at $05 from the spot market and sells to the buyer of the forward contract at $100. The trader gains 100 ~ 95 = 85. Seles pay (b) The buyer loses, because he has to buy the asset ai $100 but can only sell it ai $95, He Jose $52. (a) What the are the main shorteomings of the forward contracts? (b) How are futures contracts designed to overcome these shortcomings? Solutions: (a) Liquidity and credit risk. Because of the non-standardized terms of forward contracts and no fixed spaces to trade, it is difficult to reverse a forward position in most for- ward markets. Because no one guarantees the performance af the eomnterparty, forward traders face significant counterparty default visk. (b) To deal with Tiquidlity, h exchanges. To deal with the eredit performance of every fates margin aceount is established. ros re trndid with st us and in f ‘k, clearinghouse: is intmduced to guarantee the ket {unet, To protect the clenringhonse, 3. Consider a coffee futures contract (37.500 Ibs per contract). The December contract was settled at $1.1675 per tb on 2nd September. Suppose we bought 1 December fitures on 2nd September (day 0). On the 4 succeeding trading days, the December contract settled at the following prices:81.1043, $1.1523, $1.2004, and $1.1650. Compute: (a) The gains and losses in these 1 days: Day _Gains/Loss 1 (11043 = 1.1675) x 87.500 = —82, 2 (11523 — 1.1043) x 37,500 = +81, 800 (1.1204 ~ 1.1523) < 37,500 = +81,803.75 4A (1.1650 ~ 1.2004) 37,500 = ~81.327.50. 70 (b) Ie the initial margin was $5,000 and tHe maintenance margin was $4,000 for each eoutract, compute the dollar value of the margin account after 4 days, assuming you earn no Interest in the account. Assuming no withdrawal of the amount above the initial margin (you ean assume oth- exwise) Day Gains /TLosses Margin Account Remark 1 am $5,000 Margin call of $2,370 2 481,800 3 $S1,808.75 $8,608, 4 -si.a7.50 87,278 00) Gainin buys 10 gold futures at $1,400/oz with maturity 1, Mark-to-Market Reduces Credit Risk: Ed in 250 days (contmet size 100 oz). Suppose the gold futures price for 250 days. (a) How much will Edwin pay at maturity without marking-to-markel How much will Edwin pay daily with marking-to-market? Solutions (a) (@) Without mark-to-market (MPM), the gold (futures) priee will be S1,350/oz. 50) «100% 10 = $50,000. Without mark-to-market (MTM), T. Edwin will lose (1400—. he has to pay $50,000 at T. This makes the default rate high. (b) With MTM, ie pays 0.2 x 100 x 10 = $200 daily. This significantly decreases the de fault vate (because the broker will close out the contract if Edwin does not top up when getting a margin call). 850, ng stock whose current pi aie the fair forward price o assuming 5% interest rate and one year (o maturity, How can you make an arbitrage profit. (i:c., net investment and positive, risk-free return) if forward price is 8 (a) The actu The fair forward price is Fy = Sye"™ = 50 x el! — g50.5 60) > Fy buy low sell high suggests that the forward is too high relative Consider the following cash aud carry strategy: Since Fy to stock. (1) Borrow 850 to buy one share of the sceurity in spot market and keep it to T. (2) Sell (or short) one forward contract (8) At T= 1, deliver the sceurity to close out the forward to get $53.50 and repay the Joan, ‘The cash flow of Cash and Carry is Strategy t=0 t=T Borrow 5) 50M) = 52.56 Buy the spot si Sr Sell the forward 0 Tot 0 festment now and risk-fiee positive profit at time T, an arbitrage! You have zero i(b) The actual forward prive is $51.61? Since P= 5161 < 52.56, the forward is too low relative to the stock. Considering the following reverse eash and earry strategy (J) Short sell the stock and lend the proceeds: (2) Buy one forward contract (3) Close ont the forward usi The cash flow is as: 1g your loan and cover the short in stock. Strategy =0 Short sale +500 Tend 50 Buy the forward 0-91.61 + Sp Total 0 5161 = 0.95, 6. Compute the fair forward price under the same assumptions as that the stock will ps negotiated. How ean yo the provious question except dividend of $2 five mouths from the date the forward couteaet is, make an arbitrage profit if (a) The actual forward price Py is $5141? T= 2¢-M*5/12 = $1.96. So the fair forward price is Fy = (50 — 1.96)e™"*! = $50.50. TF = 511, the forward price is to0 b strategy: (1) Borrow $50 to buy one share of the scenrity in the spot market and keep it toT (2) Leud the dividend when it is received; (3) Sell one forward contract relative to the stock, Consider the following (4) At T= 1, deliver the security to close ont the forward to gets $51 41 and repay the loan, The cash flow is as follows: Strategy Borrow a) ihe Buy the spot so 42 Sp Lend dividend = Q) 2_ e409 Sell the forwacd 0 0 SLA - Sp Total oo 06+ 5141 = 0.01 (b) The actnal forward price is $49.53? If Fy = 49.53 < 50.50, the forward is too low relative to stock. Consider the following reverse ensh and carry strategy: (2) Short sell the stock and lend the proceeds (2) Borrow $2 to pay the dividend in 5 months: (3) Buy one forward contracts; (4) Close ont the forward nsing your loan and cover the short in stack.Strategy t=5/12 1=T Short sell +50) Lend BO 0 abe 2 52.56 Borrow 0 $2 —gesx(tny2) = yy the forward 0) 0 W584 Sr Total 0 05256 ~ 2.06 — 49, iz 7. Compute the fair forward price for a one year forward contiact under the same assumptions ‘as in Question 5 except that the stock is expected to provide a continuous dividend yield of 20% per year. How can you make an arbitrage profit if 02 (a) (a) The actual forward price is $ ‘The fair forward priee is Fy= Sel” OF = 5yel05- 002) 51 5, TE Fy = 52.000 > 51.52, consider the following strategy (1) Borrow 500! = 49.01; (2) Buy ¢-°"* auares of stock: (3) Sell one forward contract; (1) Close ont the forward using the stock and cover tie loan. Strategy i=0 i=T Borrow 50e MP! = 49.01 Age — 51.52 Buy stock 50 MOT = 49.01 Sp Sell the forward 0 ~Sr Total 0 i) — 51.52 = 1.08 (b) The a forward price is $50.05? Since Fy = 50.05 < 51.52, consider the following strategy (1) Short sell shares af stock and lend the proceeds: (2) Buy one forward contracts (3) Close ont the forward using your loan and cover the short in stock. Strategy i=0 Short sell Be O21 = 4901 —Sy Lend le MP1 = 49.01 49.0164 = 51.52 Buy the forward 0 Sp — 5005 Total 0 51.52 — 50.05 = LAT8. Take the formulas for a forward (or futures, for our purposes) contract, What will happen to the forward price around the ex-dividend day, if the underlying asset (say, a stock) was to pay a dividend? Will the share price Why or why not? ange, if the dividend was announced well before? Answer: On the ex-dividend d ty; the share price will drop by the amount of the dividend if arbitrage is to be ruled out in the stock market, Simultaneously, the present vahie of the dividend T (on the ex-date) will also drop by the amount of the dividend. As a result, the futures or forward price will remain unchanged. Of course, if someone argnes that the fitures price must drop (or rise) on any given day due toa well-known, pre-announced dividend on te underlying (0 or any perfectly predictable event), he should recognize that thats ineonsistent with a temporal strategy of selling the futures just before and buying it just aller, leading to predictable profits with no investment, 9. Suppose the annual interest rate is 5%, compounded onee a year. The TBM stock is trading, at S185. Whot is the fair forward price of a forward coutraet which ealls for delivery of 1 share of IBM stock at: the end of one year? Constmuct arbitrage portfolies and analyze ensh lows to show that this is indeed the fair forward priee. Answer: The fair forward price is Fry = Soe"? = 1856 = 191.49, Suppose the forward price Fy is greater than $194.49. Consider the following strategy (1) Borrow 185 to buy one share of IBM in spot amarket and keep it to the end of one years (2) Sell (short) the forward: (8) At the end of one year, deliver the see Let's look at. the cash flow y Co close o 1 the forward and get. Fa. Stmteey i=0 (=T Borrow 18h 194.40 Buy stock =185 Sp Sell the forward 0 Fa ~ Sp Total o 194.49 So we see that the above portfolio has zero net inve ‘k-free, and positive return, which means that it isan arbitmge strategy. Therefore the forward price cannot be greater than 194.49, Similarly, we ean show that it is cannot be less than 194.49. Therefore, 194.49 inst be the fair forward priee,‘1 nondividend paying stock whose enerent pri assuming 5% interest rate and one year to maturity. Ts there any arhitmge ‘opportunity (i.c.,0 net investment and positive, risk-free retmen) if 32.052 Te the actual forward price Fy is 32.05, fest try to sell the forward. Then since the liability is to deliver the stock at T, we need to buy the stock at time 0. To finance this we need to borrow. Since we have to buy at the ask, s0 we need to borrow 30.125. The ph time T would be 30.125! = 3167. Since we are going to 2.05, we will be making 32.05-31.67=0.88 risk fee arbitrage probit. So in this ease is an arbitrage oppor! (a) The actual forwned price Fy interest ) al forward price Fs is 1.50? From (a) we know that we cannot do cash and carry to make an arbitrage profit since Le forward price 31.5) is wot enough Lo pay back te loa 0 So let's try the reverse eas Suppose we buy the forward. Then our liab be to pay the forward price at time T. Thus we need to short sell the stock at time 0 (at the bid). So we will have 29.875 at time 0 and will grow to 20875. = 31.41 But this is not sulfcient to pay the forward price. So in this case there is no arbitrage ‘opportunity. d carry strategy ity would 5 Homeworks for Weeks 3-4 1. Suppose you bought a six-month forward contract on vidend paying stock on uppose today is September 1 aud the stock price is $35 now. What is the value of his position’? L. The interest rate is 5%, the stock price on June 1 was $2: Answer: In this case, Sy = 25.7 = 0.05, = 0.5, and = 0.25. On dune 1, Fy = 25e!!%8%85 = $25.63. The fair forward price today F(O.25) = BeOS 02) — 835,44,So the value of his position is 0.25) = (85.44 — 25.63) gy 9, 2. Asa copper tube manufacture in Singapore, you will need 50,00) Ibs copper in December. ‘The current futures price is $0.7000 per Ib. The copper futures contract size is 25,000 Ibs. (a) How would you hedge? Buy 50,0007: (b) Ifthe December spot price is $0.7100, what is the net cost of the hedged copper? What if the December spot price is $0.6000? Ir the December spot price is $0.7100, then you will pay $0.7L00 per lb to buy eopper from the spot ‘on will gain 0.7100 — 0.7090 = 0.0010 from the fut position. So the net cost is $0.7090 per Ib. IF the December spot price is $0.6900, then you will pay $0.6900 per Ib to buy copper from the spot market, but you will lose 0.7090 ~ 0.6900 = 80.0190 from the futures position. So the net cost is again $0.7000 per Th. (©) Is the net cost with hed No. In the second case, it is more than without hedge. Hedging does not always improve onteame, but it reduees the fluctnation of outcome. ways less than that without hedge? A wholesaler will purchase 1.5 million gallons of gasoline on November 1 in the spot market and would like (o hedge on September 1, He hedges with crude oil futures (the e is 1,000 bbl). THe uses historical data to compute as = $0.0505 per gallon, op = $1.6/66) and p = 0.95. How many contracts should he buy or sell? Answer The optimal hedge eatio: 05 5 LNBLgatOn — 16 gattn ontract sige ne =o: He then calculates the number of futures contract as follows: eo = 08H gailon + 1.500,000altan a T0008 oe Therefore the optimal number of crude oil futures contract is 45. 4, Suppose that S&P 500 index value is eurrently at 1,605.00, ‘The continuously compounded 1% per year. The dividend yield is estimated at 2.25% per year. What's the futnnes price for a futnres contract that: matures in three months? rate ofinterest rate Answer: ln this example, we have Si = 1, 005.00,r = 0.05.q = 0.0225, and T = 0.25. So Fy = 1,605.00 89 21 616.07.5. Consider the October fu es coutract ou S&P 50). The multiplier for this contract is 250. Suppose the futures price is quoted at 1. or gain ifon the maturity day the S&P index is at (a) 1402.00 and (2) 1,603.70? 00, How much will a buyer of one contract lose Answer: Ion the (ourily day the S&°P index is at 1,402.00, then the will lose (1,553.00 — 1,402.00) « 250 = 3 17.750) per contract. Hou the maturity day the S&P index is at 1,603.70, then the buyer in this eoutract will make (1, 603.70 — 1,558.00) x 6. Suppose on July 28, the DATA index was at 14,650, the September furmirs was at 14,700, the December one was at 14,800, and the maturity dates were 56 and 154 days away, respeetively. ‘The risk-free rate is 5.10% (Assume there ace 360 days per year). () What would be between July 23. e fair futures price if we e DITA was vero. neo — 14,766.69. For the December ul the time the Dee For the $ iplember futures, Fy = M4, futures, Fy = 14, 650e 9141541500 _ 14,973.13, (b) What is the present value of the ividends that is embedded in the market price ofeach futures contract? Iguore transaction costs in your calculations. For the ave 14, 700 = (14, 650 — T)e'1%50/200, value of the future dividends that is embedded in the market price of this futures contract is I = 66.16. For the December futures, we have L1.800 = (14,650 ~ De091*154/300, So T= 169.38 eplember futures, we » the present 7. Asa portfolio manager, you have a portfolio worth $2,000,000 and decide to hedge a possible market downturn risk with the S&P futures for 4 anonths. Suppose S&P 500 index is 1,500.00, ‘the interest rate is 6%, the dividend yield on index is 4% and the portfolio = 1.5. Tow suiauy futures contracts should the manager trade? Buy or Sell? Answer: The cnerent futures price is 1.010210 4712 1. 510,08, ‘The contract price is ¥ = 250 x 1,530.30 = 377.5084. So the optimal number of S&P futures contract is |, 2.000.000 ‘You weed sell 8 contra8, Suppose that on Sep inber 1, UK firm agreed to buy 2 Boeing, 747 trom Bocin 1 at a price of $90m each. The September I spot exchange rate was S1.6730/L. The December futures was quoted at $1.6612/ (a) What was the exchange rate risk that this UK firm tneod? This in terms of pound, isk is that pound may depreciate against USD so that the firm has to pay more (h) Should it Long. or she sy futures contracts (the size of contrac It should short the fi that should be sold e futures into hedge this risk? How £6! ures in pound. Since the firm needs $180m, the number of contracts 500)? Explain why this position serves as a hedge. 180.000.0001 62.500 70 ‘The reason that this position is a hedge is that when pound depreciates, even though, ‘the firm has to use more pounds to buy dollars, itis going to gain from the drop in the pound price in its short fut jes position. (c) Compute the total costs tothe firm when the Dee. 1 spot exchange rate is $1.6500/ and when the Dec. 1 spot exchange rate is $1.6705/. In which case, the total costs ae lower without hedging? If the Dee. 1 spot exchange rate is $1,6550/£, then it needs 180,000. —— = 1,320.3 Tass = £108. 761,320.3 to buy the airplanes, but it would gain ITB x 62.500 x (1.6612 — 1.6550)/1.6550 = £405,996.98. So the total cost is £108, 355.332. If the D . L spot exchange rate is $1.6705/£, then it needs 180,000,000 fame = £107. 752.170 to buy the airplanes, but it would be 1734 62,5100 x (1.6705 — 16612) 1.0705 So the total cost is £108, 355, 514.8. The difference = £603, 314.81. 108,355, 514.8 — 108, 355,332.3 = 182.5 is due to rounding,