Derivatives (ECONM3017)

Lecture Two: Forwards and Futures I

(Pricing Contracts)

Nick Taylor
nick.taylor@bristol.ac.uk

University of Bristol

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Table of contents

1 Learning Outcomes

2 General Information

3 Cost of Carry Model

4 Futures Prices and Expectations

5 Hedging Using Futures

6 Summary

7 Reading

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Learning Outcomes

At the end of this lecture you will be able to:

1 Understand the basic mechanics of futures markets.
2 Price various types of forward and futures contracts.
3 Understand why theoretical prices equal market prices (arbitrage proofs).
4 Describe the relationship between futures prices and expected future spot
prices.
5 Understand the concept of hedging.

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General Information

Futures Contract Specifics

The following information is specified in each contract:
The asset (including quality if appropriate).
The contract size.
Delivery arrangements.
Delivery months.
Price quotes.
Price limits and position limits.

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General Information

Daily Settlement and Margins

The following process is undertaken when buying futures contracts:
Brokers require investors to deposit funds into a margin account.
When the contract is opened investors deposit an initial margin (equal
to a proportion of the contract size).
The margin account is adjusted at the end of each trading day
(marking to market the account).
A lower limit (the maintenance margin) is placed on the margin
account.
If the balance in the margin account falls below the maintenance
margin then a margin call is made (these extra funds are called
variation margin).

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General Information (cont.)

Daily Settlement and Margins (cont.)

Example
An investor takes a long position in two December gold futures contracts on
June 5. The contract size is 100 oz, the futures price is $600/oz, the margin
requirement is $2000/contract ($4000 in total), and the maintenance margin is
$1500/contract ($3000 in total).
Futures Daily gain Cumulative Margin account Margin
price (loss) gain (loss) balance call
Day ($) ($) ($) ($) ($)
600.00 4000.00
June 5 597.00 600.00 600.00 3400.00
.. .. .. .. ..
. . . . .
June 13 593.30 420.00 1340.00 2660.00 1340.00
.. .. .. .. ..
. . . . .
June 19 587.00 1140.00 2600.00 2740.00 1260.00
.. .. .. .. ..
. . . . .
June 26 592.30 260.00 1540.00 5060.00

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General Information (cont.)

Newspaper Quotes
In newspapers (and on webpages; see, e.g., www.nymex.com), you will be
see the following information (in additional to the open, intraday high, and
intraday low prices):
Settlement Price: the trade price immediately prior to the close of
trading.
Open Interest: the total number of contracts outstanding (i.e., the
number of long, or short, positions).

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General Information (cont.)

Trader Types (revisited)

Two types of traders execute trades: commission brokers and locals.
Order Types
A number of different orders can be placed:
Market order: execute immediately at best price available.
Limit order: execute only at specified price or better.
Others: stop-loss, stop-limit, market-if-touched, discretionary,
time-of-day, good-till-cancelled, fill-or-kill orders.

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General Information (cont.)

Forward vs. Futures Contracts

The key differences between forward and futures contracts can be
summarised as follows:

Forwards Futures
Private contract between 2 parties Exchange traded
Non-standard contract Standard contract
Usually 1 specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final cash settlement usually Contract usually closed out prior to
occurs maturity
Some credit risk Virtually no credit risk

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Cost of Carry Model

Assumptions
The following assumptions are required:
1 No transaction costs.
2 Short selling is permitted.
3 All investors face the same tax rate on trading profits.
4 Borrowing and lending rates are equal.

5 Arbitrage opportunities occur and are instantly taken.

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Cost of Carry Model (cont.)

Case One (no income)

The theoretical price of a forward contract on an asset that provides no
income is given by
F = Se rT ,
where F is the (current) forward price at time 0, S is the (current) spot
price at time 0, r is the risk-free interest rate, and T is the maturity date of
the contract.

Note that if F 6= Se rT then an

arbitrage opportunity will exist.

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Cost of Carry Model (cont.)

Case One (no income, cont.)

If F > Se rT then:

Terminal Value
Action Initial Value ST F ST > F
Long asset S ST ST
Short forward 0 (ST F ) (ST F )
Borrow S Se rT Se rT
Total 0 F Se rT > 0 F Se rT > 0

If F < Se rT then:

Terminal Value
Action Initial Value ST F ST > F
Short asset S ST ST
Long forward 0 ST F ST F
Lend S Se rT Se rT
Total 0 Se rT F > 0 Se rT F > 0

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Cost of Carry Model (cont.)

Case Two (known income)

The theoretical price of a forward contract on an asset that provides a
known income is given by

F = (S I )e rT ,

where I is the present value of the income received during the life of the
contract. When an asset incurs storage costs, then I becomes a negative
income.

Note that if F 6= (S I )e rT then an

arbitrage opportunity will exist.

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Cost of Carry Model (cont.)

Case Two (known income, cont.)

If F > (S I )e rT then:

Terminal Value
Action Initial Value ST F ST > F
Long asset S ST + Ie rT ST + Ie rT
Short forward 0 (ST F ) (ST F )
Borrow S Se rT Se rT
Total 0 F (S I )e rT > 0 F (S I )e rT > 0

If F < (S I )e rT then:

Terminal Value
Action Initial Value ST F ST > F
Short asset S ST Ie rT ST Ie rT
Long forward 0 ST F ST F
Lend S Se rT Se rT
Total 0 (S I )e rT F > 0 (S I )e rT F > 0

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Cost of Carry Model (cont.)

Case Three (known yield)

The theoretical price of a forward contract on an asset that provides a
known yield is given by
F = Se (r q)T ,
where q is the (average) yield per annum on an asset during the life of the
forward contract. This yield represents an income (or cost) expressed as a
percentage of the asset price, e.g., a dividend yield.

Note that if F 6= Se (r q)T then an

arbitrage opportunity will exist.

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Cost of Carry Model (cont.)

Case Three (known yield, cont.)

If F > Se (r q)T then:

Terminal Value
Action Initial Value ST F ST > F
Long asset Se qT ST ST
Short forward 0 (ST F ) (ST F )
Borrow Se qT Se (r q)T Se (r q)T
Total 0 F Se (r q)T > 0 F Se (r q)T > 0

If F < Se (r q)T then:

Terminal Value
Action Initial Value ST F ST > F
Short asset Se qT ST ST
Long forward 0 ST F ST F
Lend Se qT Se (r q)T Se (r q)T
Total 0 Se (r q)T F > 0 Se (r q)T F > 0

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Cost of Carry Model (cont.)

A Generalisation
If the risk-free interest rate is constant, and the same for all maturities, then
the forward price of a contract with a certain delivery date is the same as
the futures price of a contract with the same delivery date.

Note that other factors will also cause

a divergence between forward and
futures prices; viz., taxes, transaction
costs, the treatment of margins, credit
risk, and liquidity. However, for most
purposes, it is safe to assume that
forward and futures prices are equal.

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Cost of Carry Model (cont.)

Applications
Stock index futures
This type of contract tracks changes in the value of a hypothetical
portfolio of stocks, e.g., S&P 500, Nikkei 225 Index, and the FTSE 100.
These futures are settled in cash.
Dividends paid by securities in the portfolio are received by the holder
of the portfolio. Therefore, these futures contracts are priced as in Case
Three above.

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Cost of Carry Model (cont.)

Applications (cont.)
Stock index futures (cont.)

Example
Consider a 3-month futures contract on the S&P 500. Suppose that the stocks
underlying the index provide a dividend yield of 1% per annum, that the current
value of the index is 1300, and that the continuously compounded risk-free
interest rate is 5% per annum. In this case, r = 0.05, S = 1300, T = 0.25, and
q = 0.01. Therefore, the theoretical futures price is given by

F = 1300e (0.050.01)0.25 = 1313.07.

Note that if F 6= 1313.07 then index arbitrage would be undertaken until the
equality held.

Warning: Index arbitrage involves buy or selling all the stocks within the index.
Is this realistic? Can this particular aspect of the arbitrage process be achieved
in a more simplistic manner?

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Cost of Carry Model (cont.)

Applications (cont.)
Forward and futures contracts on currencies
This type of contract assumes that the underlying asset is one unit of
the foreign currency.
The current spot price in dollars of one unit of the foreign currency is S.
The forward (or futures) price in dollars of one unit of the foreign
currency is F .
As foreign currency gives the holder of the currency the right to earn
interest at the risk-free rate prevailing in the foreign country, then these
contracts are priced as in Case Three above, with q replaced by the
foreign interest rate rf .

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Cost of Carry Model (cont.)

Applications (cont.)
Forward and futures contracts on currencies (cont.)

Example
If the 2-year interest rates in Australia and the United States are 5% and 7%,
respectively, and the spot exchange rate between the Australian dollar (AUD)
and the US dollar (USD) is 0.6200 USD per AUD, then the 2-year forward rate
should be
F = Se (r rf )T = 0.62e (0.070.05)2 = 0.6453.
Suppose the 2-year forward rate is say 0.6300, then an arbitrageur can:
Terminal Value
Action Initial Value ST F ST > F
Borrow AUD 0.6200e rf T ST ST
Long forward 0 ST 0.6300 ST 0.6300
Lend USD 0.6200e rf T 0.6453 0.6453
Total 0 0.0153 0.0153
Note: Take reverse positions if the observed (market) forward price is greater
than the theoretical price.

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Cost of Carry Model (cont.)

Applications (cont.)
Futures on commodities
This type of contract assumes that the underlying asset is a commodity
(e.g., gold).
They differ from other futures contracts in that the underlying asset
incurs storage costs.
Note that some commodities such as gold and silver earn income when
they are held (referred to as the gold lease rate).

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Cost of Carry Model (cont.)

Applications (cont.)
Futures on commodities.
The presence of non-zero storage costs means that the following
formulae must be used to price such futures contracts:

F = (S + U)e rT ,

where U is the present value of all the storage costs (net of income)
during the life of the forward contract.
If storage costs are proportional (to the underlying asset value) then
the following formulae must be used:

F = Se (r +u)T ,

where u is the proportional storage cost.

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Cost of Carry Model (cont.)

Applications (cont.)
Futures on commodities (cont.)

Example
Consider a 1-year futures contract on an investment asset with no income. It
costs $2 per asset to store, with the payment made at the end of the year.
Assume that the spot price is $450 per unit and the risk-free rate is 7% per
annum for all maturities. The present value of storage costs is

U = 2e (0.071) = $1.8648.

The theoretical futures price is given by

F = (S + U)e rT = (450 + 1.8648)e (0.071) = $484.6287.

If F 6= $484.6287 then an arbitrage opportunity will be present.

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Cost of Carry Model (cont.)

Applications (cont.)
Futures on commodities (cont.)

Example (cont.)
Suppose that the market futures price is $500. In this instance, an arbitrageur
can:
Terminal Value
Action Initial Value ST F ST > F
Long asset 450 ST 2 ST 2
Short futures 0 500 ST 500 ST
Borrow 450 482.6287 482.6287
Total 0 15.3713 15.3713
Note: Take reverse positions if the observed (market) futures price is less than
the theoretical price.

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Cost of Carry Model (cont.)

Applications (cont.)
Futures on commodities (cont.)
Owners of consumption commodities may benefit from the ownership
of the physical commodity (as opposed to ownership of the futures
contract associated with the consumption commodity).
This will drive a wedge between the theoretical and market prices of
futures contracts on consumption commodities.
The benefit is referred to as the convenience yield.

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Cost of Carry Model (cont.)

Applications (cont.)
Futures on commodities (cont.)
In the presence of known (non-proportional) storage costs, the
convenience yield y is defined such that

Fe yT = (S + U)e rT .

If storage costs are proportional then the convenience yield y is defined

such that
Fe yT = Se (r +u)T .
In both cases, the convenience yield measures the extent to which the
left-hand side is less than the right-hand side in the above equations.

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Futures Prices and Expectations

The Traditional Approach

Speculators require compensation for the risks they are taking, while
hedgers are prepared to pay a price to avoid risk.
This leads to the following implication: If hedges tend to hold short
(long) positions and speculators tend to hold long (short) positions
then the futures prices of an asset will be below (above) the expected
spot price (in the future).
The difference between the futures price and the expected spot price is
the compensation to speculators.

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Futures Prices and Expectations (cont.)

The Modern Approach

Speculators will be rewarded for taking on systematic risk.
Let a speculator take a long position in a futures contract in the hope
that the assets price will be above the futures price at maturity.
Assume that the speculator invests the present value of this futures
price in a risk-free asset.
The proceeds of this risk-free investment are used to buy the asset at
maturity (which is then sold immediately at the prevailing market
price).

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Futures Prices and Expectations (cont.)

The Modern Approach (cont.)

In equilibrium, the present value of this investment (and indeed all
investment opportunities) is zero, thus

Fe rT + E (ST )e kT = 0,

where k is the investors required rate return for this investment, and
E (.) is an expectations operator. Rearranging,

F = E (ST )e (r k)T ,

where all previous notation is maintained.

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Futures Prices and Expectations (cont.)

The Modern Approach (cont.)

In the presence of zero systematic risk: k = r F = E (ST ).
In the presence of positive systematic risk: k > r F < E (ST )
(normal backwardation).
In the presence of negative systematic risk: k < r F > E (ST )
(contango).

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Hedging Using Futures

Basic Principles
The objective of hedgers is to reduce a particular risk they face. If the risk is
completely eliminated then it is referred to as a perfect hedge. Also, hedges
can be categorised as follows:
Short Hedges
E.g. An oil producer negotiates sale of 1 million barrels of crude oil three months in
the future at the prevailing market price. Shorting crude oil futures contracts with a
maturity of three months will hedge the exposure.
Long Hedges
E.g. A copper fabricator requires 100000 tons of copper in three months time.
Taking a long position in copper futures contracts with a maturity of three months
will hedge the exposure.

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Hedging Using Futures (cont.)

Basis Risk
Perfect hedges are rare because
1 The asset (price) to be hedged may not be the same as the asset
underlying the futures contract.
2 The hedger may be uncertain about the date when the asset will be
bought/sold.
3 The hedge may require that the futures contract be closed out before
its maturity.
These issues give rise to basis risk.

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Hedging Using Futures (cont.)

Basis Risk (cont.)

The basis is defined as the spot price of the asset to be hedged minus
the futures price of the contract used.
The basis converges to zero. However, if the hedge position is closed at
t2 and the value of the basis at t2 was not known when the position
was initiated (say at time t1 ) then basis risk occurs.
For instance, consider a hedger who
knows that the asset will be sold at
time t2 and takes a short futures
position at time t1 . The price realised
for the asset is S2 and the profit on
the futures position is F1 F2 . So, the
effective price obtained for the asset
with hedging is S2 + F1 F2 =
F1 + b2 . The basis risk is the
uncertainty associated with b2 .

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Hedging Using Futures (cont.)

Cross Hedging
Cross hedging occurs when the asset underlying the futures contract is
different from the asset whose price is being hedged. The following
quantities are important:
The Hedge Ratio: the ratio of the size of the position taken in futures
contracts to the size of the exposure.
The Minimum Variance Hedge Ratio: the proportion of the exposure
that should optimally be hedged is
S
h = ,
F
where S is the standard deviation of S (the change in the spot price
during the hedging period), F is the standard deviation of F (the
change in the futures price during the hedging period), and is the
coefficient of correlation between S and F .

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Hedging Using Futures (cont.)

Cross Hedging (cont.)
The Minimum Variance Hedge Ratio (cont.): this is the slope of the
ordinary least squares regression of S on F , with the R 2 value from
this regression representing the hedging effectiveness.
The Optimal Number of Contracts: the number of futures contracts
required is given by
h QA
N = ,
QF
where QA is the size of the position being held (units), and QF is the
size of one futures contract (units).
Note that if you wish to adjust for
daily settlement (referred to as tailing
the hedge), then QA and QF are
replaced by VA and VF , respectively,
where VA is the dollar value of the
position being traded, and VF is the
dollar value of one futures contract.

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Hedging Using Futures (cont.)

Stock Index Futures

Consider the following hedging scenarios:
Equity Portfolio Hedging: to hedge the risk in a portfolio, the number
of contracts that should be shorted is
VP
N = ,
VF
where VP is the value of the portfolio, is its beta, and VF is the
value of one futures contract.

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Hedging Using Futures (cont.)

Stock Index Futures (cont.)

Equity Portfolio Hedging (cont.):

Example
An owner of a portfolio worth $5050000 with a of 1.5, wishes to hedge
his/her exposure. The current S&P 500 futures price is 1010; therefore, the
value of one futures contract is $250 1010 = $252500. It follows that the
number of futures contracts that should be shorted to hedge the portfolio is
5050000
N = 1.5 = 30.
252500

Individual Stock Hedging: similar to hedging a portfolio. However, it

does not work as well because only the systematic risk is hedged (the
unsystematic risk that is unique to the stock is not hedged).

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Hedging Using Futures (cont.)

Rolling the Hedge Forward

If the expiration date of the hedge is later than the delivery dates of all
available futures contracts then we can use a series of futures contracts to
increase the life of a hedge.
Note that each time we switch from
one futures contract to another we
incur a type of basis risk.

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Summary

Futures Contract Mechanics

Specifics, daily settlement, forward vs. futures contracts.
The Cost of Carry Model
Investment assets under various income and storage cost assumptions, and
consumption commodities with convenience yields.
Expectations and Futures Prices
The traditional and modern approaches to the relationship between futures
prices and expected future spot prices.
Hedging Using Futures
Various concepts relating to hedging.

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Reading

Essential Reading
Chapters 3 and 5, Hull (2015).
Further Reading
Petersen, M., and R. Thiagarajan, 2000, Risk management and hedging:
with and without derivatives, Financial Management 29, 530.

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