Lecture 5.

Determination of Forward
and Futures Prices II
EF4420. Derivative Analysis and Advanced Investment Strategies

Dr. Yongjin Kim

17 February, 2017

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Lecture Outline

Determination of Forward Price

Underlying asset paying continuous dividends

Valuing Forward Contracts

Comparison Between Forward and Futures Prices

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Determination of Forward Price - Continuous Dividends

Some securities pay constant dividends.

If we invest in stock index, dividend from each individual stock will be

paid at dierent points of time.
Having a lot of stocks in index, we can approximate the index as
paying dividends continuously.
Investing in a foreign currency also delivers continuous interests.

To simplify the argument, we assume that we reinvest the dividend

immediately to buy more shares.

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Determination of Forward Price - Continuous Dividends

Let q denote the dividend yield per annum. Stock price on date t is
St .
receive dividend everyday
q
During the day, investor receives dividend 365 St .
q
Reinvesting the dividend, the investor owns additional shares.
365
q
Thus, the number of shares increases by factor of 1 + 365 in a day.
When investing for T years, the number of shares increases by factor of
q 365T one stock the div one day can reinvest
1+ 365 . q/ 365=St * q/ 365 /St

When the time-interval for reinvestment becomes very small, then the
number of shares increases by e qT .
lim(1+q/N) power of N= e power of q
N to unlimit

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Determination of Forward Price - Continuous Dividends
What if the underlying asset pays continuous dividends with dividend
yield q per annum?

Forward price is
F0 = S0 e (r q)T

Why? Consider the two portfolios:

1 long forward with F0 + buy a bond that will pay F0
qT
2 buy e share of stock

The two portfolios have the same value at T :

1 (ST F0 ) + F0
At time 0: 0+F0*e-rT= e-qT*S0
qT qT
2 ST e e
number of shares
Thus, the current prices should be the same:
rT qT (ex-div)
0 + F0 e = S0 e 5 / 23
Determination of Forward Price - Continuous Dividends -
Currency

An investor holding foreign currency earns interests at the risk-free

rate prevailing in the foreign country.

Thus, foreign currency is an asset with continuous dividends.

Forward price is then

F0 = S0 e (r rf )T

where rf is the foreign risk-free rate.

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Determination of Forward Price - Continuous Dividends -
Currency

Q1. Suppose that 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 0.62
USD per AUD. A 2-year forward exchange rate is 0.63. Is there an
arbitrage?

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Determination of Forward Price - Continuous Dividends -
Currency

Q1. Suppose that the 2-year interest rates in Australia and the United
States are 5% and 7%, respectively, and the spot exchange ratespot price
between the Australian dollar (AUD) and the US dollar (USD) is 0.62
homeUSD per AUD. A 2-year forward exchange rate is 0.63. Is there an
arbitrage?
r-rf
Answer: 0.63 < 0.62e (0.07 0.05)2 . Thus, there is an arbitrage. We can
consider the following strategy:
Action Cash flow in 0 Cash flow in 2 year
long forward 0 ST 0.63
sell e 0.052 AUD 0.62e 0.052 USD ST future value:home
buy US bond 0.62e 0.052 0.62e 0.052 e 0.072
net 0 0.015
sell 1 AUD 0.62 USD - e power of (0.05(foreign rf)*2)*St

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Determination of Forward Price - Continuous Dividends -
Currency

Q2. Suppose that 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 0.62
USD per AUD. Suppose that the 2-year forward exchange rate is
0.65. Is there an arbitrage?
0.65> 0.62*e power of ((0.07-0.05)*2)= 0.6453
the forward price>spot price : short forward

short forward 0 0.65-ST

buy 1 AUD -0.62 (e power of 0.05*2)*ST
buy (e power of -0.05*2) /-0.62(e power of -0.05*2) /ST
sell bond 0.62(e power of -0.05*2) /-0.62(e power of -0.05*2)*e power of 0.07*2

0 0.0047

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Valuing Forward Contracts

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Valuing Forward Contracts

The value of forward is zero at the time it is first entered.

However, as time passes, its later value can be either negative or

positive.

Suppose that we have a long position in a forward with price F0 that

was entered at time 0.

What is the value f of the forward at time t?

Value at 0 Value at t
Contract with F0 0 ?
0 t T
F0 Value=0 F0 Value=? Value=payoff= ST-F0 if long
< F0-ST if short
(Ft-F0)e power of -r(T-t) Value difference between two:(ST-F0)-(st-ft)=FT-F0
Ft value=0 ST-Ft 11 / 23
Valuing Forward Contracts

To find the time-t value of forward with F0 , we consider another

forward that we start now at t.
Value at 0 Value at t Value at T
Contract with F0 0 ? ST F0
Contract with Ft 0 ST Ft

At T , the value dierence between the two contracts is Ft F0 .

Thus, at t, the value dierence between the two is (Ft F0 )e r (T t) .

As a result,
r (T t)
f = (Ft F0 )e
for a long position of forward with F0 .

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 long position with F0: f= (Ft-Fo)e-r(T-t)
Valuing Forward Contracts =(St* e power of r(T-t)-F0 )*e power of -r(T-t)

In a similar way, we can find time-t value of short position of

forward with F0 that we started at time 0.
Value at 0 Value at t Value at T
Contract with F0 0 ? F0 ST
Contract with Ft 0 Ft S T

At T , the value dierence between the two contracts is F0 Ft .

Thus, at t, the value dierence between the two is (F0 Ft )e r (T t) .

As a result,
r (T t)
f = (F0 Ft )e
for a short position of forward with F0 .

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Valuing Forward Contracts

We can express the value of forward in a dierent way by using the

forward price Ft
8
> r (T t)
< St e no dividned
Ft = (St I )e r (T t) discrete divideds
>
: (r q)(T t)
St e continuous dividends

As an example, if the underlying asset pays no dividend, the time-t

value of the forward is
r (T t)
f = St F0 e

for a long position.

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Valuing Forward Contracts

Ex. In August 2016, an investor entered a long position in forward on a

stock with maturity of August 2017. At that time, stock price was
$40. Two months later, in October 2016, the stock price becomes
$45. What is the value of the forward? Assume that the risk-free rate
of interest is 5%.
0 2/12 1

08/ 2016 10/2016 08/2017

S: 40 45
f= (Ft-F0)e power of -r(T-t)
F0: 40*e power of 0.05*1 Ft=45*e power of (0.05*10/12)

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Valuing Forward Contracts

Ex. In August 2016, an investor entered a long position in forward on a

stock with maturity of August 2017. At that time, stock price was
$40. Two months later, in October 2016, the stock price becomes
$45. What is the value of the forward? Assume that the risk-free rate
of interest is at 5%.
Answer: The forward price in August 2016 is K = 40e 0.05 = 42.05.
The forward price in October 2016 is F0 = 45e 0.0510/12 = 46.91.
Thus, the value of long forward is
0.0510/12
f = (46.91 42.05)e = 4.665

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Forward vs. Futures Prices

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Forward vs. Futures Prices

For the same underlying asset and maturity, the futures and forward
prices are very close to each other, but can be dierent (due to daily
settlement of futures).

Compare payos between forward and futures for a long position:

Day Forward Futures Gain

0
1 0 F1 F0 e power of r(T-1)
2 0 F2 F1 e power of r(T-2)
.. .. ..
. . .
T ST F0 ST FT 1
ST-F0 ST-F0: is the same when rf is 0
When the risk-free rate is zero, the cumulative gain in futures is the
same as gain in forward.

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Forward vs. Futures Prices

When the risk-free rate is not zero, the cumulative gain in futures
may be dierent from gain in forward.

1 If the price of the underlying asset is positively correlated with the

interest rate, the gain on futures tend to be larger than the gain on
correlation between St rt
forward. + ST goes up ;rt goes up
) Futures price > Forward price gain goes up
final payoff of futures goes up and greater
2 If the price of the underlying asset is than forwards correlated with the
negatively
interest rate, the gain on futures tend to be smaller than the gain on
forward. - St goes up ;rt goes down
gain goes down and loss goes up
) Futures price < Forward price final payoff of futures goes down and
less than forwards

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 Forward Prices and Expected Spot Prices

Consider a forward contract with delivery at T . We start the contract

at 0 and the forward price is F0 .

How is F0 related to the expected spot price at T ?

Recalling the discounted cash flow, the current price S0 is

kT
S0 = E (ST )e

where k is the discount rate reflecting riskiness of the underlying asset

(think of CAPM). 0 T
F0 ST
E(ST)
E(ST)*e power of -x*t= S0; x is not the rf rate, but we can use CAPM, E(ri)= r+beta*(E(rm)-r)=x
if beta>0, x>rf; beta=0, x=rf

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Forward Prices and Expected Spot Prices

Plugging the expression into the forward price, we obtain

F0= S0* e power of rT
= (e power of -kT)*E(ST)*e rTF = E (ST )e (r k)T
0
= (e power of (r-k)T)*E(ST) x in last page
beta
1 If k > r (underlying asset has positive systematic risk)

F0 < E (ST )

2 If k < r (underlying asset has negative systematic risk)

F0 > E (ST )

3 If k = r (underlying asset has zero systematic risk)

F0 = E (ST )

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 Forward Prices and Expected Spot Prices
Normal backwardation: when F0 < E (ST )

Contango: when F0 > E (ST )

F0
E(ST)
Forward prices across time
k<r
110
FT=ST=E(ST) Normal backwardation
F0 100
Contango

k>r
90

0 T 80
Expected spot price

70

60

50

40
0 1 2 3 4 5 6 7 8 9 10
time

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Things To Do

Read the textbook chapters 5.6-5.10, 5.14

Assignment 4 (due on Friday, 24 February at 11 pm)

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