Derivatives

Pricing a Forward / Futures Contract

Professor André Farber

Solvay Brussels School of Economics and Management
Université Libre de Bruxelles
 Valuing forward contracts: Key ideas

•  Two different ways to own a unit of the underlying asset at maturity:

–  1.Buy spot (SPOT PRICE: S0) and borrow
=> Interest and inventory costs
–  2. Buy forward (AT FORWARD PRICE F0)

•  VALUATION PRINCIPLE: NO ARBITRAGE

•  In perfect markets, no free lunch: the 2 methods should cost the same.

You can think of a derivative as a mixture of its constituent underliers,

much as a cake is a mixture of eggs, flour and milk in carefully specified
proportions. The derivative’s model provide a recipe for the mixture, one
whose ingredients’ quantity vary with time.
Emanuel Derman, Market and models, Risk July 2001

Derivatives 01 Introduction |2
 Discount factors and interest rates

•  Review: Present value of Ct

•  PV(Ct) = Ct × Discount factor

•  With annual compounding:

•  Discount factor = 1 / (1+r)t

•  With continuous compounding:

•  Discount factor = 1 / ert = e-rt

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 Forward contract valuation : No income on
underlying asset
•  Example: Gold (provides no income + no storage cost)
•  Current spot price S0 = $1,340/oz
•  Interest rate (with continuous compounding) r = 3%
•  Time until delivery (maturity of forward contract) T = 1
•  Forward price F0 ? t=0 t=1
Strategy 1: buy forward
0 ST –F0
Strategy 2: buy spot and borrow
Should
Buy spot -1,340 + ST be
equal
Borrow +1,340 -1,381

0 ST -1,381

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 Forward price and value of forward contract

rT
•  Forward price: F0 = S 0 e
•  Remember: the forward price is the delivery price which sets the value of a
forward contract equal to zero.

•  Value of forward contract with delivery price K

− rT
f = S 0 − Ke
•  You can check that f = 0 for K = S0 e rT

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 Arbitrage

•  If F0 ≠ S0 e rT : arbitrage opportunity

•  Cash and carry arbitrage if: F0 > S0 e rT

•  Borrow S0, buy spot and sell forward at forward price F0

•  Reverse cash and carry arbitrage if S0 e rT > F0

•  Short asset, invest and buy forward at forward price F0

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 Arbitrage: examples

•  Gold – S0 = 1,750, r = 1.14%, T = 1 S0 erT = 1,770

•  If forward price =1,800

•  Buy spot -1,750 +S1
•  Borrow +1,750 -1,770
•  Sell forward 0 +1,800 – S1
•  Total 0 + 30
•  If forward price = 1,700
•  Sell spot +1,750 -S1
•  Invest -1,750 +1,770
•  Buy forward 0 S1 – 1,700
•  Total 0 + 70

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 Repurchase agreement (repo)

•  An important kind of forward contract.

•  Sale of a security + agreement to buy it back at a fixed price.
(=reverse cash-and-carry, sale coupled with long forward)
•  Underlying security held as a collateral
•  Most repo are overnight
•  Counterparty risk => haircut = Value of collateral - Loan
 Schematic repo transaction

Time t
buy bond at Pt deliver bond

MARKET TRADER REPO

pay Pt DEALER
get Pt - haircut

Time T
sell bond at PT get bond

MARKET TRADER REPO

get PT DEALER
Pay (Pt-Haircut)
(1+RepoRate * (T-t))
 The repo market

Deposit
(overnight)

Financial Institutional
institution investors
Non financial firms
Collateral
(No checking
Market value
account insured by
+ haircut
FDIC)
Huge repo market – exact size unknown

10 February 18, 2013

 Spot rates and the yield curve

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 Forward on a zero-coupon : example

•  Consider a:
•  6- month forward contract
•  on a 1- year zero-coupon with face value A = 100
•  Current interest rates (with continuous compounding)
–  6-month spot rate: 4.00%
–  1-year spot rate: 4.30%
•  Step 1: Calculate current price of the 1-year zero-coupon
•  I use 1-year spot rate
•  S0 = 100 e –(0.043)(1) = 95.79
•  Step 2: Forward price = future value of current price
•  I use 6-month spot rate
•  F0 = 95.79 e(0.04)(0.50) = 97.73

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 Forward on zero coupon

•  Notations (continuous rates):

A ≡ face value of ZC with maturity T*
r* ≡ interest rate from 0 to T*
r ≡ interest rate from 0 to T A
R ≡ forward rate from T to T*
•  Value of underlying asset: r*
S0 = A e-r* T*
•  Forward price:
F0 = S0 er T
= A e (rT - r* T*)
t T T*
= A e-R(T*-T)
r R
Ft

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 Forward interest rate

•  Rate R set at time 0 for a transaction (borrowing or lending) from T to T*

•  With continuous compounding, R is the solution of:
A = F0 eR(T* - T)
•  The forward interest rate R is the interest rate that you earn from T to T* if you buy forward the
zero-coupon with face value A for a forward price F0 to be paid at time T.
•  Replacing A and F0 by their values:
r *T * − rT
R= *
T −T

In previous example: 4.30% × 1 − 4% × 0.50

R= = 4.60%
1 − 0.50

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 Forward rate: Example

•  Current term structure of interest rates (continuous):

–  6 months: 4.00% ⇒ d = exp(-0.040 × 0.50) = 0.9802
–  12 months: 4.30% ⇒ d* = exp(-0.043 × 1) = 0.9579
•  Consider a 12-month zero coupon with A = 100
•  The spot price is S0 = 100 x 0.9579 = 95.79
•  The forward price for a 6-month contract would be:
–  F0 = 97.79 × exp(0.04 × 0.50) = 97.73
•  The continuous forward rate is the solution of:
•  97.73 e0.50 R = 100
⇒ R = 4.60%

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 Forward rate - illustration

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 Forward borrowing

•  View forward borrowing as a forward contract on a ZC

You plan to borrow M for τ years from T to T*
Define: τ = T* - T
The simple interest rate set today is RS
You will repay M(1+RS τ) at maturity
•  In fact, you sell forward a ZC
The face value is M (1+RS τ)
The maturity is is T*
The delivery price set today is M
•  The interest will set the value of this contract to zero

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 Forward borrowing: Gain/loss

•  At time T* :
•  Difference between the interest paid RS and the interest on a loan made at
the spot interest rate at time T : rs
M [ rs- Rs ] τ

•  At time T:
•  ΠT = [M ( rs- Rs ) τ ] / (1+rSτ)

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 FRA (Forward rate agreement)

•  Example: 3/9 FRA

•  Buyer pays fixed interest rate Rfra 5%
•  Seller pays variable interest rate rs 6-m LIBOR
•  on notional amount M $ 100 m
•  for a given time period (contract period) τ 6 months
•  at a future date (settlement date or reference date) T ( in 3 months, end of
accrual period)

•  Cash flow for buyer (long) at time T:

•  Inflow (100 x LIBOR x 6/12)/(1 + LIBOR x 6/12)
•  Outflow (100 x 5% x 6/12)/(1 + LIBOR x 6/12)

•  Cash settlement of the difference between present values

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 FRA: Cash flows 3/9 FRA (buyer)

(100 rS 0.50)/(1+rS 0.50)

T=0,25 T*=0,75

(100 x 5% x 0.50)/(1+rS 0.50)

•  General formula:CF = M[(rS - Rfra)τ]/(1+rS τ)
•  Same as for forward borrowing - long FRA equivalent to cash settlement of
result on forward borrowing

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 Review: Long forward (futures)

Synthetic long forward:

borrow S0 and buy spot

S0 ST Receive
underlying asset

f0 = 0
0 t T
rT
S0 F0 = S0 e Pay forward
price

ft = St − F0e − rT = ( Ft − F0 )e − rT Value of forward

contract

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 Review Long forward on zero-coupon
(1) Face value of zero-
coupon given

* *
−r T A = F0 e Rτ
S0 = Ae ST
(3) Calculate
forward
interest rate
f0 = 0
0 t T T *
τ
rT (2) Calculate forward
S0 F0 = S0 e price which set the
initial value of the
contract equal to 0.
ft = St − F0e − rT = ( Ft − F0 )e − rT

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 Review Forward investment=buy forward zero-
coupon (2) Calculate face value of zero-
coupon which set the value of
the contract equal to 0
* * A = M (1 + RSτ ) = F0 e Rτ
S0 = Ae− r T ST

f0 = 0
*
0 T τ T

S0 F0 = M (1) Forward price given

M (1 + RSτ ) M ( RS − rs )τ
fT = ST − M = −M =
1 + rsτ 1 + rsτ
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 Review Forward borrowing=sell forward zero-
coupon

S0
F0 = M

f0 = 0
*
0 T τ T

ST A = M (1 + RSτ ) = F0 e Rτ
− r *T *
S0 = Ae
M (1 + RSτ ) M (rs − RS )τ
fT = M − ST = M − =
1 + rsτ 1 + rsτ
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 Review Long Forward Rate Agreement

Mrsτ
S0
1 + rsτ

f0 = 0
*
0 T τ T

MR fraτ
1 + rsτ
* *
S0 = Ae− r T

M (rs − R fra )τ
fT =
1 + rsτ
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 To lock in future interest rate

Borrow short & invest long

Buy forward zero coupon

Invest forward at current forward interest rate

Sell FRA and invest at future (unknown) spot interest

rate

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 Valuing a FRA

Mrsτ M
+ =M
1 + rsτ 1 + rsτ

*
0 t T τ T

MR fraτ + M
⇔ M (1 + R fraτ )
1 + rsτ 1 + rsτ

ft = M × d (T − t ) − M (1 + R fraτ ) × d (T * − t )
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 Basis: definition

•  DEFINITION : SPOT PRICE -

FUTURES PRICE
Futures price
•  bt = St - Ft

•  Depends on: Spot price

•  - level of interest rate
F =S
•  - time to maturity (↓ as maturity ↓) T T

T time

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 Extension : Known cash income

F0 = (S0 – I )erT
where I is the present value of the income

•  Ex: forward contract to purchase a coupon-bearing bond

0 0.25 T =0.50
r = 5%

S0 = 110.76 C=6

I = 6 e –(0.05)(0.25) = 5.85

F0 = (110.76 – 5.85) e(0.05)(0.50) = 107.57

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 Known dividend yield

•  q : dividend yield p.a. paid continuously

F0 = [ e-qT S0 ] erT = S0 e(r-q)T

•  Examples:
•  Forward contract on a Stock Index
r = interest rate
q = dividend yield
•  Foreign exchange forward contract:
r = domestic interest rate (continuously compounded)
q = foreign interest rate (continuously compounded)

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 Interest rate parity
r$: foreign interest rate (2%)
Underlying
asset: one unit $1 $e r$T
of foreign
currency $e2%×0.5 = 1.0101
F0 forward exchange rate €/$

r$T
€ F0e F0e r$T
= S0er€T
( r€ − r$ )T
r€T
F0 = S0e
Spot exchange €S0 € S0 e
rate €/$
€0.70 €0.70 × e4%×0.50 = 0.7141
Time 0 r€: domestic interest rate (4%) Time T

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 Commodities

•  I = - PV of storage cost (negative income)

•  q = - storage cost per annum as a proportion of commodity price

•  The cost of carry:

•  Interest costs + Storage cost – income earned c=r-q
•  For consumption assets, short sales problematic. So:
F0 ≤ S0e(r +u )T

•  The convenience yield on a consumption asset y defined so that:

F0 = S0e(c − y)T

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 Summary

Value of forward contract Forward price

No income − rT
f = S − Ke F = Se rT
Known income
I =PV(Income)
f = (S − I ) − Ke − rT F=(S – I)erT
Known yield q
f =S e-qT – K e-rT F = S e(r-q)T
Commodities
f=Se(u-y)T- Ke-rT F=Se(r+u-y)T

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 Valuation of futures contracts

•  If the interest rate is non stochastic, futures prices and forward prices are
identical
•  NOT INTUITIVELY OBVIOUS:
–  èTotal gain or loss equal for forward and futures
–  èbut timing is different
•  Forward : at maturity
•  Futures : daily

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 Forward price & expected future price

•  Is F0 an unbiased estimate of E(ST) ?

•  F < E(ST) Normal backwardation
•  F > E(ST) Contango
r = risk-free rate
k = expected return
F = E(ST) e(r-k) T = risk-free + risk premium

•  If k = r F = E(ST) CAPM:
•  If k > r F < E(ST)
k = r + β (kMarket − r)
•  If k < r F > E(ST)

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 Does the forward price predict the future price?

Consider a non dividend paying stock.

E0 (S1 )
S0 = ⇔ E0 (S1 ) = S0 (1+ E(R))
1+ E(R)

Forward price: F0 = S0 (1+ rF )

E0 (S1 ) − F0 = S0 [ E(R) − rF ]
Risk premium on
Forward price bias =
underlying asset
This is also the expected cash flow on the derivative

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 E(S1 − F0 ) = E(S1 ) − F0
= S0 (1+ k) − S0 (1+ r)
= S0 (k − r)

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