Option Tutorial 7 (week)

Q1. At the beginning of a contract, value of the future contract is zero, because neither party pays anything and neither party
receives anything of monetary value.
 Commodity spot prices and futures prices are different quotes for different types of contracts. The spot price is
the current price of a spot contract, at which a particular commodity could be bought or sold at a specified place for
immediate delivery and payment on the spot date. Conversely, a commodity's futures price is quoted for a financial
transaction that will occur on a future date and is the settlement price of the futures contract.
 Differences Between Commodity Spot and Futures Prices
 The main differences between commodity spot and futures prices are the delivery dates and prices.
 A commodity's spot price is the price at which the commodity could be traded at any given time in the marketplace. In
contrast, a commodity's futures price is the price of the commodity in relation to its current spot price, time until delivery,
risk-free interest rate and storage costs at a future date.
 Calculate commodity futures prices by adding storage costs to the spot price of a particular commodity. Multiply the
resulting value by Euler's number raised to the risk-free interest rate multiplied by the time to maturity. Generally,
futures prices and spot prices are different because the market is always forward-looking. The difference in a
commodity's spot price and future price is due to the cost of carry and interest rates.
 For example, assume the spot price of gold is $1,200 per ounce and it costs $5 per ounce to store the gold for six months.
The six-month futures contract on gold, given a risk-free interest rate of 0.25%, is $1,206.51, or
(($1,200+$5)*e^(0.0025*0.5)).
 The Relationship Between Spot Prices and Futures Prices
 The difference between spot prices and futures contract prices is usually significant. The most common relationship
between spot prices and futures prices, referred to as a normal market, is one where futures contract prices are
increasingly higher over time as compared to the current spot price. The higher futures prices reflect carrying costs
such as storage, the additional risk posed by the uncertainty of future supply and demand conditions in the marketplace,
and the fact that prices for goods generally tend to increase over time.
 In an inverted market, futures prices are decrease in comparison with the current spot price. Inverted markets are
most frequently caused by extreme demand pressures in the current marketplace that enable sellers to command
premium prices for immediate sale and delivery.
The value is zero. After purchasing it, and apart from a small initial + maintenance margin, the contract requires no initial
outlay. If you tried to sell it before the price of the contract has changed you would receive nothing for it. Therefore, it has
no value. However, with the spot market, purchasing the spot entitles you to the good/service, which has value and can be
re-sold to earn money.

Q2. There are five conditions under which forward and future price would be equal:
1. At the expiration
- Forward and future price are equal, and both must equal the spot price.
- This is because forward, futures and spot transactions are all equivalent at expiration.
2. One day prior to expiration
- Forward and futures prices must be equal because there is no effect of marking-to-market with only one day to
go.
3. At any time prior to expiration
- Forward and futures prices are equal if future interest rates are constant.
4. At any time prior to expiration
- Forward and futures prices are equal if interest rates change is a known manner (predictable).
- The above 3 and 4 means that the uncertainty caused by marking to market can be eliminated.
5. At any time prior to expiration
- Forward and futures prices are equal if future prices and interest rates are uncorrelated.
- This is because marking-to-market profits and losses are not augmented or reduced by rising or falling
interest rates.
- Thus, the effect of reinvested future profits or losses is irrelevant, and a forward contract serves as well as a futures
contract.
Q3. The future price is the expected spot price of high-graded crude oil in three months from today.
The futures price represents market expectations that the price of crude oil will rise by $1.1 over the next three months.

Q5
A. When the instrument is sold short, the short seller will not incur the storage cost. Instead of incurring the opportunity cost of
funds tied up in the assets, the short seller can earn interest on the funds received from the short sale.
Fo(T) < So + θ
Arbitrageurs: sell short the asset buy the futures
profit: So + θ - Fo(T) Positive profit.

Fo(T) > So + θ
Arbitrageurs: buy the asset sell the future contract
profit: Fo(T)- So - θ Positive profit.

The arbitrage strategy that would take advantage of the arbitrage opportunity is a Reverse Cash and Carry. A
Reverse Cash and Carry opportunity results from the following relationship not holding true: F(0,t)≥ S0 (l+ C)
 If the futures price is less than the spot price plus the cost of carrying the goods (Fo (T)< So + θ) to the futures
delivery date, an arbitrage in the form of a Reverse Cash and Carry exists.
 A trader would be able to sell the asset short, use the proceeds to lend at the prevailing interest rate, and buy the
asset for future delivery.
 At the future delivery, the trader would then collect the proceeds from the loan with interest, accept delivery of
the asset, and cover the short position of the commodity.

B. Arbitrage profit
Opening transaction now
 Sell the spot commodity short +$120
 Buy the commodity future expiring in 1 year 0
 Contract to lend $120 at 8% for 1 year -$120
 Total cash flow 0
Closing transaction one year from now
 Accept delivery on expiring futures -$125
 Cover short commodity position 0
 Collect on loan of $120 @ interest rate of 8% +$129.6  $120(1+8%)
 Total arbitrage profit +$4.96

C. Market imperfections could limit her ability to implement this arbitrage strategy
1. Transaction cost: commissions, exchange fees, bid-ask spread
- Same arbitrage opportunity that is profitable without transactions costs may not be after transaction costs.
2. Restrictions on short selling
- Even in well developed markets, for many commodities, short selling is impossible because the underlying asset
cannot be borrowed, e.g. residential homes. When an asset cannot be shorted, it is often believed that the market
may be “overpriced” because the market value does not reflect negative sentiments. This is called the overpricing
hypothesis
3. Different with borrowing and lending rate
- Generally, borrowing rate> lending rates