Financial Forwards and Futures

• Alternative ways to buy a stock

• Prepaid forward contracts on stock
• Forward contracts on stock
• Futures contracts
• Uses of index futures

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 Introduction

• Financial futures and forwards

• On stocks and indexes
• On currencies
• On interest rates
• How are they used?
• How are they priced?
• How are they hedged?

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 Alternative Ways to Buy a Stock

• Four different payment and receipt timing combinations

• Outright purchase: ordinary transaction
• Fully leveraged purchase: investor borrows the full
amount
• Prepaid forward contract: pay today, receive the
share later
• Forward contract: agree on price now, pay/receive
later
• Payments, receipts, and their timing

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 Alternative Ways to Buy a Stock
Four different ways to buy a share of stock that has price S0
at time 0. At time 0 you agree to a price, which is paid either
today or at time T . The shares are received either at 0 or T .
The interest rate is r.

Description Pay at Receive security payment

time at time
Ourtright purchase 0 0 S0 at time 0
Fully leveraged T 0 S0 erT at time T
purchase
Prepaid forward 0 T ?
contract
Forward contract T T ? × erT

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 Pricing Prepaid Forwards

P
• If we can price the prepaid forward ( F0,T ), then we can
calculate the price for a forward contract
• F0,T = Future value of F0,TP

• Three possible methods to price prepaid forwards

• Pricing by analogy
• Pricing by discounted present value
• Pricing by arbitrage
• For now, assume that there are no dividends

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 Pricing Prepaid Forwards (cont’d)
• Pricing by analogy
• In the absence of dividends, the timing of delivery is
irrelevant
• Price of the prepaid forward contract same as current
stock price
P
• F0,T = S0 (where the asset is bought at t = 0,
delivered at t = T )
• Pricing by discounted preset value ( α: risk-adjusted
discount rate)
• If expected t = T stock price at t = 0 is E0 [ST ] then
P
F0,T = E0 [ST ]e−αT
• Since t = 0 expected value of price at t = T is
E0 [ST ] = S0 eαT
• Combining the two, F0,TP
= S0

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 Pricing Prepaid Forwards (cont’d)

• Pricing by arbitrage
• Arbitrage: a situation in which one can generate
positive cash flow by simultaneously buying and
selling related assets, with no net investment and
with no risk. Free money!!!
• If at time t = 0, the prepaid forward price somehow
P
exceeded the stock price, i.e., F0,T > S0 , an
arbitrageur could do the following

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 Pricing Prepaid Forwards (cont’d)

• Cash flows and transactions to undertake arbitrage when

P
the prepaid forward price, F0,T , exceeds the stock price,
S0 .
Cash flows
Transaction Time 0 Time T (expiration)
Buy stock @ S0 −S0 ST
P
Sell prepaid +F0,T −ST
P
forward @F0,T

P
Total F0,T − S0 0
• Since, this sort of arbitrage profits are traded away
quickly, and cannot persist, at equilibrium we can expect:
P
F0,T = S0

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 Pricing Prepaid Forwards (cont’d)

P = S still valid?
What if there are dividends? Is F0,T 0
• No, because the holder of the forward will not receive
dividends that will be paid to the holder of the stock
P
• F0,T = S0 − PV(all dividends paid from t = 0 to t = T )
• For discrete dividends Dti at times ti , i = 1, 2, 3...n
• The prepaid forward price:
P
= S0 − ni=1 PV0,ti (Dti )
P
F0,T
• For continuous dividends with an annualized yield δ
P
• The prepaid forward price: F0,T = S0 e−δT
Adjusting the initial quantity in order to offset the effect of the
income from the asset is called tailing the position.

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 Pricing Prepaid Forwards (cont’d)

• XYZ stock costs $100 today and is expected to pay a

quarterly dividend of $1.25. If the risk-free rate is 10%
compounded continuously, how much does a 1-year
prepaid forward cost?
P
= $100 − 4i=1 $1.25e−0.025i = $95.30
P
• $F0,1

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 Pricing Prepaid Forwards (cont’d)

• The index is $125 and the dividend yield is 3%

continuously compounded. How much does a 1-year
prepaid forward cost?
P
• F0,1 = $125e−0.03 = $121.31

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 Pricing Forwards on Stock

• Forward price is the future value of the prepaid forward

P
• No dividends F0,T = FV(F0,T ) = FV(S0 ) = S0 erT
n
• Discrete dividends F0,T = S0 erT − er(T −ti ) Dti
P
i=1
• Continuous dividends F0,T = S0 e(r−δ)T

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 Pricing Forwards on Stock (cont’d)

• Forward premium
• The difference between current forward price and
stock price
• Can be used to infer the current stock price from
forward price
• Definition
• Forward premium = F0,T /S0
F
• Annualized forward premium = 1 ln( 0,T )
T S0

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 Creating a Synthetic Forward

• One can offset the risk of a forward by creating a synthetic

forward to offset a position in the actual forward contract
• How can one do this? (assume continuous dividends at
rate δ)
• Recall the long forward payoff at expiration ⇒:
ST − F0,T
• Borrow and purchase shares as follows

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 Creating a Synthetic Forward

• Demonstration that borrowing S0 e−δT to buy e−δT shares

of the index replicates the payoff to a forward contract,
ST − F0,T .
Cash flows
Transaction Time 0 Time T (expiration)
Buy e−δT units of −S0 e−δT +ST
the index
Borrow S0 e−δT +S0 e−δT −S0 e(r−δ)T

Total 0 ST − S0 e(r−δ)T
• Note that the total payoff at expiration is same as forward
payoff

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 Creating a Synthetic Forward (cont’d)

• The idea of creating synthetic forward leads to following

• Forward = Stock – zero-coupon bond
• Stock = Forward + zero-coupon bond
• Zero-coupon bond = Stock – forward
• Buy the underlying asset and short the offsetting forward
contract is cash-and-carry.
• If F0,T 6= S0 e(r−δ)T , arbitrage opportunities:
• if F0,T > S0 e(r−δ)T cash-and-carry arbitrage: buy the
index, short the forward
• if F0,T < S0 e(r−δ)T reverse cash-and-carry: short the
index, buy the forward

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 Cash-and-carry arbitrage

• Transactions and cash flows for a cash-and-carry: A

marketmaker is short a forward contract and long a
synthetic forward contract.
Cash flows
Transaction Time 0 Time T (expiration)
Buy tailed position in −S0 e−δT +ST
−δT
stock, paying S0 e
Borrow S0 e−δT +S0 e−δT −S0 e(r−δ)T
Short forward 0 F0,T − ST

Total 0 F0,T − S0 e(r−δ)T

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 Cash-and-carry arbitrage (cont’d)
• Cash-and-carry arbitrage with transaction costs
• Trading fees, bid-ask spreads, different
borrowing/lending rates, the price effect of trading in
large quantities, make arbitrage harder
• No-arbitrage bounds: F + > F0,T > F −
• Suppose
• Bid-ask spreads: for stock S b > S a , and for
forward F b < F a
• Cost k of transacting forward
• Interest rate for borrowing and lending are
rb < rl
• No dividends and no time T transaction costs for
simplicity
• Arbitrage possible if
b
• F0,T > F + = (S0a + 2k)er T
l
• F0,T < F − = (S0b + 2k)er T
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 Other Issues in Forward Pricing

• Does the forward price predict the future price?

• According to the formula F0,T = S0 e(r−δ)T the
forward price conveys no additional information
beyond what S0 , r and δ provides
• Moreover, the forward price underestimates the future
stock price
• The forward contract is a biased predictor of the
future stock price
• Forward pricing formula and cost of carry
• Forward price = Spot price +
Interest to carry the asset - asset lease rate
| {z }
cost of carry, (r−δ)S
• Lease rate is what to pay to the lender of the asset

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 Futures Contracts
• Exchange-traded “forward contracts”
• Typical features of futures contracts
• Standardized, with specified delivery dates, locations,
procedures
• A clearinghouse
• Matches buy and sell orders
• Keeps track of members’ obligations and
payments
• After matching the trades, becomes counterparty
• Differences from forward contracts
• Settled daily through the mark-to-market process ⇒
low credit risk
• Highly liquid ⇒ easier to offset an existing position
• Highly standardized structure ⇒ harder to customize

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 Collateral and maintenance margins
â Marking to market is a daily settlement feature of
futures contract in which profits and losses are paid over every
day at the end of trading.
â The purchaser must deposit a sum as an initial margin or
collateral (initial performance bond (IM), for example, 10
percent of contract value, either in cash or T-bills).
â A maintenance margin (MM) (70 – 80% of initial margin)
is required. The value of the contract is marked to market
daily, and all changes in value are paid in cash daily.
â When your initial performance bond drops below the
maintenance level you will be required to post more money
(you receive a margin call).
â Excess equity above the IM can be withdrawn
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 Daily resettlement: Example

Daily cash flow in a three-day contract (date 0, 1, 2, 3) to

purchase a stock, is computed as follows

Day 0 1 2 3
Futures price 100 98 96 97
Marking to market − pay 2 pay 2 receive 1
Final payment for delivery pay 97

(Ignoring time value), the cumulative payments from the buyer

are equal to 2 + 2 − 1 + 97 = 100

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 Example: S&P 500 Futures

• Mark-to-market proceeds and margin balance over 10

weeks from long position in 8 S&P 500 futures contracts
(Notional value of a single contract: $250 × Index. 8
contracts mean the multiplier of 2,000).
• Assume continuous compounding annual interest rate of
6% and 10% margin. The last column does not include
additional margin payments. Expiration week 10, weekly
settlement.

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 Example: S&P 500 Futures
Furtures price margin
week multiplier price change balance
0 2000 1100 220,000
1 2000 1027.99 -72.01 76,233.99
2 2000 1037.88 9.89 96,102.01
3 2000 1073.23 35.35 166,912.96
4 2000 1048.78 -24.45 118,205.66
5 2000 1090.32 41.54 201,422.13
6 2000 1106.94 16.62 234,894.67
7 2000 1110.98 4.04 243,245.86
8 2000 1024.74 -86.24 71,046.69
9 2000 1007.30 -17.44 36,248.72
10 2000 1011.65 4.35 44,990.57

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Detailed calculation

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Yesterday, you entered into a futures contract to buy
CAD100,000 at $0.95 per CAD. Your initial performance bond
(IM) is $2,000 and your maintenance level (MM) is $1,500. At
what settle price will you get a demand for additional funds to
be posted (i.e, a margin call)?

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At what settle price will you be free to withdraw $500 from
your margin account?

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 Futures prices versus forward prices

• Very similar
• The difference negligible especially for short-lived
contracts
• Can be significant for long-lived contracts and/or
when interest rates are correlated with the price of
the underlying asset

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 Uses of Index Futures

• Why buy an index futures contract instead of synthesizing

it using the stocks in the index? Lower transaction costs
• Asset allocation: switching investments among asset
classes
• Example: invested in the S&P 500 index and temporarily
wish to temporarily invest in bonds instead of index.
What to do?
• Alternative #1: sell all 500 stocks and invest in bonds
• Alternative #2: take a short forward position in S&P
500 index

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 Switching from stocks to T-bills

Effect of owning the stock and selling forward, assuming that

S0 = $100 and F0,1 = $110.
Cash flows
Transaction Today 1 year, S1 = $80 1 year, S1 = $130
Own stock @ $100 -$100 $80 $130
Short forward 0 $110-$80 $110-$130
@$100
Total -$100 $110 $110

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Cross hedging: using a derivative on one asset to
hedge another

• Cross-hedging with perfect correlation

• Suppose we own $100 million stocks with beta of 1.4
(recall CAPM: rp = r + β(rM − r))
• Better, rp − r = β(rM − r) ⇒ β is a multiplier
• the S&P 500 index is $1,100, annual risk free rate is 6%.
The futures price is $1,166.
• The number of contracts needed to cover $100 million of
stock is (100million/250/1100) = 363.636
• Adjust for the difference in beta, multiply that number by
1.4 ⇒ 509.09.

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 Uses of Index Futures

• Results from shorting 509.09 S&P 500 index futures

against a $100 million portfolio with a beta of 1.4.
S&P 500 Gain on 509 Portfolio Total
index Futures value
900 33.855 72.145 106
950 27.491 78.509 106
1000 21.127 84.873 106
1050 14.764 91.236 106
1100 8.400 97.600 106
1150 2.036 103.964 106
1200 -4.327 110.327 106

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 Detailed calculation

If index price turns out to be 1100, index return is

1100 − 1100
= 0%
1100
our portfolio return is

rp = 6% + 1.4 × (0% − 6%)

= −2.4%

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509.09 index futures contract profit/loss is

= 509.09 × 250 × 1166 − 509.09 × 250 × 1100

= 509.09 × 250 × (1166 − 1100)
= 1.4 × 363.636 × 250 × (1166 − 1100)
100M
= 1.4 × × 250 × (1166 − 1100)
250 × 1100
1166 − 1100
= 1.4 × 100M ×
1100

509.09 index futures contract (against the $100M portfolio)

return then is

1166 − 1100
1.4 × = 8.4%
1100

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 Detailed calculation

If index price turns out to be 1150, index return is

1150 − 1100
= 4.545
1100
our portfolio return is

rp = 6% + 1.4 × (4.545% − 6%)

= 3.964%

index futures return is

1166 − 1150
1.4 × = 1.4 × 1.455% = 2.036%
1100

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 Uses of Index Futures

• Cross-hedging with imperfect correlation

• General asset allocation: futures overlay
• Risk management for stock-pickers

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