Forward & Futures Price Determination

Priced by the Prevention of Arbitrage Principle. ( Arbitrage means “Making Risk-less Profit” )
2 Types

Go long & short in 2 diff. derivatives Take a simultaneous long & short position
Today,such that there is +ve cash flow such that cash flow Today is nil & non- zero
Today & no risk of future loss. Prob. Of future profit.
PRICING OF A FWD CONTRACT VALUE OF A FWD CONTRACT OTHER LEARNING OUTCOMES

Price-The F/W Rate decided It refers to the amount that will be received or paid on A)
initially based on Prevention the cancellation or sale of the fwd contract. Investment Asset Consumption Asset
of Arbitrage. Value=ZERO ,to begin with.
Fwd Rate in the market
changes as time passes. Asset held for Asset held for
A)In case of Asset having no storage cost & no income investment. consumption eg.
copper,oil.
A)In case of Asset having no Value to the Long = S- Ke
-rt

storage cost & no income OR F/W /Futures price- F/W /Futures price-
CAN be determined by CANNOT be
rt
F=Se ( F-K )*e
-rt Arbitrage Arguments determined by
i.e. F=Spot Price + Funding where,F is the new F/W Rate Arbitrage Arguments
Cost & K is the old F/W Rate
rt
B) Short Selling-Borrow stock,sell it short
Case 1: If actual F > Se B)In case of Asset which provides known income Adv- Price fall,Short Int Rebate etc
-
Sell F/W, Buy spot & Borrow Disadv-Short squeeze, Price/Div Risk etc
funds at Rf
Value to the Long= S*-ke-rt C) Currency F/W Contracts
-CASH & CARRY ARBITRAGE
where, S =Ex coupon Spot Price=(S-I)
*
F= S e (rA-rB)t (if the quote is A/B)
Remember,
f= S*- ke-rAt
rt
Case 2: If actual F < Se
-Buy F/W,Shot sell spot & Value is denoted by f (Small f)
i.e.
Invest proceeds at Rf
f= S e-rBt-ke-rAt
-REVERSE CASH & CARRY Relationship btw F & E(S)
ARBITRAGE
F=E(S) {Pure Expectations Theory} D) Futures Price on commodities incorporating
F>E(S) {Normal Contango} income/storage cost and/or convenience yield.
Arbitrage Profit= Amt of
Mispricing
F<E(S) {{Normal Backwardation} F=(S+U)ert
Where U=PV of the storage cost
F ~ Sert FIRST EXPLANATION
KENES & HICKS
If storage cost is given as ctsly compounded rate,
Case 1:Hedgers are net short on the commodity
B)In case of Asset which (Eg. Bakery Firms)
To hedge, they wish to go long--- speculators wl go short F=Se(r+u)t
provides known income
,if, F>E(S) –NORMAL CONTANGO
(r+u)t
rt If F< Se , EVEN THEN,Reverse Cash & Carry
F=(S-I)e Case 2: Hedgers are net long on the commodity Arbitrage doesn’t occur-bcoz it’s a consumption
Where ;I = PV of div or coupon (Eg. Wheat farmers) asset.Convenience Yield is derived out of it.
within the maturity of the F/W To hedge, they wish to go short---speculators wl go long
Contract ,if, F<E(S) –NORMAL BACKWARDATION
So, F=Se(r+u-y)t
Case 3:Hedgers are neither net long nor net short
So, F= S*ert i.e. F=E(S) E) Delivery Options available in the Futures
*
where, S =Ex coupon Spot Market
Price SECOND EXPLANATION -which grade to deliver & when to deliver –
CAPM enjoyed by Short.
rt kt (r-k)t (r+u-y)t
F/e = E(ST)/e i.e. F=E(S)e ,where k= Rf+(Rm-Rf)Be In the eq:- F=Se i.e. F=Sect ,where
Remember, C=COST OF CARRY
Price is denoted by F (Capital Case 1: Beta=0 i.e. r=k i.e. F=E(S) Case 1: If c>0
F) Pure Expectations Theory r+u>y ( Assume delivery at the beginning of Month)
Case 2: +ve Beta i.e. k>r i.e. F<E(S) Case 2: If c<0
NORMAL BACKWARDATION y> r+u ( Assume delivery at the end of Month)
Case 3: -ve Beta i.e. k<r i.e. F>E(S)
NORMAL CONTANGO Page 20