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    Chapter 1 S

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    杨杨柳

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    of 11
    Chapter 1 Derivatives: Forward and Futures A financial derivative is a sceurity whose value depends on the values of yy, bond and commodity. Forward other more elementary securities, like eq contracts and futures contracts are two typical derivatives trading in the financial market. The primary use of forward and futures is to hedge against portfolio risk. In this chapter, principles of derivatives pricing are illustrated through the structures of forward and futures. Key principles include no arbitrage pricing theory, risk-nentral valuation and concepts of hedging with deviva- tives. These concepts are also useful in managing financial risks, especially when derivatives positions are concerned. ‘To make things clear, I would like to state down some useful definitions: 1, Arbitrage: It involves locking in a riskless profit by entering sinmulta- neously into transactions in two or more markets. In most of the time, arbitrage opportunities cannot last for long in the financial market. ‘Therefore, in pricing derivatives, we would like to obtain fair prices of the derivatives so that arbitrage opportunities does not exist. 2. Hedging: It is a technique for transferring the risk of unfavorable price fluctuations to other market participants. Existence of derivatives mar- kets facilities hedging, of course, as well as speculation, 3. Risk-nentral pricing: Th states that the price of derivative seenrity determined in a “risk-neutral world” would totally agree with that obtained in the real world. In the risk neutral world, every security generates the same expected rate of return, the risk-free interest rate, An investor can earn excessive return only because of “pure luck”. 1.1 Forward Contracts A forward contract 18 an agreement to buy or sell an asset at a certain future Gime for a certain price. The contract is usually beoween lwo financial institutions or between a financial institution and one of its corporate clients. It is not normally traded on an exchange. ‘The asset: to buy or to sell is called the underlying asset, the specified future time is called the maturity of the contract and the pre-specified purchasing/selling price is the delivery price. ‘Two parties involved in a forward contract have different positions. One agrees to buy the underlying asset on maturity for a delivery price takes a Jong position. The other party assumes a short position. Av the Gime the contract is entered into, the delivery forward contract to both parties is zero. At maturity, the holder of the short position delivers the asset to the holder of the long position in return for a cash amount equal to the delivery price. price is chosen ¢o that the value of the 1.1.1 Forward Price The forward price for a forward contract is defined as the delivery price h would make the contract have zero value. At the time the contract entered into, the delivery price equals the forward price. As time passes, the delivery price is fixed but the forward price changes time to time to make the point. Therefore, the forward forward contract have 210 value al each (i. price generally does not equal to the delivery price except at the starting time of the contract. 1.1.2 Payoffs from Forward Contracts Denote S; as the aeset price at time t, Kas the delivery price of the contract and T as the maturity time of the contract. ‘Then, the payoff from a long position in a forward contract on one unit of an asset is Sr-K. Similarly, the payoff from a short position in a forward contract on one unit of an asset is K-Sp. 1.1.3 Forward price determination Assumptions 1. No transaction costs 2. All trading profits (or losses) are subject to the same tax rate 4 3. Zero borrowing and lending rate differential Notations © 7. maturity of the forward (years) current time (years) S: underlying asset price at time t Sp: underlying asset: price at time T (unknown at time t) © K: delivery price # fr value of a long forward contract at value) et (also called the forward © F: forward price at time t © r: risk-free rate of interest per annum at time ¢, with continuous com- pounding, for an investment maturing at time T Given the notations above, we should aware of the following facts: 1. The forward price, F, is quite different from the forward value, f. When the contract is initiated, F = K and f = 0. As time passes, both f and F change but in general do not equal each other 2. As the risk-free interest rate is cont coupon with mat jously compounding, a unit zero ity T, has the value equal to e-"™~0 Case 1. No intermediate incomes from the underlying asset Suppose the underlying asset that provides the holder with no income. Non- dividend paying stock and discount bonds are examples of such securities. Then, Ue uo arbilrage forward price reads Fase?) and f=5- Ker) (ay Justification: Consider the following two portfolios: * Portfolio A: one long forward contract on the asset plus an amount of cash eqnal to Ke-T(=0) invested at the risk-free rate, © © Portfolio B: one unit of the asset Both portfolios consist of one unit of the asset at time 7. It implies that they must have the same value at any time t before maturity. Otherwise, an investor can generate a riskless profit by selling the expensive one and purchasing the cheap one at time t. In other words, we have Ke-Nt-1) As forward price is the delivery price that make the forward value be zero. We have 0=8— FeMl-) Pa gertT- example: A G-month forward to buy a stock at $13.5 per share, The current price of share ix $12.0 aud Une continuously compounding risk-free rate is 5.25%, The stock is expected to pay no dividends in the next 6 months. Fy = 120500825 _ 19.39 < 136. This represents an arbitrage profit. Why? Strategy: Short 1 forward contract, and borrow $12 to buy 1 share of stock. The result: Cost now = U Payoll in G-month (ime = 13.5 - 12.32 = 1.18, A question asked by an undergraduate student Suppose the distribution of the stock price at time Tis known, Then, one must be able to estimate the expected payoff of a forward contract. It follows that the value of the forward contract must be the present value of the expected payoff, Le. P= (E(Sr) — Kye, ‘When compare this reeult to the earlier ones, we have S-KeTt9 = (E(Sr)— Ke = E(Sr) = Se = forward price. Is it true? If yes, then every security must have the same expected rate of return which is the risk-free interest rate. If no, what is the problem? 6 Case 2: With a known cash income Define I as the present value of income to be recived during the life of the forward, For there to be no arbitrage, we have F=(S-De "9 and f=S-I-Ke "9. (1.2) Justification: Use the same portfolio A in the previous analy: the portfolio B to: We change © Portfolio B: one unit of the security plus borrowing of amount J at the risk-free rate ‘The income from the security can be used to repay the borrowings so that this portfolio has the same value as one unit of the security at time 7. The two portfolios have the same value, that is, fHKeMO) = $13 fa$—-1- Ke) “The forward price is the delivery price that makes f zero, Hence, we have F=(S— Dent, Example A 6-month forward to buy (sell) a stock at $11.5 per share. The current price of the share is $13.0 and the risk-free rate 5.25% for the 6- month maturity, and 5.1% for the 3-month maturity. The stock is expected to pay a $12 dividend 3 months from now. Fi = (19 —1.2er0 25008) pss = 2.13 > 11.5. ‘This represents an arbitrage profit. Why? Strategy: Long 1 forward contract, short 1 share of stock, make a 3-month deposit in the amount of $1.2e~°?°*°!, and the rest goes to a 6-month deposit. Result: Cost now = 0 Payoff in 3-month time = 1.2-1.2=0 Payoff in 6-month time = 12.13 - 11.5 = 0.63. Case 3: With a known dividend yield ‘What is the continuons dividend yield? The rate of dividend payments per unit of time. Mathematically, if aS, Se — —adt + adt + 5 — Selo“. Both curriencies and stock indices can be regarded as securities that provide known dividend yields. We assume that the dividend is paid continuously at an annual rate q, ‘hen, the forward value, f, and forward price, H’, are respectively, f= Se) —KeMT) and F = Selt-OT-0), (1.3) Keep the portfolio A fix and change the portfolio B (o be © Portfolio B: e~% TY of the security with all income being reminvested in the security. ‘The security holding in portfolio B grows as a result of the dividends that are paid, so that at time T exactly one unit of the security is held. Applying ‘the same argument as before, the required result is reached. Example: A 6-month forward to buy (sell) a stock at $14 per share. The current price of the share is $13.4 and the risk-free rate for the 6-month maturity is 5.2%. The underlying stock is paying 2% dividend yield F = 13.del0-092-002)20.5 _ 13.69 < 1d This represents an arbitrage profit. Why? Strategy: Short 1 forward contract, borrow $13.4e~%205 to buy e205 shares of stock with dividends being reinvested in the stock. The result: Cost now = 0 In-between = 0 Payoff in 6-month time = 14 - 13.4¢~®02X05 138 General form for the value of a forward contract h=(F- Mere, ‘we 1.2 Futures Contracts A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future price. Unlike forward contracts, futures ‘ave uorurally leaded ou au exeliange. Oue way inn which # futures is different from a forward contract is that an exact delivery date is usually not specified. The contract is referred to by its delivery month, and exchange specifies the period during the month when delivery must be made. Theoretically, the forward price for a contract with a certain delivery date is the same as the futures price for a contract with the same delivery 8 date when the risk-free rate is a constant (or even a deterministic function) for the whole life of the futures. This can be justified through the following, table: Day 0 TI T Future Price A Fra Fr Futures Pos e ce 0 Gain/loss 0 7 Gain/loss at time T 0 (A -Fie™ (- Fj (Pr = Freije"™ Total Gain/loss 0+ (Fi — Faje"™ + (Fa — Fie"? +--+ (Fp — Fr-aye™ at time T Fr — Fo)e"™ = (Sr — Fo)e™™ ‘Strategy A: Long the above position and invest F) into a risk-free asset. Result: Payoff at time T =(Sp — Faje™! + Fye™! = Se" Strategy B: Long &7 units of forward with forward price Fy and invest Fy into a risk-free asoet Result: Payoff at time T =(Sp — eT + Ryerl = SpetT By no arbitrage argument, two strategy should yield the same value at any moment before time T. Therefore, we have R-h In other words, forward price agrees with the future price, 1.3 Hedging with Futures 1.3.1 Minimum-variance hedge ratio Static hedge Natural position: sell N. units of an asset at time t Futures positions: short futures at time 0 for Nip units of the same asset Hedge ratio: h = Ne/Na Payoff of the static hedge position: Y = SNa—-(K—- Fo)Nr ~ S0)Na— (Fi Fu) Ne SNA + Na(AS;— hOF) 9 Volatility of the hedge position: Var(¥i) aVar(¥.) adh Mt Hedging effectiveness: NAVar(AS, — hAfi) Nj (05 + Po — 2hpasor) Ni (2ho} - 2posor) =0 os pS. oF (1.4) Variance of the portfolio without: hedge - variance of the hedge position Example: Var Variance of the portfolio without hedge 81) = Var(¥i) _ 98 = (= p*)og ar(NaSi) Month, 15 mean SD. Con AF 0.021 0.035 0.036 0.001 0.01 0.029 0.026 -0.029 0.048 -0.006 0.019 0.027 0.029 “0.018 AS 0.029 0.020 0.044 0.008 0.026 0.019 -0.10 -0.007 0.043 O.0LL 0.036 0.018 0.009 0.032 0.023 ES 0.00313 0.00262 0.928 0.928 x 0.00262 0.00313 10 If N4 = 50,000 units and the futures contract size is 1,000 units, Np = Wx Na 0.786 % 50,000 30 (6) This is approximately 39 contracts, 1.8.2 Hedging a stock portfolio First, we measure the stock porfolio in terms of index units = So/To ‘The hedge porfolio’s payoff is expressed according to the following steps, XY Si-(F- Fa)Nr = Nah(l tate +NasiAh - hon) (1) It enables us to compute the variance of the hedge portfolio, Putting the first differential of the variance to zero, we arrive at bs 101p2 Aspe (1s) If Fy = hel" OT-8, then pie and op = aye""-T-Y. Tn this case, the optimal number of futures contract becomes = Nabsse"-OT-9 So ~(r-qT= = Bpssert-or-9 Sh 30.9. pclae 9 = as re 19 Ree (1.9) Furthermore, if ¢ is small, i.e. we just want to hedge for a short period of time, the formula reduces to Example: On January 1998, we want to hedge a stock porfolio of HK$5,000,000 with 7 = 1.1 over a fonr-month period. ‘The HK d-month risk-free rate is 45%. rt Month Pri Spot 8894.61 Jan 98 8800 Feb 8865 * Use ISI futures because there is no futures contract on this portfolio. ‘© Use the June contract because the May contract is not available. ist of allot us determine the dividend yield, q. By formula (4.3), 9O15 = 8894.64e°%(2.919-9)/12 > g = 1.27% ‘Then, we cousull (4.9) 5000000 0.012 NRO x LeLe(.09-0.0127)/3 — 616,609, ro 9015 ic, short 12 June contracts (616.699/50 = 12.334). Performance of this hedge ‘Scenarios HSI spot in May 3500 [9000 9500 June HSI futures in May 8523, 9024 9526 (e(40%-1200)/14 — 1.9037) ‘Cash position in May TSLSOS | 5,038,364 | 5,347,101 (using CAPM to predict it) Futures gain (Jose) 5.00450 | (108)

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