Forward and Futures Prices

Derivatives Securities (MFFINTECH 6003)

Hugh Kim

The University of Hong Kong

Preliminary Note on Short Selling
I Short selling means selling a security you do not own
I You borrow the security from another person and sell it in the
market
I In future you buy the security in the market and give it back to
the lender
I If the price of the security declines (increases) you pay less
(more) when you have to return the security than what you have
received when you borrowed it ⇒ payoff is opposite to holding
the security (long position)
I You also have to pay dividends and other benefits the owner of
the security would receive if he did not lend it to you
I There may be a small fee for borrowing the security
Short Selling: Example
I You short 100 shares when the price is $100 and close out the
short position 2 days later when the price is $90 (risk free rate
for 2 days is almost 0)
I During the 2 day window a dividend of $3 per share is paid

I What do you earn?

Short Selling: Example
I What would you earn if you had bought 100 shares?
Assumptions for Pricing
I No transaction costs
I Same tax rate on all (net) trading profits
I Investors can lend and borrow without limits at the risk free
interest rate
I Investors exploit arbitrage opportunities as soon as they appear
An Arbitrage Opportunity?
I Suppose the price of a stock is $100 today and it is expected to
increase to $105 until next year; the stock does not pay
dividends within the next year
I Short selling of the stock is possible at no cost
I You can lend and borrow at a 1 year risk free interest rate of
10%

I Is it an arbitrage to short sell the stock and invest $100 in the

risk free asset at 10%?
I Though in expectation you earn money, there is a probability to
have a negative payoff.
An Arbitrage Opportunity?
I If you can enter into a forward contract (long or short position)
to buy or sell in 1 year 100 shares of the stock for $109 per
share (assume no counter-party risk), is there an arbitrage
opportunity?
Investment Asset without Intermediate Payoffs
I Consider a forward written on an asset (underlying) which is
hold by investors purely as an investment and does not have any
payoffs between origination (time t) and maturity (time T ) of
the forward
I Create an investment strategy which takes positions in the
forward, underlying asset and risk free asset (zero-coupon bond)
but does not generate any payoff in the future
Derivation of Forward Price/Investment Strategy
I At time t:
I Borrow an amount of Ft(T ) e −rt,T (T −t ) for (T − t )-years at the
risk free interest rate rt ,T
(T )
⇒ receive Ft e −rt,T (T −t )
I Buy 1 unit of the asset
⇒ pay St and receive 1 unit of the asset
I Take a short position in forward contract with forward price Ft(T )
I Cash flow: Ft(T ) e −rt,T (T −t ) − St

I At time T > t:
I Close short position in forward contract
(T )
⇒ deliver 1 unit of the asset and receive Ft
I Pay back borrowed money and interest
(T ) −rt,T (T −t ) rt,T (T −t ) (T )
⇒ pay Ft e e = Ft
I Cash flow: Ft(T ) − Ft(T ) = 0
Forward Price
I Because the strategy never pays off anything in the future
(every state of the world), its cost must be zero

(T )
Ft = St e rt,T (T −t )
Forward Price: Questions
I Is there an arbitrage if Ft(T ) > St e rt,T (T −t ) ? What do you do?
I Yes – Buy the above strategy (borrow Ft(T ) e −rt,T (T −t ) , buy
underlying, short forward) ⇒ immediate payoff:
(T )
Ft e −rt,T (T −t ) − St > 0, no future payoff

I Is there an arbitrage if Ft(T ) < St e rt,T (T −t ) ? What do you do?

I Yes – Sell the above strategy (lend Ft(T ) e −rt,T (T −t ) , short sell
underlying, long forward) ⇒ immediate payoff:
(T )
St − Ft e −rt,T (T −t ) > 0, no future payoff

I Note: if short selling the asset is not possible, then a similar

(but weaker) argument holds but only investors who already
hold the underlying can profit from the "arbitrage"
Investment Asset with Known Income
I Consider a forward written on an asset (underlying) which is
hold by investors purely as an investment and pays some
discrete payoffs Isi for si ∈ {s1 , s2 , ..., sN } between origination
(time t) and maturity (time T ) of the forward
I Example: dividend paying stock (Isi > 0)
I Example: commodity (gold, silver, etc) with storage cost Isi < 0)

I Pricing follows the same principle as before

(T )
Ft = (St − It ) e rt,T (T −t )
−rt,si (si −t )
with It = ∑N
i =1 Isi e (present value of payoffs)
Investment Asset with Known Income: Questions
I Consider a 6-month forward contract to buy 100 stocks
I The current stock price is $100
I A stock pays two $2 dividends per share in 2 and 4 months
I The yield curve is flat at 5% c.c.
I What should be the forward price?
Investment Asset with Known Income: Questions
I Is there an arbitrage if the forward price is $10, 000? How can
you make money?
Investment Asset with Known Yield
I Consider a continuous intermediate payoff flow/yield qt,T
instead of N discrete payoffs Isi at time si
I qt,T describes the payoff stream as a percentage of the
underlying’s value received at every instant in time on the
interval [t, T ]
I Example: stock index with dividend yield qt ,T > 0
I Example: commodity (gold, silver, etc) with storage cost
qt ,T < 0

I Pricing follows the same principle as before

(T )
Ft = St e (rt,T −qt,T )(T −t )
Foreign Exchange: Spot Rate
I Spot foreign exchange rate St at time t is the instant price
(immediate delivery) of one country’s currency in exchange for
another’s
I Example:
I Suppose you are a retailer in the US and need CHF 1 million
(Swiss francs) to pay for imports from Switzerland
US $
I If the FX spot rate today is St = 1.03 CHF
I You have to pay US $1, 030, 000 for CHF 1 million
Foreign Exchange: Forwards on Currencies
I In a forward contract the foreign currency is the underlying

I Agreement today (time t) to exchange Ft(T ) units of the local

country’s currency for 1 unit of another currency at time T > t
I Example:
I Suppose you need CHF 1 million in half a year
I Assume you can enter a forward contract to lock in the future
US $
exchange rate at 1.035 CHF
I If you take a long position, then in half a year you have to pay
US $1, 035, 000 for CHF 1 million
Derivation of Forward price
I You have one unit of foreign currency at time t
I rt,T is the (T − t )-year spot rate in the local currency (c.c.)
f
I rt,T is the (T − t )-year spot rate in the foreign currency (c.c.)
I Strategy 1:
I St dollars at time t
I St e rt,T (T −t ) dollars at time T

I Strategy 2:
f
I e rt,T (T −t ) units of foreign currency at time T
f
I Ft(T ) e rt,T (T −t ) dollars at time T
Forward Price
I Strategy 1 and 2 are both risk free and therefore have to yield
the same payoff:

(T ) rt,T
f (T −t )
Ft e = St e rt,T (T −t )

or
= St e (rt,T −rt,T )(T −t )
(T ) f
Ft

I A foreign currency is analogous to a security providing a known

yield
I Yield is the risk free interest rate prevailing in the foreign
country
I The holder of the foreign currency can earn interest by investing
in a foreign denominated bond
Consumption Asset: Arbitrage?
I Consider an asset that can be used for consumption (or
production)
I Asset pays a stream of intermediate payoffs q (positive: income;
negative: storage cost)
I Examples: orange juice, copper, oil, corn, etc
I Consider Ft(T ) > St e (rt,T −qt,T )(T −t ) : as discussed before there is
an arbitrage (borrow money, buy underlying, short forward)
I Consider Ft(T ) < St e (rt,T −qt,T )(T −t ) : no arbitrage opportunity as
the holder of a consumption asset may not want to sell it to
lock in a positive risk free return above rt,T because he holds
the asset for consumption
Consumption Asset: Condition on Forward Price
I Therefore, we have the (weaker) inequality

(T )
Ft ≤ St e (rt,T −qt,T )(T −t )

I Similar for discrete payoffs

(T )
Ft ≤ (St − It ) e rt,T (T −t )

I The forward price has to be determined in general equilibrium (a

concept based on demand and supply) which is weaker and more
complex than a no arbitrage argument that uses a replication
strategy
Cost of Carry and Convenience Yield
I The cost of carry ct,T is the interest "costs" rt,T minus
intermediate payoffs qt,T with qt,T = income − storage costs
(during period [t, T ])
I The convenience yield on the consumption asset yt,T for the
period [t, T ] is defined such that

(T )
Ft = St e (ct,T −yt,T )(T −t )

I The convenience yield yt,T indicates how large the opportunity

costs are if one does not have the asset available during the
period [t, T ] and has to postpone consumption until time T
I yt,T is determined in general equilibrium
Convenience Yield: Questions
I The spot price of corn per bushel on June 4 is $5.63 per bushel
I Suppose the storage cost of corn per year is 2% of its current
price
I Suppose you can enter into a forward contract to trade 10,000
bushels of corn in 18 months for $5.24 per bushel
I The 1.5-year spot rate is 0.5% (c.c.)

I What would the forward price Ft(T ) have to be if the

convenience yield were zero?
Convenience Yield: Questions
I What is the convenience yield between today and December
next year?
Limits to Arbitrage: Financial Constraints
I Financial constraints such as portfolio constraints, collateral
requirements or liquidity constraints can lead to a failure of
theoretically good arbitrage or hedging strategies
I Derivative price may deviate from “no arbitrage” price
I A danger in reality is that an “arbitrageur” or “hedger” ignores
(or does not understand) that there are limits to arbitrage and
takes large offsetting positions which will converge in the long
run, but may strongly diverge in the short run and he may have
to liquidate his “arbitrage” or “hedging” strategy and realize
large losses
⇒ The collapse of LTCM
Example of Limits to Arbitrage: LTCM
I Long Term Capital Management was a hedge fund founded in
1994
I Very successful for about 4 years, but suddenly collapsed in 1998
during the Asian financial crisis and the default of Russia
I Run by a very promising group of academics and professionals,
including 2 Nobel memorial prize laureates
I Highly regarded, much trusted, very desired, and access to
particularly cheap financing including low margin and collateral
requirements ⇒ LTCM was highly leveraged!
I Investment strategy was based on various arbitrages, for
instance a combination of long and short positions in two debt
contracts which are identical except for their liquidity, or
offestting positions in dual-listed firms where one stock trades at
a premium ⇒ offestting positions are expected to converge in
the long run and thus, buying cheap and selling expensive yields
a "certain" profit
Example of Limits to Arbitrage: LTCM
I The problem is that there were limits to arbitrage! ⇒ during
the crisis some offestting trades diverged instead of converged in
the short run, LTCM was not able to post enough collateral and
had to liquidate positions with large losses although they
expected to make money on these positions in the long run
I Some argue that LTCM also started to take on larger
speculative bets over time which caused losses during the crisis
I LTCM was bailed out in 1998 and the partners lost everything
(just before the crisis the fund was worth several billions of US$)
Pricing Forwards: A Summary
I The forward price only depends on the current price of the
underlying (St ) and the cost of carry (ct,T )
I it is independent of the expected future price of the underlying
(ST )

I For an investment asset: Ft(T ) = St e ct,T (T −t )

I For a non dividend paying stock, ct ,T = rt ,T
I For a dividend paying stock or stock index (dividend yield qt ,T ):
ct ,T = rt ,T − qt ,T
I For a foreign exchange (interest rate in foreign currency rtf,T ):
ct ,T = rt ,T − rtf,T

I For a consumption asset: Ft(T ) = St e (ct,T −yt,T )(T −t )

I ct ,T = rt ,T − qt ,T , qt ,T = income − storage cost
Value of a Forward Contract at time s in [t,T]
I At origination (time t) a forward contract has a value of 0
(that is how we have derived the forward price
(T )
Ft = St e (ct,T −yt,T )(T −t ) )
I After origination at time s ∈ (t, T ) a new forward contract with
the same maturity at time T has (in general) a different forward
price than a contract negotiated at time t,
(T ) (T )
Ft 6 = Fs = Ss e (cs,T −ys,T )(T −s )
Value of a Forward Contract at time s in [t,T]
I Because the price of a newly issued forward contract (Fs(T ) ) can
be locked in,
I the value of a long forward contract is
 
(long ,t ,T ) (T ) (T )
fs = F s − Ft e −rs,T (T −s )

I the value of a short forward contract is

 
(short ,t ,T ) (T ) (T )
fs = Ft − F s e −rs,T (T −s )