Agenda

Forward and futures

Part I
Forward prices and the no-arbitrage channel
20189 Quantitative Finance and Derivatives 2
F. Saita-A. Cosentini
Forward prices for a non-dividend paying
stock
Cash and carry vs reverse cash and carry
Transaction costs and the no-arbitrage
channel
The implied repo rate
Forward prices for dividend-paying stocks
Value of a forward contract
2

(1) Forward price with no (1) Forward price with no

dividends dividends: cash and carry
Possible strategy: buy the stock cash + borrow
On March 1st, an individual wants to buy a
forward contract on the non-dividend paying On March 1st:
stock XY, with delivery on Sep. 1st Buy stock at 40.00
If no counterparty were available, how could the Borrow 40.00 with maturity 6 months
contract be replicated? → Net cashflow: - 40 + 40 = 0
On September 1st :
S0 = 40.00 (spot price) Repay the loan
r = 3% (simple interest, annual rate) → 40.00 (1+3%×0.5) =40.60
The long forward can be replicated (at a cost of
3 40.60) 4
(1) Forward price with no (1) Forward price with no
dividends: cash and carry dividends: cash and carry
Let us review the same idea graphically (positive cashflows If the forward price were different from 40.60 there would
over the line, negative cashflows below the line) be a clear arbitrage opportunity. Example: F=40.70

Forward sale
+ + Profit +0.10 +40.70
Borrow Borrow
t0
+40.00 6 months
t +40.00 t

Buy stock Repay Buy stock Repay

-40.00 borrowed money -40.00 borrowed money
- -
-40.60 -40.60

5 6

(1) Forward price with no (1) Forward price with no

dividends: cash and carry dividends: cash and carry
Generalization (with continuous compounding) Therefore, the equilibrium forward price F* is the
At time 0: forward price that does not make arbitrage
buy a share at S0 possible, i.e. F*=S0 ert
borrow S0 at the risk-free rate r for maturity T If Factual > F* the future is overvalued and a cash
and carry arbitrage can be made
sell a forward contract on the share at F0
At time 0 net cashflow is equal to S0-S0=0
What happens if instead Factual < F* ?
At maturity the payoff is equal to
- S0 ert + F0
No arbitrage condition implies F0=S0 ert
7 8
(1) Reverse cash and carry (1) Reverse cash and carry
A reverse cash and carry strategy is Case n. 1 (completely unlikely): the arbitrageur
just the opposite of a cash and carry already owns the stock on which the arbitrage is
strategy, and implies: possible
selling short the asset; →Everything is ok: sell spot the owned stock,
invest proceedings, buy back the stock forward
investing the proceeds at the risk-free rate;
entering a long forward contract Case n. 2 (typical): the arbitrageur does not
Problem: do I own the stock I should sell own the stock, so he/she should borrow it first
spot? Two possible cases → impact of cost of borrowing
→ can ANY stock be easily borrowed?
9 10

(1) Reverse C&C with stock

(1) Reverse cash and carry borrowing
Example without cost of stock borrowing (i.e., owned stock) If the stock must be borrowed, how does stock
F = 40.50 vs F*=40.60 → arbitrage opportunity
borrowing work?
Investment The asset management company L (lender) lends stock
+ Profit +0.10 proceedings Alpha to arbitrageur B for three months.
Sell stock +40.60
+40.00 t The borrower B commits to:
- Give back 1 Alpha stock to L in 3 months
Forward - Pay a fee equal to, say, 0.04 (usually defined as x% of
- Invest at the purchase the stock value)
risk-free rate -40.50
-40.00
- Transfer to L any dividend potentially paid by Alpha
during the three months
11 12
(1) Reverse C&C with stock
borrowing (2) The no-arbitrage channel
Example with cost of stock borrowing (0.04)
F = 40.50 vs F*=40.60 → (smaller) arbitrage opportunity
Cash and carry and reverse cash and
Investment carry have been considered assuming no
+
Sell stock
Profit +0.06 proceedings transaction costs.
(not 0.10) +40.60
+40.00 t In practice, transaction costs may imply:
Stock borrowing – 0.04
a bid-ask spread on the spot transaction
Forward
Total cost: purchase a bid-ask spread on the forward transaction
- Invest at the
-40.54
risk-free rate -40.50 a bid-ask spread on borrowing/investment
-40.00
Question: If F where equal to 40.57 (i.e. below F*=40.60) would
there be an arbitrage opportunity? 13 14

(2) The no-arbitrage channel (2) The no-arbitrage channel

Cash and Reverse C&C
Example (maturity 3 months, simple interest rates) While there is carry
an apparent
Spot transaction Buy at 40.05, Sell at 39.95,
Bid Ask Mid arbitrage borrow at invest at
opportunity 3.01% 2.99%
Spot 39.95 40.05 40.00 based on mid Borrowing/ 40.65 (-) 40.55
prices, it investment cashflow (40.653) (40.547)
Forward 40.58 40.68 40.63 disappears at maturity
when Relevant fwd price Bid price: Ask price:
r 2.99% 3.01% 3%
considering 40.58 40.68 (-)
bid-ask Overall P&L -0.07 -0.13
By (simplistically) looking at mid prices, we would spreads (-0.073) (-0.133)
have a mid forward of 40.63, vs F*=40.60…
15 16
(2) The no-arbitrage channel (2) The no-arbitrage channel

If the cash and

Cash and Reverse C&C Example 2: Imagine mispricing on the forward is
carry
carry does not larger… Is arbitrage possible now?
Spot transaction Buy at 40.05, Sell at 39.95,
work, does this borrow at invest at Bid Ask Mid
mean the 3.01% 2.99%
reverse C&C Borrowing/ 40.65 (-) 40.55
Spot 39.95 40.05 40.00
would? NO! investment cashflow (40.653) (40.547)
at maturity Forward 40.75 40.85 40.80
Loss would be Relevant fwd price Bid price: Ask price: r 2.99% 3.01% 3%
40.58 40.68 (-)
even larger…
Overall P&L -0.07 -0.13
(-0.073) (-0.133)

17 18

(2) The no-arbitrage channel (2) The no-arbitrage channel

In this case the mispricing is large enough to Let us get back to example 1
justify an arbitrage transaction: Is there anybody who can profit from the slight
cost of buying cash + interests = 40.653 (buy at mispricing of the market forward price? How?
40.05, borrow at 3.01% as before)
Bid Ask Mid
bid forward price = 40.75
net profit = 0.097 (i.e. 40.75 – 40.653) Spot 39.95 40.05 40.00
Intuitively, there is a no-arbitrage channel: if the Forward 40.58 40.68 40.63
market forward price does not differ enough from
the fair price (ex. 1) arbitrage is not feasible… r 2.99% 3.01% 3%
…but when it deviates enough (ex. 2) arbitrage Consider somebody who simply wants to buy
becomes feasible even after transaction costs forward… how could this be done?
19 20
(2) The no-arbitrage channel (2) The no-arbitrage channel
Real price(s) fluctuate within a no-arbitrage channel
Strategy 1 Strategy 2 - Even if a full arbitrage
Buy fwd Cash and carry is unfeasible… Price becomes too high
Spot - Buy at 40.05, P Cash and carry arbitrage
transaction borrow at 3.01% …knowing no arbitrage
relationships enables
Payment 40.68 40.65 the forward buyer to Price becomes too low
Reverse cash and carry arbitrage
at maturity (ask save money (replicating
price) the long forward is t
cheaper) Issue # 1: boundaries for bid vs ask prices
No arbitrage relationships may be important in practice even Higher bound (buy at ask+borrow at ask)→ upper limit for bid fwd price
when taking directional positions (i.e., for trading) Lower bound (sell at bid+invest at bid)→ lower limit for ask fwd price
Specular opportunities may arise for a seller under opposite Issue # 2: who exploits arbitrage opportunity first?
market conditions (slightly undervalued F) 21 22

(3) The implied repo rate (3) The implied repo rate
A repurchase agreement (repo) is a deal in which a
counterparty buys a bond spot and sells it forward
at a specified price (investment repo) or vice versa
sells spot and buys forward (financing repo)
If there are no dividends/coupons between the two
dates, it is extremely easy to derive the interest
rate obtained or paid through the repo
E.g. non-dividend paying stock X
buy spot X at 100 + sell 1-year forward X at 102
= 1-year risk-free investment at 2%
23
If S is the spot price of a non-dividend paying
stock, and Fmkt the actual (note: not the
equilibrium, or fair) forward price, then the
(continuously compounded) implied repo rate rimp is
the rate such that
r imp t
F mkt = Se
So if the actual forward is equal to the equilibrium
forward price (Fmkt=F*) the implied repo rate must
equal the risk-free rate
24
 (3) The implied repo rate
Corollary: if Fmkt≠F*, the potential arbitrage opportunity
could be interpreted also in term of rates
Example: if Fmkt>F* (forward overvalued → cash and
carry arbitrage strategy) then rimp >r
(3) The implied repo rate
A very simple consideration, that will be helpful later in a
different setting, is that given the maturity of the
forward t, the larger the difference between S and Fmkt
and the greater is the implied repo rate

The usual cash and carry (i.e., buy cash+borrow at r
+sell fwd at Fmkt) could be interpreted as
(1) buy cash+sell fwd at Fmkt=investment repo at rimp
(2) financing at the lower rate r
=gaining the difference between rates!
25
For instance, given t and F, if S is particularly low
(cheap) then we have a greater implied repo rate
(this will be useful when discussing bond futures later)
26

(4) Forward price with one or (4) Forward price with

more dividends dividends: cash and carry
In the case of one dividend the cost of carry is
reduced and the fair forward price is
F0 = (S0 – I) ert Borrow
S-I
where I= present value of the dividend +
Receive
Borrow
t’ D t time
I= e-rt’D
Intuition: part of the purchase of the stock at
time zero might be financed with a second Buy stock
Repay
Repay
I ert’=D
borrowing transaction repaid through -
-S (S-I) ert
dividends

Then F* = (S0 – I) ert

27 28
(5) Value of a forward
contract
On March 1st you have bought forward a stock at
40.60 for maturity September 1st .
On June 1st the 3-month forward price of the
same stock is 40.70.
(5) Value of a forward
contract
If we define K the originally contracted forward
price (i.e. 40.60) and F the new forward price
for the same maturity, then the value of the
forward f is given by

Which is the value (on June 1st) of the forward f= e-rt (F – K) for the buyer
deal you made three months ago? f= e-rt (K – F) for the seller
The profit you could lock in (and get at maturity, where t is time from today (valuation date) to
on Sep 1st) could be 40.70-40.60=0.10 the forward deal’s maturity, and r the risk-
The value of the forward contract is 0.10 free interest rate on maturity t
discounted back for 3 months (to June 1st ).
29 30