Valuation assumptions

Forwards on investment assets

Futures prices vs. forward prices
Commodity futures

Derivatives and Risk Management

Lecture 3: Forward and futures prices

Charlotte Sun Clausen-Jørgensen and Søren Hesel

Department of Business and Management

Fall 2022

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 Valuation assumptions
Forwards on investment assets
Futures prices vs. forward prices
Commodity futures

Outline

1 Valuation assumptions

2 Forwards on investment assets

3 Futures prices vs. forward prices

4 Commodity futures

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 Valuation assumptions
Basic assumptions
Forwards on investment assets
Investment assets vs. consumption assets
Futures prices vs. forward prices
Short selling
Commodity futures

Our valuation formulas assume. . .

• No arbitrage (= no profitable risk-free investment strategies)
• No transaction costs, in particular risk-free borrowing and lending
at the same interest rate
• No distorting taxes
• No portfolio restrictions
I Short-selling is allowed: you may sell an asset you do not own
I Assets are perfectly divisible

An investment strategy which is an implementable arbitrage for one

market participant may not be an implementable arbitrage for other
market participants due to differences in the transaction costs or
portfolio restrictions they face.

At least these assumptions should hold for a few key market

participants.
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 Valuation assumptions
Basic assumptions
Forwards on investment assets
Investment assets vs. consumption assets
Futures prices vs. forward prices
Short selling
Commodity futures

The nature of the underlying matters

• Investment asset: an asset held by a significant number of

people purely for investment purposes
I financial assets such as stocks and bonds
I gold, silver
• Consumption asset: an asset held primarily for consumption or
production purposes
I copper, oil, pork bellies

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 Valuation assumptions
Basic assumptions
Forwards on investment assets
Investment assets vs. consumption assets
Futures prices vs. forward prices
Short selling
Commodity futures

Short selling (”shorting”)

• Selling an asset you don’t own borrow from someone who

owns the asset
• Close out the position by buying the asset in the market
I If the price of the asset has increased → loss
I If the price of the asset has declined → profit
• The one with the short position must pay any income (e.g.
dividends or interest) that would normally be received on the
asset that has been shorted

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 Valuation assumptions Underlying pays no dividends
Forwards on investment assets Underlying pays known dividend payments
Futures prices vs. forward prices Underlying pays a known continuous dividend yield
Commodity futures Forward price vs. expected spot price

Notation

T : delivery date
K : delivery price, paid at time T
St : price of underlying asset at time t
ftT : value at time t of long position in forward contract with delivery
date T and a given delivery price K
FtT : forward price at time t for delivery at time T , i.e. the value of K
that makes ftT = 0
r : risk-free interest rate over the relevant period, continuously
compounded
I does not have to be the same for all periods and at all points in
time, but that is not clear using Hull’s notation

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 Valuation assumptions Underlying pays no dividends
Forwards on investment assets Underlying pays known dividend payments
Futures prices vs. forward prices Underlying pays a known continuous dividend yield
Commodity futures Forward price vs. expected spot price

Underlying asset pays no dividends

Underlying asset: zero-coupon bond, some stocks, . . .

Value of forward contract:

ftT = St − Ke−r (T −t)

Forward price:
FtT = St er (T −t)

Note that  
ftT = FtT − K e−r (T −t)

Here K = F0T for a forward contract entered into at time 0.

Examples

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 Valuation assumptions Underlying pays no dividends
Forwards on investment assets Underlying pays known dividend payments
Futures prices vs. forward prices Underlying pays a known continuous dividend yield
Commodity futures Forward price vs. expected spot price

Underlying asset pays known dividends

Underlying asset: coupon bond, stock, . . .

Value of forward contract: ftT = St − It − Ke−r (T −t) ,

where It is the value at time t of the dividend payments between
time t and T .

For example, with dividends D1 , . . . , DN at times t1 , . . . , tN ∈ [t, T ] we

P
have It = Nj=1 Dj e
−r (tj −t)
.

Note: St − It is what you need to invest at time t to have ST at time T

Proof on the board(?)

Forward price: FtT = (St − It )er (T −t)

ftT = FtT − K e−r (T −t)

Note that again:
Examples
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 Valuation assumptions Underlying pays no dividends
Forwards on investment assets Underlying pays known dividend payments
Futures prices vs. forward prices Underlying pays a known continuous dividend yield
Commodity futures Forward price vs. expected spot price

Underlying pays a known continuous dividend yield

Underlying asset: foreign currency, large stock index, . . .

Dividend yield q means a dividend payment over any small interval

[t, t + ∆t] equal to (eq∆t − 1)St ≈ q · St · ∆t.

Need to invest e−q(T −t) St at time t to end up with ST at time T .

Value of forward contract: ftT = St e−q(T −t) − Ke−r (T −t)

Forward price: FtT = St e(r −q)(T −t)

ftT = FtT − K e−r (T −t)

Once again:

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 Valuation assumptions Underlying pays no dividends
Forwards on investment assets Underlying pays known dividend payments
Futures prices vs. forward prices Underlying pays a known continuous dividend yield
Commodity futures Forward price vs. expected spot price

Forward on foreign currency

For currency forwards q = rf so FtT = St e(r −rf )(T −t)
Example: Homeland: Denmark. Foreign country: USA.
Data from September 6, 2021 (source: www.investing.com)
Spot currency rate: 6.2675 DKK for 1 USD
Interest rates from DFBF and US treasury

Period DKK interest rate USD interest rate forward quote forward price
1m -0.3693% 0.04% -32.5 6.2642
3m -0.3988% 0.05% -100.5 6.2575
6m -0.4025% 0.05% -233 6.2442

Forward quote is difference between forward price and spot price multiplied
by 10,000.
1m forward price: F = 6.2675 e(−0.0036930−0.0004)/12 ≈ 6.2654
3m forward price: F = 6.2675 e(−0.003988−0.0005)·3/12 ≈ 6.2604
6m forward price: F = 6.2675 e(−0.004025−0.0005)·6/12 ≈ 6.2533
. . . roughly consistent with the forward prices listed at www.investing.com
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 Valuation assumptions Underlying pays no dividends
Forwards on investment assets Underlying pays known dividend payments
Futures prices vs. forward prices Underlying pays a known continuous dividend yield
Commodity futures Forward price vs. expected spot price

Forward price vs. expected spot price

Do forward/futures prices reflect expected spot prices in the future?

• Assume zero dividends

• Write St = E[ST ]e−k (T −t) for a relevant discount rate k
• Then FtT = St er (T −t) = E[ST ]e(r −k )(T −t)
• According to the CAPM (recall the SML)
I if Corr[underlying, market] > 0: k > r and thus FtT < E[ST ]
(normal) backwardation
I if Corr[underlying, market] = 0: k = r and thus FtT = E[ST ]
I if Corr[underlying, market] < 0: k < r and thus FtT > E[ST ]
contango

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 Valuation assumptions
Forwards on investment assets Constant interest rates
Futures prices vs. forward prices Non-constant interest rates
Commodity futures

Futures price vs. forward price

Of course: Same underlying + same final settlement date

FtT : forward price

ΦTt : futures price

RESULT: If interest rates are constant, then FtT = ΦTt .

(Proof in Hull)

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 Valuation assumptions
Forwards on investment assets Constant interest rates
Futures prices vs. forward prices Non-constant interest rates
Commodity futures

Futures price vs. forward price

What if interest rates vary stochastically over the life of the contracts?

• If cov[S, r ] > 0:
I positive payment from the futures when interest rate is high
I negative payment from the futures when interest rate is low
A long futures will be more attractive than a forward (if delivery
prices were the same) so ΦTt > FtT
• If cov[S, r ] < 0:
I positive payment from the futures when interest rate is low
I negative payment from the futures when interest rate is high
A long futures will be less attractive than a forward (if delivery
prices were the same) so ΦTt < FtT

A more precise statement involves risk-neutral probabilities

introduced later in the course.

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 Valuation assumptions
Forwards on investment assets
Futures prices vs. forward prices
Commodity futures

Consumption commodities
Storage costs ∼ negative dividends
Ut : present value of all the storage costs over [t, T ]

Forward/futures price according to previous results

FtT = (St + Ut )er (T −t)

If storage costs are proportional to price of the asset and paid

continuously, Ut = St eu(T −t) so that

FtT = St e(r +u)(T −t)

What happens if FtT > (St + Ut )er (T −t) ? Arbitrage!

What happens if FtT < (St + Ut )er (T −t) ? Arbitrage, if underlying is an

investment asset. If the underlying is a consumption asset: holding
the asset has some value maybe not exploit the apparent arbitrage
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 Valuation assumptions
Forwards on investment assets
Futures prices vs. forward prices
Commodity futures

Convenience yield
We can measure the benefit of holding the asset by the difference
between FtT and (St + Ut )er (T −t)
• Convenience yield: y defined such that

FtT ey (T −t) = (St + Ut )er (T −t)

• Convenience yield reflects the market’s expectations concerning

the future availability of the commodity
I high inventories: low convenience yield
I low inventories: high convenience yield
Forward/futures price: FtT = (St + Ut )e(r −y )(T −t)

or FtT = St e(r +u−y )(T −t)

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