Chapter 3 Forwards and Futures

Options, Futures, and Other Derivatives
Tenth Edition
Chapter 5
Determination of
Forward and
Futures Prices
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Consumption vs Investment Assets
• Investment assets are assets held by significant numbers of people
purely for investment purposes (Examples: stocks, bonds) we can hold commodities like
GOLD, silver for investment
• Consumption assets are assets held primarily for consumption

(Examples: copper, oil) This consumption for big firms not individuals. Gold and silver can also be here if they are used
for purification.
Short Selling Extreme bearish short sell. Borrowing an asset
• Short selling involves selling securities you do not own

Refer Note book
Assumptions and Notation
Assumptions
– No transaction costs
– Same tax rate on all net trading profits
– Market participants can borrow and/or lend money at the same
risk free rate
– Market participants take advantage of any existing arbitrage
opportunity Assume market participants are active traders
S0: Spot price today

F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for maturity T
We always use continuous compounding
An Arbitrage Opportunity?
• Suppose that:
– The spot price of a non-dividend-paying stock is $40
– The 3-month forward price is $43
– The 3-month US$ interest rate is 5% per annum
• Is there an arbitrage opportunity?
If Forward price = S0*e^r*t
Arbitrager does not use his own asset, if he is buying the asset he will always borrow the money.
Note that borrwoing will always continuous compounding.
If Short Sales Are Not Possible…

This means u cannot borrow the assets.....
As an arbitrager buy low sell high
Another Arbitrage Opportunity?
• Suppose that:
– The spot price of nondividend-paying stock is $40
– The 3-month forward price is US$39
– The 1-year US$ interest rate is 5% per annum (continuously
compounded)
Own the assets
Sell it at $ 40
• Is there an arbitrage opportunity? enter into a forward to buy back at $39
40.5-39 = 1.5
40*e^0.05*3/12 = 40.5
If Short Sales Are Not Possible…

If short sale is possible = I will borrow T0 and sell at T0 invets in FD and enter into long forwrad aftter 3 months
When an Investment Asset Provides a
Known Income
F0 = (S0 – I )erT
where I is the present value of the income during life of forward
contract
When an Investment Asset Provides a

Known Yield
F0 = S0 e(r–q )T
where q is the average yield during the life of the contract (expressed
with continuous compounding)
Valuing a Forward Contract
• By considering the difference between a contract with delivery price
K and a contract with delivery price F0 we can deduce that:
– the value of a long forward contract is
(F0 – K )e–rT
– the value of a short forward contract is
(K – F0 )e–rT
Value of the contract when written has to be = 0. As you go forwrad in time the value will change. Its a zero sum game
Futures
Stock Indices These are futures exchange traded. This is from Chapter 3 (section 3.5 of Text book)
There are multiple futures that trade on these indices
• Dow Jones Industrial Average 2 futures eg: (10* indices) (5*indexprice) Smaller once are called minis, they are
mostly traded.
• Standard & Poor’s 500 2 futures (250*index), (50 * index)
• Nasdaq - 100 2 futures (100*index) (20*index)
Stock Indices Futures Use stock index future to hedge an existing protfolio
• A futures contract to buy or sell a broad stock market index at a

predetermined price and for “delivery” to be made at a predetermined
date.
• Settlement is cash only. Contracts does not pay any dividends.
coz there is no stocks to settle this as they are indices.
Calculating Hedge Ratio
• To hedge stock portfolio, sell futures according to the hedge ratio
Your portfolio is different from futures. u are holding portfolio and selling the futures.
Beta/Risk/sensitivity of your portfolio to the index. VA = Current value of portfolio VF= Current value of futures
You should do this only if you are in a small time period. In long term this is not useful as you will always stay at
one value. You should not do it in a long position. This is only for short position. We are trying to hedge market risk
Hedging with Stock Index Futures:

Example (Section 3.5, page 62)
4 months futures
• Portfolio Description:
– Current portfolio value : $5,050,000 Index
Lets assume they pay Dividends. 1% p.a.
– Beta of the portfolio: 1.5
– Index level = 1,000 = S0 One future contract is $250. you cannot trade 1 future
– Index Future price = 1,010 contract you will have to trade 250 futures at a time. Think
about 250 as a size (standardized.)
– S&P 500 futures price = $250 *index future price= 250*1010=
Capital required $252,500 Price of one future contract = F0
1.5* 5.05/0.2525 = 30. So 30 future contracts.
– HR=? hedge Ratio
• Scenarios in 3 months
– Suppose market fall to index level 900, future price on index to
902 on one month future contract
– Suppose market rises to index level 1050, future price on index
to 1053
Keep index separte from the

Copyright ©futures
2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Stock Index
• Can be viewed as an investment asset paying a dividend yield
• The futures price and spot price relationship is therefore
F0 = S0 e(r–q )T q = Income yield. is %
where q is the average dividend yield on the portfolio represented by

the index during life of contract
Index Arbitrage
• When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index
and sells futures
• When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the
stocks underlying the index
Futures and Forwards on Currencies
• A foreign currency is analogous to a security providing a yield
• The yield is the foreign risk-free interest rate
• It follows that if rf is the foreign risk-free interest rate
1000 units of
foreign currency
(time zero)
( r  r f )T
rf T
1000 e units of
1000S0 dollars
F0  S 0 e
foreign currency at time zero
at time T
rf T 1000S0erT
1000 F0 e
dollars at time T
dollars at time T
If there is no arbitrage then both should give me same amount
Futures on Commodities If we have income
F0 =(S0-I) e^r*t
• Investment Commodities F0 = (S0 +U -I) e^r*t
F0 = (S0+U )erT Investment commodity will always be

equality
• Consumption Commodities
F0 ≤ (S0+U )erT
where U is the present value of the storage costs.
here U is the yield
F0 ≤ S0 e(r+u )T
where u is the storage cost per unit time as a percent of the asset’s spot
price Consumption inequality not going to go away. Future price for commodities is always F0<or =
Convenience Yield
To convert convienece inequality into equality we use th below formula
F0*e^y*t = S0*e^(r*t)T
Copyright © 2018, 2015, 2012 Pearson Education,
F0= S0e(r+u+y)T Inc. All Rights Reserved
The Cost of Carry
• The cost of carry, c, is the storage cost plus the interest costs less the
income earned
– For non-dividend paying stock c=r
– For stock index c=r-q
– For currency c=r-r_f
– For commodity which provides income c=r-q+u
• For an investment asset F0 = S0ecT
• For a consumption asset F0 ≤ S0ecT
• The convenience yield on the consumption asset, y, is defined so that
Y is not included in cost of carrying
F0 = S0 e(c–y )T
Futures Prices & Expected Future Spot
Prices
• Suppose k is the expected return required by investors in an asset
• We can invest F0e–r T at the risk-free rate and enter into a long futures
contract to create a cash inflow of ST at maturity
• This shows that
 rT
F0e e kT
 E ( ST )
or
F0  E ( ST )e ( r  k )T
IGNORE THIS SLIDE
Futures Prices & Future Spot Prices
No Systematic Risk k=r F0 = E(ST)
Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic Risk k<r F0 > E(ST)
Positive systematic risk: stock indices

Negative systematic risk: gold (at least for some periods)
IGNORE THIS SLIDE

Chapter 3 Forwards and Futures

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Chapter 3 Forwards and Futures

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Options, Futures, and Other Derivatives

• Consumption assets are assets held primarily for consumption

Short Selling Extreme bearish short sell. Borrowing an asset

• Short selling involves selling securities you do not own

S0: Spot price today

If Short Sales Are Not Possible…

As an arbitrager buy low sell high

If Short Sales Are Not Possible…

When an Investment Asset Provides a

• Nasdaq - 100 2 futures (100index) (20index)

• A futures contract to buy or sell a broad stock market index at a

Hedging with Stock Index Futures:

Keep index separte from the

where q is the average dividend yield on the portfolio represented by

F0 = (S0+U )erT Investment commodity will always be

Positive Systematic Risk k>r F0 < E(ST)

Negative Systematic Risk k<r F0 > E(ST)

Positive systematic risk: stock indices

IGNORE THIS SLIDE

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