Derivatives

Chapter 5 Financial Forwards and Futures

Financial Forwards and Futures

• In this chapter we continue to explore these contracts and study

in detail forward and futures contracts on financial instruments,
such as stocks, indexes, currencies, and interest rates.
• Our objectives are to understand more about the use of these
contracts, how they are priced, and how market-makers hedge
them.
• Questions to keep in mind throughout the chapter include: Who
might buy or sell specific contracts? What kinds of firms might
use the contract for risk management? Why is the contract
designed as it is?
5.1 ALTERNATIVE WAYS TO BUY A STOCK

• The purchase of a share of XYZ stock has three components:

(1) fixing the price
(2) the buyer making payment to the seller
(3) the seller transferring share ownership to the buyer.
• If we allow for the possibility that payment and physical receipt
can occur at different times, there are four logically possible
purchasing arrangements:
- payment can occur at time 0 or T
- physical receipt can occur at time 0 or T
5.1 ALTERNATIVE WAYS TO BUY A STOCK

• Four different payment and receipt timing combinations

- Outright purchase: ordinary transaction
- Fully leveraged purchase: investor borrows the full amount
- Prepaid forward contract: pay today, receive the share later
- Forward contract: agree on price now, pay/receive later
Continuously Compounded Interest Rate

• Continuously compounded interest rate r

• Denote effective annual rate R
• If you borrow 1 for 1 year, you repay er or 1 + R
• If you borrow 1 for time T, you repay erT

FV = PVerT = PV (1 + R)T
• To discount future value and compute the present value

FV
PV = FVe−rT =
(1 + R)T
5.1 ALTERNATIVE WAYS TO BUY A STOCK

• If we know the price for the prepaid forward, then we can

calculate the price for a forward contract
5.2 PREPAID FORWARD CONTRACTS ON STOCK

• Prepaid forward contract: entails paying today to receive

stocks in the future.
• The sale of a prepaid forward contract permits the owner to sell
an asset while retaining physical possession for a period of time.
• How to price the prepaid forward?
• Assume no dividends for now
Pricing the Prepaid Forward by Analogy

• In the absence of dividends, the timing of delivery is irrelevant

1. Outright purchase: you get the stock at time 0
2. Prepaid forward: you get the stock at time T
- In either case you own the stock at time T
- it will be exactly as if you had owned the stock the whole time
• Price of the prepaid forward contract same as current stock price
P , stock
• Denote the price of prepaid forward from time 0 to T F0,T
price S0
P
F0,T = S0

no time value? forward no cost?

Pricing the Prepaid Forward by Arbitrage

• Classical arbitrage
- we can generate a positive cash flow either today or in the future
by simultaneously buying and selling related assets
- no net investment of funds
- no risk
• Arbitrage, in other words, is free money.
• An important pricing principle is that the price of a derivative
should be such that no arbitrage is possible
- Otherwise, someone will do it and keep doing it
- They “arbitrage away” the gap
Pricing the Prepaid Forward by Arbitrage
P =S .
• We just showed F0,T 0
P >S .
• If F0,T 0
• Can we arbitrage?
- buy low and sell high
• Which one is low? S0 . buy stock
P . sell prepaid forward
• Which one is high? F0,T

• We have earned positive profits today and offset all future risk.
Pricing the Prepaid Forward by Arbitrage
P <S .
• If F0,T 0
P . buy prepaid forward
• Which one is low? F0,T
• Which one is high? S0 . short stock
P and offset all future
• We have earned positive profits S0 − F0,T
risk.
• Arbitrage profits are traded away quickly and cannot persist
P P
- Many people buy F0,T , F0,T will increase
- Many people short S0 , S0 will decrease
P
- Unitil F0,T = S0 arbitrage stops
• At equilibrium we expect

P
F0,T = S0
Pricing the Prepaid Forward by Arbitrage

• Throughout the course we will assume that prices are at levels

that preclude arbitrage.
• In reality, arbitrage happens from time to time
- many market makers and proprietary trading firms
• Prices are “corrected” to be the equilibrium theoretical price
• If you see the price different from the theoretical price
- the theory could be wrong
- there are practical considerations: transaction cost, taxes,
expertise, market access
- you could go ahead and arbitrage
Pricing Prepaid Forwards with Dividends

• What if there are dividends?

- the dividends are paid to the owner
• The owner of stock receives dividends
• But the owner of a prepaid forward contract does not
• So pricing by analogy breaks down
- direct purchase is better than prepaid forward because of the
dividend

P
F0,T = S0 − PV (dividends between t = 0 and t = T )
Discrete Dividends
• For discrete dividends
• Dti at times ti , i = 1,. . . ., n

n
X
P
F0,T = S0 − PV0,ti (Dti )
i=1

Example. (5.1) Suppose XYZ stock costs $100 today and is

expected to pay a $1.25 quarterly dividend, with the first coming 3
months from today and the last just prior to the delivery of the stock.
Suppose the annual continuously compounded risk-free rate is 10%.
• The quarterly continuously compounded rate is therefore 2.5%.
4
X
P
F0,T = 100 − 1.25e−0.025i = 95.3
i=1

= 100 − 1.25e−0.025 − 1.25e−0.05 − 1.25e−0.075 − 1.25e−0.1

Continuous Dividends

• Stocks usually pay dividends every quarter/year

• For stock indexes containing many stocks, it is common to model
the dividend as being paid continuously
- different constitutes pay dividends at different date
• Dividend yield: the annualized dividend payment divided by the
stock price.
- compare this to bond yield
Continuous Dividends

• To model a continuous dividend, suppose that the index price is

S0 and the annualized daily compounded dividend yield is δ.
- We assume the dividend yield is constant. This is an
approximation.
• Then the dollar dividend over 1 day is δ
365 × S0
• We get the dividend everyday and should do something with it.
Now suppose that we reinvest dividends in the index. After 1
day, we will have more shares 1 + δ/365
• After 1 year, the number of share (1 + δ/365)365 ≈ eδ
• After T year, the number of share (1 + δ/365)365T ≈ eδT
- similar to continuously compounded interest
Continuous Dividends
• With continuous dividends
• You buy 1 share today and get eδT shares at time T
• To get 1 share at time T, you just need to buy fewer than 1 share
• You buy e−δT share today and get 1 shares at time T
- Adjusting the initial quantity in this way in order to offset the effect
of income from the asset is called tailing the position
• How to price prepaid forward
• An investment of e−δT , after reinvestment of dividends, gives us
one share at time T
• The analogy: prepaid forward should have the same price as
e−δT share of stock
P
F0,T = S0 e−δT
Continuous Dividends

Example. (5.2) Suppose that the index is $125 and the annualized
daily compounded dividend yield is 3%.
• The daily dollar dividend is (0.03/365) × 125 = 0.01027
• If we start by holding one unit of the index, at the end of 1 year
we will have e0.03 = 1.030455 unit
• If we wish to end the year holding one share, we must invest in
e−0.03 = 0.970446
• The prepaid forward price is
125e−0.03 = 121.306
5.3 FORWARD CONTRACTS ON STOCK
• If we know the prepaid forward price, we can compute the
forward price.
• The difference between a prepaid forward contract and a forward
contract is the timing of the payment for the stock
• The forward price F0,T is just the future value of the prepaid
p
forward price F0,T
P
F0,T = FV (F0,T )
• This formula holds for any kind of dividend payment.
• For continuous dividend,

F0,T = FV (S0 e−δT ) = erT S0 e−δT

= S0 e(r −δ)T

• Forward price depends on the current stock price, interest rate,

and dividend yield
FORWARD CONTRACTS ON STOCK

• The forward price is generally different from the spot price.

- could be smaller or larger
• The forward premium: the ratio of the forward price to the spot
price
F0,T
forward premium = = e(r −δ)T
S0
• Annualized forward premium r − δ
Does the forward price predict the future price?

• According the formula

F0,T = S0 e(r −δ)T

• the forward price conveys no additional information beyond what

S0 , r, and d provides
Does the forward price predict the future price?

• What should be the future expected stock price?

• Denote α the expected stock return
• Remind yourself of stock valuation. If we use CAPM

α − r = β(rm − r )
• α − r is the risk premium
• E0 (ST ) is the expectation at time 0 of the stock price at time T

E0 (ST ) = S0 e(α−δ)T

expect what should be future stock price

Does the forward price predict the future price?

• The forward price is NOT the expected future stock price

F0,T = S0 e(r −δ)T = S0 e(−(α−r )+(α−δ))T = E0 (ST )e−(α−r )T

• The forward price is the expected future spot price, discounted

at the risk premium.
- It underestimates the future stock price

spot，stock區別？
Time Value of Money and Risk Premium

r is risk free
• When you buy a bond, you expect to earn interest as
compensation for the time value of money. r .
• When you buy a stock, you expect to earn interest as
compensation for the time value of money. r .
• You also expect an additional return as compensation for the risk
of the stock—this is the risk premium. α − r .
• When you buy a forward, there is no investment; hence, you are
not compensated for the time value of money.
• However, the forward contract retains the risk of the stock, so
you must be compensated for risk.
Time Value of Money and Risk Premium

Example. Suppose that a stock index is 100. It has an expected

return of 15%, while the risk-free rate is 5%. Risk premium is 10%.
No dividend.
• The 1 year forward is 105.
• If you have 100 and want to get the time value of money, buy the
risk-free bond and get 105.
• If you have 100 and want both time value of money and risk
premium, buy the stock and get 115 in expectation.
- Of course, you could lose money.
• If you do not have money, you can still earn the risk premium by
buying a forward. Your payoff is 10 in expectation.
Creating a Synthetic Forward Contract
• We can replicate a forward
• Payoff of a forward at expiration is ST −F0,T
• We buy a tailed stock position S0 e−δT . This gives us 1 share
and future payoff of ST
• We borrow S0 e−δT . This gives us future payoff of
−S0 e(r −δ)T = −F0,T .
• This transaction has the same cash flow at time 0 and time T as
a forward
• This is called a synthetic forward:
Creating a Synthetic Forward Contract

• We have just shown

- Forward = Stock − zero-coupon bond
• Rearrange and we get
- Stock = Forward + zero-coupon bond
- Zero-coupon bond = Stock − forward
Creating a Synthetic Forward Contract

• Creating a synthetic stock

• Stock = Forward + zero-coupon bond
• Go long a forward contract and lend the present value of the
forward price
Creating a Synthetic Forward Contract

• Creating a synthetic stock

• Comparing a Forward and Outright Purchase in Ch 2
Creating a Synthetic Forward Contract

• Creating a synthetic bond

• Zero-coupon bond = Stock − forward
• We buy the stock and short the forward
Creating a Synthetic Forward Contract

• Be familiar with these relationships

• If you forget, draw payoff diagrams
Synthetic Forwards in Market-Making and Arbitrage

• Someone want to buy a forward for some reason

• The market maker, as the counterparty, is left holding a short
forward position
• Now let’s think from the perspective of a market maker
• A market-maker must be able to offset the risk of a forward
contract
• It is possible to do this by creating a synthetic forward contract to
offset a position in the actual forward contract.
Synthetic Forwards in Market-Making and Arbitrage

• Forward = Stock − zero-coupon bond

• − Forward + Stock − zero-coupon bond = 0
• cash-and-carry : buy the underlying asset and short the
offsetting forward contract
Synthetic Forwards in Market-Making and Arbitrage

• If the client wants to short a forward, you can do the opposite

• Forward − Stock + zero-coupon bond = 0
• reverse cash-and-carry : short-sell the underlying asset and
long the offsetting forward contract
No-Arbitrage Bounds with Transaction Costs

• We show arbitrage makes the actual price close to the

theoretical price
• We just ignore things that make arbitrage harder
- trading fees
- bid-ask spreads
- different interest rates for borrowing and lending
- the possibility that buying or selling in large quantities will cause
prices to change.
• Rather than there being a single no-arbitrage price, there will be
a no-arbitrage bound:
- a lower price F − and an upper price F + such that arbitrage will
not be profitable when the forward price is between these bounds.
No-Arbitrage Bounds with Transaction Costs

• No dividends and no time T transaction costs for simplicity

• Bid-ask spreads: for stock S b < S < S a , and for forward
Fb < F < Fa
• Cost k of transacting stock and forward
• Interest rate for borrowing and lending are r b > r > r l
• We believe forward price is too high
No-Arbitrage Bounds with Transaction Costs

• We believe forward price is too high

• We sell the forward and borrow to buy the stock
- pay the transaction cost k to short the forward
- pay S0a + k to acquire one share of stock
- Borrow S0a + 2k .
b
- At time T , the payoff is −(S0a + 2k )er T + F0,T
b
− ST + ST .
b
- the arbitrage profit is positive if F b > (S a0 + 2k )er T
≡ F+
• Even if SerT < F b < F + , we could not arbitrage
- Without costs, we could arbitrage as long as SerT < F
No-Arbitrage Bounds with Transaction Costs

• We believe forward price is too low

• We buy the forward and lend and short the stock
- pay the transaction cost k to buy the forward
- get S0b − k from shorting the stock
- lend S0b − 2k .
l
- At time T , the payoff is (S b0 − 2k )er T + S T − F0,T
a
− ST .
l
- the arbitrage profit is positive if F a < (S b0 − 2k )er T ≡ F −
• F − < SerT < F +
- If the price is between F − and F + , we cannot arbitrage
No-Arbitrage Bounds with Transaction Costs
• Other considerations
- significant amounts of trading can move prices, so that what
appears to be an arbitrage may vanish if prices change
- execution risk. If trades do not occur instantaneously, the
arbitrage can vanish before the trades are completed.
• It is likely that the no-arbitrage region will be different for different
arbitrageurs
- A large investment bank sees stock order flow from a variety of
sources and may have inventory of either long or short positions
in stocks
- The bank may be able to buy or sell shares at low cost by serving
as market-maker for a customer order
- It may be inexpensive for a bank to short if it already owns the
stocks,
- It may be inexpensive buy if the bank already has a short position.
- Borrowing and lending rates can also vary
No-Arbitrage Bounds with Transaction Costs

• Arbitrage may be difficult, risky, and costly.

• Large deviations from the theoretical price may be arbitraged
• But small deviations may or may not represent genuine arbitrage
opportunities.
5.4 FUTURES CONTRACTS

• Futures contracts are essentially exchange-traded forward

contracts.
- The information are public.
- Futures trading hours are longer than stock trading hours.
Futures prices are informative when the stock market is closed.
• Because futures are exchange-traded, they are standardized
and have specified delivery dates, locations, and procedures.
• Each exchange has an associated clearinghouse
- Matches buy and sell orders
- Keeps track of members’ obligations and payments
- After matching the trades, becomes counterparty
Futures Prices

• Consider the difference between a bond and a loan(lending)

- You lend some money for 1 year. You will get them back in 1 year.
Nothing happens in between.
- You buy a 1-year bond. If you hold it for 1 year, it is the same as
the loan. Or you can sell the bond in between. The price changes
over the year.
• Forwards
- we only consider time 0 and time T
• Futures
- we need to think about the time in between
Futures Prices
• We buy a forward at time 0 that expires at time T

F0,T = S0 e(r −δ)T

• At time 1, the forward price is

forward price will change
F1,T = S1 e(r −δ)(T −1)

- the stock price S1 changes, the time to expiration decreases by 1

- r , δ might change, but we assume they do not
• At time 2, the forward price is

F2,T = S2 e(r −δ)(T −2)

• At time T, the forward price is

FT ,T = ST e(r −δ)(T −T ) = ST
Futures Prices
Example. We buy a gold miner stock futures at time 0 that expires at
time T. S0 = 100. Assume r = δ for simplicity. At time 1, the company
finds a new gold mine. The stock price S1 = 1000.

F0,T = S0 = 100

F1,T = S1 = 1000

• What’s the value of your position?

• You can sell the futures at time 1. You payoff at time T is

(ST − F0,T ) + (F1,T − ST ) = F1,T − F0,T = 900

• You can get the money PV (900) and walk away.

• This is marking-to-market.
Futures Prices
Example. We buy a restaurant stock futures at time 0 that expires at
time T. S0 = 100. Assume r = δ for simplicity. At time 1, virus starts.
The stock price S1 = 10.

F0,T = S0 = 100

F1,T = S1 = 10

• What’s the value of your position?

• You can sell the futures at time 1. You payoff at time T is

(ST − F0,T ) + (F1,T − ST ) = F1,T − F0,T = −90

• You loss money PV (−90).

• This is marking-to-market.
Futures vs Forwards
• Whereas forward contracts are settled at expiration, futures
contracts are settled daily.
- The determination of who owes what to whom is called
marking-to-market.
- Frequent marking-to-market and settlement of a futures contract
can lead to pricing differences between the futures and an
otherwise identical forward.
• As a result of daily settlement, futures contracts are liquid
- it is possible to offset an obligation on a given date by entering
into the opposite position.
- For example, if you are long the September S&P 500 futures
contract, you can cancel your obligation to buy by entering into an
offsetting obligation to sell the September S&P 500 contract. If
you use the same broker to buy and to sell, your obligation is
officially cancelled
Futures vs Forwards
• Over-the-counter forward contracts can be customized to suit
the buyer or seller, whereas futures contracts are standardized.
• Because of daily settlement, the nature of credit risk is different
with the futures contract. In fact, futures contracts are structured
so as to minimize the effects of credit risk.
• There are typically daily price limits in futures markets (and on
some stock exchanges as well). A price limit is a move in the
futures price that triggers a temporary halt in trading. For
example, there is an initial 5% limit on down moves in the S&P
500 futures contract. An offer to sell exceeding this limit can
trigger a temporary trading halt, after which time a 10% price
limit is in effect. If that is exceeded, there are subsequent 15%
and 20% limits. The rules can be complicated, but it is important
to be aware that such rules exist.
The S&P 500 Futures Contract

• The S&P 500 is an example of a cash-settled contract: the

contract calls for a cash payment that equals the profit or loss as
if the contract were settled by delivery of the underlying asset.
• A physical settlement process would call for delivery of 500
shares in the precise percentage they make up the S&P 500
index. This basket of stocks would be expensive to buy and sell.
Cash settlement is an inexpensive alternative.
Margins and Marking to Market

• Suppose the futures price is 1100 and you wish to acquire a

$2.2 million position in the S&P 500 index.
• Notional value of one contract $250 x 1100 = 275,000.
• You enter into 8 long contracts that totals 2.2 million
Margins and Marking to Market
• Margin: both buyers and sellers are required to post a
performance bond with the broker to ensure that they can cover
a specified loss on the position.
• Suppose that margin is 10% of the notional value. The margin is
$220,000.
• Futures price drops to 1027.99 (6.5%) in a week
• Mark to market
- if we close the position, we short 8 contracts and get $2000 x
1027.99
- therefore, we lost 2000 x 72.01 = 144,020
• Our margin is 220, 000e0.06/52 −144, 020 = 76, 233.99
- Our margin drops by 76, 233.99/220, 000 = 65%.
- 10 times leverage.
Margins and Marking to Market
• The exchange has significantly less protection should we default.
• Margin call: we are required to maintain the margin at a
minimum level
• Maintenance margin: often set at 70% to 80% of the initial
margin level
t =0 t =1
price P0 P1 = (1 + x)P0
gain/loss xP0
margin 10%P0 (10% + x)P0
initial margin 10%P0
maintainance margin 7%(1 + x)P0
• If magin< maintainance margin, we get a margin call
• (10% + x)P0 < 7%(1 + x)P0 , x < −3.09%
• If we close the position, we walk away with the remaining margin
Margins and Marking to Market
Comparing Futures and Forward Prices

• Forward and futures prices are very similar

• They differ sometimes because interest is earned on the
mark-to-market proceeds in futures but not in forwards
Arbitrage in Practice: S&P 500 Index Arbitrage

• We determine the theoretical price of an S&P 500 futures

contract
• We need three inputs: (1) the value of the cash index (S0 ), (2)
the value of dividends (δ), and (3) the interest rate (r).
• On December 16, 2010, the closing S&P 500 index price was
1242.87.
• S&P 500 futures contracts expiring in March 2011 and June
2011 had closing prices of 1238.50 and 1233.60.
• The dividend yield on the S&P 500 in mid-December was about
1.89%.
Arbitrage in Practice: S&P 500 Index Arbitrage

• What interest rate is appropriate?

• Two interest rates that we can easily observe are the yield on
U.S. Treasury bills and the London Interbank Offer Rate
(LIBOR), which is a borrowing rate for large financial institutions.
• LIBOR yields are greater than Treasury yields for two reasons.
- Banks have greater default risk than the government and thus the
interest rate on their deposits is greater.
- Treasury securities are more liquid—they are easier to buy and
sell—and consequently their price is greater (their yield is lower).
- The appropriate rate is therefore greater than the T-bill rate and
likely lower than LIBOR.
Arbitrage in Practice: S&P 500 Index Arbitrage

• Our theoretical formula works fairly well

- Future dividends on the S&P 500 stocks are uncertain
- There are transaction costs of arbitrage
Arbitrage in Practice: HSI Index

• Hang Seng Index

Arbitrage in Practice: HSI Index

• Interest rate Link

- The interest rate is different for different horizons
- Let’s use 1 month. We will talk about this in Chapter 8.

• Dividend yield Link

- 3.83%
Arbitrage in Practice: HSI Index
• Let’s compute the theoretical prices and compare them with the
actual price
• r < δ, so futures is smaller than spot. The price decreases with
expiration.
Arbitrage in Practice: HSI Index

• The margin, look for the margin table Link

• maigin/notional = 125,352/23,853/50 = 11%
Quanto Index Contracts

• A dollar-based investor wishing to invest in the Nikkei 225 cash

index.
- changing dollars to yen
- using yen to buy the index
- selling the index
- converting yen back to dollars
• There are two sources of risk in this transaction: the risk of the
index, denominated in yen, and the risk that the yen/dollar
exchange rate will change
Quanto Index Contracts

• Settlement of the contract is in a different currency (dollars) than

the currency of denomination for the index (yen).
• The contract insulates investors from currency risk, permitting
them to speculate solely on whether the index rises or falls. This
kind of contract is called a quanto.
• Quanto contracts allow investors in one country to invest in a
different country without exchange rate risk.
5.5 USES OF INDEX FUTURES: Asset Allocation

• Switching from Stocks to T-bills

• Suppose that we have an investment in the S&P 500 index and
we wish to temporarily invest in T-bills instead of the index.
• Instead of selling all 500 stocks and investing in T-bills, we can
simply keep our stock portfolio and take a short forward position
in the S&P 500 index
• This creates a synthetic T-bill
• When we wish to revert to investing in stocks, we simply offset
the forward position
5.6 CURRENCY CONTRACTS

• Widely used to hedge against changes in exchange rates

• Exporters and asset mangers want to hedge
Currency Prepaid Forward

• Suppose that 1 year from today you want to have ¥1.

• A prepaid forward allows you to pay dollars today to acquire ¥1
in 1 year.
• What is the prepaid forward price?
• Suppose the yen-denominated interest rate is ry and the
exchange rate today ($/¥) is x0 .
• We can work backward.
• If we want ¥1 in 1 year, we must have e−ry in yen today.
• To obtain that many yen today, we must exchange x0 e−ry dollars
into yen.
P
F0,T = x0 e−ry T
Currency Forward

• The prepaid forward price is the dollar cost of obtaining 1 yen in

the future.
• The forward price is the future value using the
dollar-denominated interest rate r:
P
F0,T = F0,T erT = x0 e(r −ry )T

• The idea is the same as stock

F0,T = S0 e(r −δ)T

- The stock price S0 , the yen price x0 .

- Be careful! Exchange rates can be denominated in both ways. x0 :
how much dollar do you need to buy 1 yen.
- The stock dividend δ, the yen interest ry
Currency Forward

Example. (5.4, 5.5) Suppose that the yen-denominated interest rate

is 2%, the dollar-denominated rate is 6%, and that the current
exchange rate is 0.009 dollars per yen. The 1-year prepaid forward
rate is

0.009e−0.02 = 0.008822

The 1-year forward rate is

0.009e0.06−0.02 = 0.009367
Covered Interest Arbitrage

• Synthetic currency forward: borrowing in one currency and

lending in another creates the same cash flow as a forward
contract
• To have 1 yen in 1 year, we need to invest x0 e−ry T in dollars
• We obtain this amount by borrowing. The required dollar
repayment is x0 e(r −ry )T
• At time 0, no cash flow
• At time T, we have 1 yen at the dollar price x0 e(r −ry )T
• This is the same as the forward exchange rate
Currency Forward

• If the forward price is different from the synthetic forward price,

we can arbitrage
• Suppose the forward price is 0.01, how to arbitrage?
- buy low: buy a synthetic forward
- sell high: sell a forward