FINA2322EFG Tutorial 5

THE UNIVERSITY OF HONG KONG

HKU BUSINESS SCHOOL
FINA2322EFG – DERIVATIVES
SECOND SEMESTER, 2023-2024

Tutorial 5 –Pricing of Forward

ü Arbitrage
- Arbitrage opportunities arises from mispricing
- Riskless profit can be earned from arbitraging
- The profit should be stock price invariant
- At least one of the CF at time = 0 or time = T is zero

ü Pricing of Forward by No Arbitrage Assumption

With discrete Dividends:

CF
Transaction t=0 t=T
Buy Stock

Short ZCB

Sell forward

Total

Assuming no Arbitrage,
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Understand the continuous dividend yield:

Assume you purchase 1 share of stock, at $100. What is your payoff in the future if you
receive a dividend yield of !% p.a. and keep reinvesting the dividend into the stock?

Assume Annually Semi-annually Quarterly Continuously

dividend are
paid
Number of
shares at t=1

Pricing of Forward with Continuous Dividends:

CF
Transaction t=0 t=T
Buy Stock

Short ZCB

Sell forward

Total
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ü Arbitrage from mispricing

Forward = Stock – Bond

Cash-and-Carry Arbitrage:
If the forward is overpriced: Long Stock and Short Forward (Buy low Sell high)

Reverse Cash-and-Carry:
If the forward is underpriced: Short Stock and Long Forward (Buy low Sell high)

Tutorial Exercise
Question 1
The S&R index spot price is 1100, the risk-free rate is 5% p.a., continuously compounded,
assuming no dividends payment.

(a) Suppose you observe a 6-month forward price of 1120. What arbitrage would you
undertake?

(b) Suppose you observe a 6-month forward price of 1130. What arbitrage would you
undertake?
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ü Currency Forwards
• Exchange rate at time = 0: "! ($⁄%&')
• $ is the domestic currency, yen is the foreign currency
• Currency forwards are used to hedge the exchange rate risk.

• A carry trade is defined as borrowing at a lower interest rate and lending in a higher
interest rate à speculate the high-rate currency will not depreciate much.

• Covered interest arbitrage is a strategy to gain from mispricing of the forward contract

ü Proof of currency forward price

Time 0 Time T

Position Dollar Yen Dollar Yen

Long Forward contract on yen

Borrow yen

Convert yen to dollar at spot rate at time 0

Deposit Dollar

Total CF
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Tutorial Exercise
Question 2 (Currency Forward)
Suppose the spot $/¥ exchange rate is 0.008, the 1-year continuously compounded dollar-
denominated rate is 5% and the 1-year continuously compounded yen-denominated rate is 1%.
Suppose the 1-year forward exchange rate is 0.0084.

Explain precisely the transactions you could use (being careful about currency of denomination)
to make money with zero initial investment and no risk.
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Summary of Forward Formulae

*+,ℎ./, 1+2+3&'34,

6 " !,$ = 8!
6!,$ = 69 .: 8!

*+,ℎ 1+2+3&'34 +' 3+4;<&,& :.<=,

6 " !,$ = 8! − ?9 .: @AA 3+2+3&'34 B&:.<& ,+=& C

6!,$ = 69 .: 8! − 69 .: @AA 3+2+3&'34 B&:.<& ,+=& C

*+,ℎ 1+2+3&'34 +' ;.',+'/./4 :.<=,

6 " !,$ = 8! & %&$

6!,$ = 8! & ((%&)$

Remark:
• Forward is a biased predictor of stock price (FV calculated based on risk-free interest rate
instead of expected rate of return)

• Prepaid Forward
- Long forward position involves paying in the future
- Prepaid Forward means that you want to pay it NOW
- Thus Prepaid Forward has a price = PV of Forward Price

• Forward Price = Spot price + Interest to carry the asset – asset lease rate
(cost of carry)

• Forward premium
The difference between current forward price and stock price
Can be used to infer the current stock price from forward price

Definition
Forward premium = F0,T /S0
Annualized forward premium = (1/T)ln(F0,T /S0)
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• For cases with transaction costs, the forward price should be between 2 numbers:
(Assuming no transaction costs at time = T, and transaction cost = k at time = 0 for both
stocks and forwards)
(8 * ! − 2E)& +$ < 6!,$ < (8 , ! + 2E)& *$

Proof:
CF
Transaction t=0 t=T
Buy Stock −8 , ! − E ST
Borrowing +8 , ! + 2E −(8 , ! + 2E)& (
!$

Sell forward -k F0,T -ST

!$
Total 0 F0,T −(8 , ! + 2E)& (

CF
Transaction t=0 t=T
Short Stock 8*! − E -ST
Lending −8 * ! + 2E "
(8 * ! − 2E)& ( $
Long forward -k ST - F0,T
"
Total 0 (8 * ! − 2E)& ( $ − 6!,$

ü Futures Contract
- Standardized, with specified delivery dates, locations, procedures
- Mark to market – earnings and losses are marked to market daily
- Initial deposit in margin account
- Difference with forward contract: liquid, marked to market, small credit risk, price limit,
cannot be customized
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Tutorial Exercise
Question 3 (Mark to Market Procedures)

Suppose the S&P500 futures price is currently 950 and the initial margin is 10%. You wish to enter
long positions with 10 S&P500 futures contracts. The size of S&P contract is $250 times index
level.

(a) What is the initial margin requirement?

(b) Suppose you earn a continuously compounded rate of 6% on your margin balance, your
position is marked to market weekly, and the maintenance margin is 80% of the initial margin (i.e.
8% of total value). What is the greatest S&P500 futures price 1 week from today at which you will
receive a margin call?