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# Chapter 2

FORWARD AND FUTURES CONTRACTS (12 hours)

Outline

I. Mechanics of futures markets II. Hedging strategies using futures III. Determination of forward and futures prices

**I. Mechanics of Futures market
**

• • • • • • • Specification of a futures market Margins Closing out positions Delivery Some terminology Patterns of futures price Forward and futures contracts

**Specification of a futures contract
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• Asset • Contract size • The time and place of delivery

Margins

• A margin is cash or marketable securities deposited by an investor with his or her broker • The balance in the margin account is adjusted to reflect daily settlement • Margins minimize the possibility of a loss through a default on a contract

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**Example of a Futures Trade
**

• An investor takes a long position in 2 December gold futures contracts on June 5

– contract size is 100 oz. – futures price is US$900 – margin requirement is US$2,000/contract (US$4,000 in total) – maintenance margin is US$1,500/contract (US$3,000 in total)

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. 5. . (2. . (1. . .340) . . . . .A Possible Outcome Table 2. (1.660 + 1. . . . . .00 5-Jun 897.740 + 1. Ch 2.140) .1. .30 Day 2. . Futures Price (US$) 900. Hull 2010 . 26-Jun 892. 13-Jun 893. Page 27 Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4.060 0 7 Fundamentals of Futures and Options Markets.600) . . . . . . . .000 (600) .00 . .540) 3. . . Copyright © John C. .000 . . 0 . 19-Jun 887. .400 . (420) . .340 = 4. . . . .00 . . 7th Ed.000 .260 = 4. . 260 (600) . . . .30 . 2. (1. .

Other Key Points About Futures • They are settled daily • Closing out a futures position involves entering into an offsetting trade • Most contracts are closed out before maturity 8 .

it is usually settled by delivering the assets underlying the contract. Ch 2. Most of traders choose to close out their positions prior to maturity. Fundamentals of Futures and Options Markets. • A few contracts (for example. 7th Ed. When there are alternatives about what is delivered. Hull 2010 9 . the party with the short position chooses. • If a futures contract is not closed out before maturity.Delivery • The vast majority of futures contracts do not lead to delivery. where it is delivered. those on stock indices and Eurodollars) are settled in cash • When there is cash settlement contracts are traded until a predetermined time. Copyright © John C. All are then declared to be closed out. and when it is delivered.

This equals to number of long positions or number of short positions • Settlement price: the price just before the final bell each day. This is used for the daily settlement process • Volume of trading: the number of trades in 1 day 10 .Some Terminology • Open interest: the total number of contracts outstanding.

Questions • When a new trade is completed what are the possible effects on the open interest? • Can the volume of trading in a day be greater than the open interest? 11 .

Hull 2010 (b) 12 . page 25) Futures Price Spot Price Spot Price Futures Price Time Time (a) Fundamentals of Futures and Options Markets. Copyright © John C.Convergence of Futures to Spot (Figure 2. 7th Ed. Ch 2.1.

Patterns of futures price • Normal market: The settlement futures prices increase with the maturity of the contract. . • Inverted market: the settlement futures prices decrease with the maturity of the contract.

Copyright © John C.Futures for Crude Oil on Aug 4. Ch 2. 2009 Fundamentals of Futures and Options Markets. 7th Ed. Hull 2010 14 .

7th Ed. Ch 2.Futures for Soybeans on Aug 4. Copyright © John C. Hull 2010 15 . 2009 Fundamentals of Futures and Options Markets.

Forward Contracts • A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price • There is no daily settlement (but collateral may have to be posted). At the end of the life of the contract one party buys the asset for the agreed price from the other party 16 .

Profit from a Long Forward or Futures Position Profit Price of Underlying at Maturity 17 .

Profit from a Short Forward or Futures Position Profit Price of Underlying at Maturity 18 .

page 40) Forward Private contract between two parties Not standardized Usually one specified delivery date Settled at end of contract Delivery or final settlement usual Some credit risk Futures Traded on an exchange Standardized Range of delivery dates Settled daily Usually closed out prior to maturity Virtually no credit risk 19 .3.Forward Contracts vs Futures Contracts (Table 2.

Changing the beta of a portfolio . Basic principles 1. Basis risk 1.2.2.Long hedge 1.II.4.1. Choice of contract 2. Hedging an equity portfolio 3.3.1. Cross hedging 3. Hedging strategies using futures 1. Stock index futures 3. Short hedge 1.

Long & Short Hedges • A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price • A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price 21 .

Each futures contract on NYMEX is for the delivery of 1. It has been agreed that the price that will apply in the contract is the market price on August 15.Example (a) • It is May 15 today and an oil producer has just negotiated a contract to sell 1 million barrels of crude oil. • Short hedge: the company can hedge its exposure by shorting 1.000 barrels. How does the firm hedge its exposure? • Suppose that on May 15.000 futures contracts for August delivery and close its position on August 15. .Short Hedges. the spot price is $60 per barrel and the crude oil futures price on the NYMEX for August delivery is $59 per barrel.

The firm gains approximately 59 . August is the delivery month for the futures contract The futures price on August 15 should be very close to the spot price of $55 on that date.Example (b) . Short Hedges.• On August 15 (1) Suppose the spot price is $55 per barrel: The firm realizes $55 million for the oil under its sales contract.55= $4 per barrel or $4 million in total from the short futures position. Total amount realized from both the futures position and the sales contract is approximately $59 per barrel or $59 million in total.

The firm losses approximately 65 .Example (c) • On August 15 (2) Suppose the spot price is $65 per barrel: The firm realizes $65 million for the oil under its sales contract. . August is the delivery month for the futures contract The futures price on August 15 should be very close to the spot price of $65 on that date.Short Hedges.59= $6 per barrel or $6 million in total from the short futures position. Total amount realized from both the futures position and the sales contract is approximately $59 per barrel or $59 million in total.

Long Hedges. A copper fabricator knows it will require 100.000 pounds of copper on May 15 to meet a certain contract. • Long hedge: the firm can hedge its exposure by taking a long position in four futures contract on COMEX division of NYMEX and closing its position on May 15. and the futures price for May delivery is 320 cents per pound. How does the firm hedge its exposure? • Suppose that the spot price of copper is 340 cents per pound.Example (a) • It is now January 15. .

It net cost is approximately $320.000 or 320 cents per pound.Long Hedges. .320= 5 cents per pound or $5000 on the futures contract. The firm gains approximately 325 .Example (b) • On May 15: (1) Suppose the spot price is 325 cents per pound. May is the delivery month for the futures contract The futures price on May 15 should be very close to the spot price of 325 cents on that date. The firm pays: 100.000 for the copper in the spot market.000 x$3.25= $325.

May is the delivery month for the futures contract The futures price on May 15 should be very close to the spot price of 305 cents on that date.05= $305. The firm losses approximately 320.000 x$3.000 or 320 cents per pound. The firm pays: 100.000 for the copper in the spot market.Example (c) • On May 15: (1) Suppose the spot price is 305 cents per pound.305= 15 cents per pound or $15000 on the futures contract. It net cost is approximately $320. .Long Hedges.

• Basis risk: In practice. because: The asset whose price is to be hedged may not exactly the same as the asset underlying the futures contract. . hedging is often not quite as straightforward. The hedge may require the futures contract to be closed out before its delivery month. Basis risk often exists. The hedger may be uncertain as to the exact date when the asset will be bought or sold.

Hull 2010 .Convergence of Futures to Spot (Hedge initiated at time t1 and closed out at time t2) Futures Price Spot Price Time t1 t2 29 Fundamentals of Futures and Options Markets. 7th Ed. Ch3. Copyright © John C.

Hull 2010 30 . Copyright © John C. 7th Ed. Ch3.Basis Risk • Basis is the difference between spot & futures: Basis= Spot price of asset to be hedged – Futures price of contract used • Basis risk arises because of the uncertainty about the basis when the hedge is closed out Fundamentals of Futures and Options Markets.

the hedger’s position improves. if basis decreases unexpectedly. 31 . the hedger’s position worsen.Long Hedge • Suppose that F1 : Initial Futures Price (time t1) F2 : Final Futures Price (time t2) S2 : Final Spot Price (time t2) Basis=b2 = S2-F2 • You hedge the future purchase of an asset by entering into a long futures contract • Cost of Asset=S2 – (F2 – F1) = F1 + Basis • If basis increases unexpectedly .

• Suppose that F1 : Initial Futures Price (time t1) F2 : Final Futures Price (time t2) S2 : Final Spot Price (time t2) Basis= b2= S2-F2 • You hedge the future sale of an asset by entering into a short futures contract • Price Realized=S2+ (F1 – F2) = F1 + Basis • If basis increases. the hedger’s position improves unexpectedly. the hedger’s position worsens. Short Hedge 32 . if basis decreases unexpectedly.

If the asset underlying the futures contract is not the same as the asset whose price is being hedged: • S2* : spot price of the underlying asset at time t2 : • F1-F2 +S2 = F1 + (S2*-F2)+(S2-S2*) Basis composes of two components: S2*-F2 : the difference between spot & futures of the underlying asset. S2-S2* : the difference between the spot prices of the two assets. • .

Problems

1.On March 1 the spot price of a commodity is $20 and the July futures price is $19. On June 1 the spot price is $24 and the July futures price is $23.50. A company entered into a futures contracts on March 1 to hedge the purchase of the commodity on June 1. It closed out its position on June 1. What is the effective price paid by the company for the commodity? 2. On March 1 the price of a commodity is $300 and the December futures price is $315. On November 1 the price is $280 and the December futures price is $281. A producer entered into a December futures contracts on March 1 to hedge the sale of the commodity on November 1. It closed out its position on November 1. What is the effective price received by the producer?

Choice of Contract (a)

• The choice of the asset underlying the futures contract. • The choice of the delivery month

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Choice of Contract (b)

• Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge • When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price.

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7250. June.Example (a) • It is March 1. When the yen are received at the end of July.5 million yen. One contract is for the delivery of 12. A US company expects to receive 50 million Japanese yen at the end of July.7800 and the spot and futures prices when the contract is closed out are 0. • The company shorts four September yen futures contract on March 1. Yen future contracts on the CME have delivery months of March.72000 and 0. September and December. • The futures price on March 1 in cents per yen is 0.Choice of Contract. respectively. . the company closes out its position.

7800 + (-0.Choice of Contract.Example (b) • The gain on the futures contract: 0.7200 + 0.7250 = 0.7250= -0.0050.7750 Or the initial future price + the final basis 0.72000-0. • The basis: 0.7800-0.0550 cents per yen.0550 = 0. • The effective price obtained in cents per year: The final spot price + the gain 0.0050) = 0.7750 .

it might choose to use heating oil futures contracts to hedge its exposure. . • Ex: An airline is concerned about the future price of jet fuel. Because there is no futures contract on jet fuel.Cross hedging: • When the asset underlying the futures contract is not the same as the asset to be hedged.

• Hedge ratio: is the ratio of the size of the position taken in futures contracts to the size of the exposure. • The hedger should choose a value for the hedge ratio that minimizes the variance of the value of the hedged position. • When the asset underlying the futures contract is the same as the asset being hedged. the hedge ratio equals 1. .

(See appendix. Ch3. sF is the standard deviation of DF. Copyright © John C. page 71) Fundamentals of Futures and Options Markets. the change in the futures price during the hedging period r is the coefficient of correlation between DS and DF. 7th Ed. the change in the spot price during the hedging period.Optimal Hedge Ratio Proportion of the exposure that should optimally be hedged is sS h* r sF where sS is the standard deviation of DS. Hull 2010 41 .

+ Observe the changes in spot price of the asset being hedged and the changes in future price of the underlying asset. Compute the standard deviations of these changes. Ideally. the length of each interval is the same as the length of the time interval for which the hedge is in effect. + Choose a number of equal non-overlapping time intervals.• How to calculate h*? .Using data on the changes in historical spot and futures prices. .

Optimal number of contracts - QA: Size of position being hedged (units) - QF: Size of one futures contract (units) - N* : Optimal number of futures contracts for hedging.

QA N h QF

* *

• Ex: An airline expects to purchase 2 million gallons of jet fuel in 1 month and decides to use heating oil futures for hedging. The size of one heating oil futures contract is 42,000 gallons Compute the optimal number of futures contracts for hedging.

**• Data on the changes in historical prices:
**

Month (i) 1 2 3 4 5 6 7 8 9 10 11 12 12 14 15 Changes in heating oil futures price per gallon (xi) 0.021 0.035 -0.046 0.001 0.044 -0.029 -0.026 -0.029 0.048 -0.006 -0.036 -0.011 0.019 -0.027 0.029 Changes in jet fuel price per gallon (yi) 0.029 0.020 -0.044 0.008 0.026 -0.019 -0.010 -0.007 0.043 0.011 -0.036 -0.018 0.009 -0.032 0.023

0263/0.0313) = 0.928x(0.78 Method 2: h* is the slope of the best-fit line when deltaS is regressed against deltaF.0313 F r Cov( F . standard deviation.0263 s 0.928 h= 0. S ) / s F s S 0. correlation of the changes in the spot and futures prices.Method 1: Calculate mean. s S 0. deltaS = 0.78 deltaF .

78 x 2.000/42.• The optimal number of futures contracts for hedging: 0.000 = 37.14 .000.

Problems 3.4.2.000 pounds of live cattle next month.81.000 pounds of cattle. Each contract of/ for the delivery of 40. Suppose that the standard deviation of quarterly changes in the prices of a commodity $0.65.8.7. The correlation between the futures price changes and the spot price changes is 0. What strategy should the beef producer follow? . A beef producer is committed to purchasing 200. and the coefficient of correlation between the two changes is 0. The producer wants to use the live cattle futures contracts to hedge its risk. The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound) 1. What is the optimal hedge ratio for a 3month contract? What does it mean? 4. the standard deviation of quarterly changes in a futures price on the commodity is $0. The standard deviation of monthly changes in the futures price of live cattle for the closest contract is 1.

A stock index tracks changes in the value of a hypothetical portfolio of stocks. For example: Dow Jones Industrial Average.• Stock index futures .S.Some exchanges provide futures contracts for underlying assets of stock indices. The stock index is given a beta of 1. Russell 100. Dollar Index futures contracts. .The weight assigned to the stocks are proportional to their market prices or their market capitalizations. . .Return on the stock index is usually used as a proxy of the market return. U. Nasdaq 100. S&P500. .

Hull 2010 50 .Hedging Using Index Futures To hedge the risk in a portfolio the number of contracts that should be shorted is VA N* b VF where VA is the current value of the portfolio. Ch3. b is its beta. Copyright © John C. 7th Ed. and VF is the current value of one futures (=futures price times contract size) Fundamentals of Futures and Options Markets.

Beta of portfolio= 1.One contract is on $250 times the index .Value of S&P 500 index= 1000 .050.• Example (a) : Suppose that a futures contract with 4 months to maturity is used to hedge the value of a portfolio over the next 3 months: .000 .Risk-free interest rate =4% per annum .Dividend yield on index =1% per annum .What position in futures contracts on the S&P 500 is necessary to hedge the portfolio? .S&P 500 futures price= 1.010 USD .5 .Value of portfolio= $5.

5 x (5.500 .000 USD .To hedge the risk in a portfolio the number of contracts that should be shorted : 1.The current value of one futures F = 250 x 1010 = 252.000/ 252.050.Example (b) .The current value of the portfolio: 5.050.500) = 30 .

Example (c) • Suppose that the index turns out to be 900 in 3 months and the futures price is 902. Calculate the value of the hedged portfolio in 3 months? .

187= $5. The gain from the short futures position: 30 x(1010-902) x 250 = 810. The index pays a dividend of 1% per annum. When dividends are taken into account.000 x (1-15.25% per three months.286.125% Expected value of the portfolio: 5. or 0.• Example (d) • The index futures price decreases to 902 in 3 months.5.75-1 ) = -15.187 The expected value of the hedger’s position: 810. The portfolio has beta=1. an investor in the index would earn 9.75%.5( -9.187 .000 + 4. risk-free rate= 1% per 3 months The expected return on the portfolio during the 3 months: 1 + 1.125%) = $4.050.096.000 The index turns out to be 900 in 3 months The loss on the index is 10%.286.

The beta of the stock is 1. The index futures price is currently 1. What strategy should the investor follow? .500 and one contract is for delivery of $50 times the index. an investor holds 50.3. The investor is interested in hedging against movements in the market over the next month and decides to use the September Mini S&P 500 futures contract. On July 1.Problems 5. The market price is $30 per share.000 shares of a certain stock.

A fund manager has a portfolio worth $50 million with a beta of 0. one contract is on 250 times the index.87. The current level of the index is 1.5. Calculate the expected value of the company after hedging the risk. the index decreases to 1000.250. The current 3-month futures prices is 1259. and the index futures price is 1002. the riskfree rate is 6% per annum. The manager is concerned about the performance of the market over the next 2 months and plans to use 3-month futures contracts on the S&P 500 to hedge the risk. and the dividend yield on the index is 3% per annum.6. . • What position should the fund manager take to hedge all exposure to the market over the next 2 months? • Suppose that in 2 months.

Changing the beta of a portfolio • Sometimes futures contracts are used to change the beta of a portfolio to some value other than zero. the number of futures contract should be shorted: N * (b b * ) P F b b* . . the number of futures contracts should be taken in a long position: P N (b b ) F * * b b * .To reduce the beta.To increase the beta.

0? .• - Example Value of portfolio= $5.000 Beta of portfolio= 1.5 Value of S&P 500 index= 1000 S&P 500 futures price= 1.75? What position is necessary to increase the beta of the portfolio to 2.010 USD One contract is on $250 times the index What position is necessary to reduce the beta of the portfolio to 0.050.

Problems 7. and each contract is for delivery of $250 times the index. It would like to use futures contracts on the S&P 500 to hedge its risk.6? . A company has a $20 million portfolio with a beta of 1. What is the hedge that minimizes risk? What should the company do if it wants to reduce the beta of the portfolio to 0.2. The index futures price is currently standing at 1080.

Problems 8.000. The beta of the portfolio is 1.What position should the company take? . A company has a portfolio of stocks worth $100 million. The index futures price is currently 1. and each contract is on $250 times the index. The company would like to use the CME December futures contract on the S&P 500 to change the beta of the portfolio to 0.2. during the period July 16 to November 16.2 to 1. It is July 16.5. .5. What position in futures contracts should it take? .Suppose that the company changes its mind and decides to increase the beta of the portfolio from 1.

3. Some specific forward/futures contracts 2. Valuing a forward contract 1. Are forward prices and futures prices equal? 2.IV.2.2.4.1. Forward price for an investment asset 1. Forward and futures contract on currencies 2.3. Assumption and notation 1. Futures on stock indices 2. Forward price 1.1. Futures on commodities . Determination of Forward and Futures Prices 1.

.The market participants are subject to the same tax rate on all net trading profits. . .• Assumptions and notation .The market participants can borrow money at the same risk-free rate of interest as they can lend money. .The market participants take advantage of arbitrage opportunities as they occur.The market participants are subject to no transaction costs when they trade.

Notation S0: Spot price today F0: Futures or forward price today T: Time until delivery date r: Risk-free interest rate for maturity T 63 .

silver) • Consumption assets are assets held primarily for consumption (Examples: copper.Consumption vs Investment Assets • Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold. oil) 64 .

Short Selling • Short selling involves selling securities you do not own • Your broker borrows the securities from another client and sells them in the market in the usual way 65 .

Short Selling (continued) • At some stage you must buy the securities back so they can be replaced in the account of the client • You must pay dividends and other benefits the owner of the securities receives 66 .

Arbitrage . (Oxford Dictionary) • An arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state. or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset.• The simultaneous buying and selling of securities. currency. it is the possibility of a risk-free profit at zero cost. in simple terms.

Forward price for an investment asset • Example (a): Consider a long forward contract to purchase a non-dividend-paying stock in 3 months. The forward price is relatively high at $43. The current stock price is $40 and the 3-month risk-free interest rate is 5% per annum. What arbitrage opportunities does this create? .

• Example (b): An arbitrageur can: Action now: Borrow $40 at 5% for 3 months Buy one unit of asset.50 .50 to repay loan with interest Profit realized: $2. Enter into forward contract to sell in 3 months for $43. Action in 3 months: Sell asset for $43 Use $40.

• Example (c) Suppose that the forward price is $39. What arbitrage opportunities does this create? .

50 . Action in 3 months: Buy asset for $39 Close short position Receive $40.• Example (d): An arbitrageur can: Action now: Short 1 unit of asset to realize $40 Invest $40 at 5% for three months Enter into a forward contract to buy asset in 3 months for $39.50 from investment Profit realized: $1.

A generalization • Forward price: F0 S 0 e rT This equation relates the forward price and the spot price for any investment asset that provides no income and has no storage costs .

buy the asset and short forward contracts on the asset. rT • If F0 S 0 e arbitrageurs can short the asset.A generalization (b) • Forward price: F0 S 0 e rT F0 S 0 e • If arbitrageurs can borrow money. invest in the risk-free asset and enter into long forward contracts on the asset. rT .

Suppose that you enter into a 6-month forward contract on a non-dividend-paying stock when the stock price is $30 and the riskfree interest rate (with continuous compounding) is 12% per annum.Problems 9. What is the forward price? .

A coupon payment of $40 is expected after 4 months. respectively. The 4-month and 9-month risk free interest rates (continuously compounded) are 3% and 4%. What arbitrage opportunities does this create? . The forward contract matures in 9 months. The forward price is relatively high at $910.When an Investment Asset Provides a Known Dollar Income Example: Consider along forward contract to purchase a coupon-bearing bond whose current price is $900 .

Of the $900. The remaining $860.Borrow $900 to buy the bond and short a forward contract on the bond. $39. .60 is borrowed at 3% per annum for 4 months so that it can be repaid with the coupon payment. .• An arbitrageur can: Action now .40 is borrowed at 4% per annum for 9 months.

• Action in 4 months: Receive a coupon payment of $40 Use $40 to repay the first loan with interest • Action in 9 months Sell the bond for $910 Use $886.40 to repay the second loan with interest Profit realized: $23.40 .

Enter into a forward contract to buy the bond in 9 months for $870. An arbitrageur can: Short the bond.• Suppose that the forward price is relatively low at $870. .

rT .A generalization F0 ( S 0 I )e rT Where I is the present value of the income during life of forward contract. rT • If F0 ( S 0 I )e short the asset and take a long position in the forward contract. F0 ( S 0 I )e • If buy the asset and short the forward contract.Known Income.

We also assume that dividends of $0. We assume that the risk-free rate of interest (continuously compounded) is 8% per annum for all maturities. What is the forward price? .75 per share are expected after 3 months. and 9 months. 6 months.• Example: Consider a 10-month forward contract on a stock when the stock price is $50.

equation 5.When an Investment Asset Provides a Known Yield (Page 107.3) F0 = S0 e(r–q )T where q is the average yield during the life of the contract (expressed with continuous compounding) Options. Futures. Copyright © John C. and Other Derivatives 7th Edition. Hull 2008 81 .

at time 0: • Borrow NS 0 • Buy N units of the assets and invest the income from the asset in the asset • Enter into a forward contract to sell the asset for F0 per unit at time T. .Method 1: Action now.

By time qT T. qT • Sell the asset for F0: NF0 e Net cash flow at time T: ( r q )T qT ( F0 S0e ) Ne . our holding has grown to Ne units of asset.Action at time T rT • Repay the loan: NS 0 e • The income from the asset causes our holding in the asset to grow at a continuously compounded rate q.

If there are no arbitrate opportunities then the forward price must be F0 S 0 e Or ( r q )T 0 F0 S 0 e ( r q )T Where q is the average yield during the life of the contract (expressed with continuous compounding) .At time T .

.

• If F0 S 0e ( r q )T an arbitrageur can short the asset and take a long position in the forward contract.• If F0 S 0 e ( r q )T an arbitrageur can buy the asset and short the forward contract. .

Method 2: Action now. at time 0: qT • Borrow NS 0e • Buy Ne qT units of the assets and invest the income from the asset in the asset • Enter into a forward contract to sell the asset for F0 per unit at time T. .

NF0 • Sell the asset for F0: Net cash flow at time T: ( r q )T ( F0 S 0 e )N .Action at time T ( r q )T • Repay the loan: NS 0 e • The income from the asset causes our holding in the asset to grow at a continuously compounded rate q. our holding has grown to N units of asset. By time T.

If there are no arbitrate opportunities then the forward price must be: Or F0 S 0 e ( r q )T 0 F0 S 0 e ( r q )T Where q is the average yield during the life of the contract (expressed with continuous compounding) .At time T .

02) =0.5. simple yield = 2% continuous yield: q= 2 ln(1+ 0. What should an arbitrageur do? S0=25. The asset price is $25 and the forward contract is $30. r=0.0396 .Ex: Consider a 6-month forward contract on an asset that is expected to provide income equal to 2% of the asset price once during a 6-month period.10. T=0. The riskfree rate (continuously compounding) is 10% per annum.

and the risk-free rate of interest is 10% per annum (with continuous compounding). What is the forward price? 11. (b) the forward price is $53? . Consider a long forward contract to purchase the stock. The contract matures in 6 months. A stock is expected to pay a dividend of $1 per share in 3 months. Suppose that you enter into a 6-month forward contract on a non-dividend-paying stock when the stock price is $30 and the risk-free interest rate (with continuous compounding) is 12% per annum.Problems 10. Are there any arbitrage opportunities if : (a) the forward price is $49?. The stock price is $50.

A stock index currently stands at $350. What should an arbitrageur do? . The risk-free interest rate is 12% per annum (with continuous compounding) and the dividend yield on the index is 4% per annum (with continuous compounding). If the forward price for a 4-month contract is $360.12.

It is important for banks and other financial institutions to value the contract each day. it may prove to have a positive or negative value. • At a later stage. .Valuing forward contracts • The value of a forward contract at the time it is first entered into is zero.

Valuing forward contracts • Suppose that K is delivery price in a forward contract & F0 is forward price that would apply to the contract today. K stays the same but the forward price changes and the value of the long position is : ƒ = (F0 – K )e–rT • Similarly. • As time passes. the value of a short forward contract is (K – F0 )e–rT 94 . ƒ is the value of a long forward contract • At the beginning of the contract life: K = F0 f = 0.

the delivery price is $24. The risk-free rate of interest (with continuous compounding) is 10% per annum. Calculate the current value of the forward contract? . the stock price is $25. It currently has 6 months to maturity.• Ex: A long forward contract on a non-dividendpaying stock was entered into some time ago.

• S0=25.1.10.5 • The 6-month forward price: F0 S 0 e rT 26 . r=0.28 • The current value of the forward contract: • f (26 .17 .5 2. T = 0.28 24 )e f S 0 Ke rT 0. K=24.

Valuing forward contracts • When the underlying asset provides no rT income: f S 0 Ke • When the underlying asset provides a known dollar income: f S 0 I Ke rT • When the underlying asset provides a qT rT known yield: f S e Ke 0 .

. This gain/loss is realized almost immediately because of the way futures contracts are settled daily. the gain or loss on a futures contract is calculated as the change in the futures price multiplied by the size of the position. • When a forward price changes.Forward vs Futures Values • When a futures price changes. the gain or loss is the present value of the change in the forward price multiplied by the size of the position.

forward and futures prices are equal. F0 G0 S 0 e rT . slightly different. The current futures price is F0. • Forward and futures prices are usually assumed to be the same. A futures contract on the same underlying asset matures at time T. The current forward price is G0. When interest rates are uncertain they are. in theory. Ex: Suppose a forward contract maturing at time T.Are forward prices and futures prices equal? • Appendix p.126: when interest rates are constant.

• Futures on stock indices • Stock indices 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 where q is the dividend yield on the portfolio represented by the index during life of contract .

Calculate the futures price. T = 0.01. r = 0. • S0 = 1300. The current value of the index is 1.300.05. Suppose that stocks underlying the index provide a dividend yield of 1% per annum. q = 0. The continuously compounded risk-free interest rate if 5% per annum.• Ex: Consider a 3-month futures contract on the S&P 500.25 .

. profits can be made by buying stocks underlying the index at the spot price and shorting futures contract • If F0 < S0e(r-q)T profits can be made by shorting the stocks underlying the index and taking a long position in futures contracts.Index Arbitrage • Index arbitrage involves simultaneous trades in futures and many different stocks • Very often a computer is used to generate the trades • If F0 > S0e(r-q)T..

• The relationship between spot and futures/forward prices: F0 S0 e ( r rf ) T 103 . • F0 = the forward or futures price in dollars of one unit of foreign currency. • S0 = the current spot price in dollars of one unit of foreign currency.Futures and Forwards on Currencies • A foreign currency is analogous to a security providing a dividend yield. • rf = the foreign risk-free rate. • r = the dollar risk-free rate. The continuous dividend yield is the foreign risk-free interest rate.

and NZD are USD per unit of foreign currency. EUR.g. CAD and JPY) are quoted as units of the foreign currency per USD. AUD. Other currencies (e. This means that GBP.. 104 .Foreign Exchange Quotes • Futures exchange rates are quoted as the number of USD per unit of the foreign currency • Forward exchange rates are quoted in the same way as spot exchange rates.

Hull 2010 105 .1. Ch 5. 7th Ed. page 113 1000 units of foreign currency at time zero 1000 e rf T units of foreign currency at time T 1000S0 dollars at time zero 1000 F0 e rf T dollars at time T 1000 S 0 e rT dollars at time T Fundamentals of Futures and Options Markets.Why the Relation Must Be True Figure 5. Copyright © John C.

Calculate the 2-year forward exchange rate. What should an arbitrageur do? . Suppose that the 2 year forward exchange rate is 0.6200 USD per AUD. respectively. The spot exchange rate between AUD and USD is 0.6300.Ex: Suppose that the 2-year interest rate in Australia and the US are 5% and 7%.

.Gold and silver provide income to the holder and also have storage costs. net of income.U= present value of all the storage costs.• Futures on commodities .Forward/ Futures price: F0 ( S 0 U )e rT . . silver). . during the life of a forward contract.Consider futures on commodities that are investments assets (gold.

with the payment being made at the end of the year. .• Ex: Consider a 1-year futures contract on an investment asset that provides no income. Calculate the futures price. It costs $2 per unit to store the asset. The spot price is $450 per unit and the risk-free rate is 7% per annum for all maturities.

F0 S 0 e ( r u )T • If the above equations do not hold. they can be treated as negative yield. what should an arbitrageur do? .• If the storage costs net of income incurred at any time are proportional to the price of the commodity.

110 . F0 (S0+U )erT where U is the present value of the storage costs.Futures on Consumption Assets F0 S0 e(r+u )T where u is the storage cost per unit time as a percent of the asset value. Alternatively.

• Convenience yield • The users of a consumption commodity may feel that ownership of the physical commodity provides benefits that are not obtained by holders of futures contracts. F0 e yT ( S 0 U )e rT F0 e yT S 0 e ( r u )T • Or F0 S 0 e ( r u y )T . The benefits from holding the physical asset are referred to as the convenience yield provided by the commodity.

The Cost of Carry • The cost of carry. c. y. is defined so that F0 = S0 e(c–y )T 112 . is the storage cost plus the interest costs less the income earned • For an investment asset F0 = S0ecT • For a consumption asset F0 S0ecT • The convenience yield on the consumption asset.

• Normal Backwardation and Contango • Normal Backwardation: when the futures price is below the expected future spot price. . • Contango: when the futures price is above the expected future spot price.

• Normal Backwardation và Contango .

Value of a forward contract Value of a forward No income Known income I =PV(Income) Known yield q Commodities Forward price f S Ke rT rT F Se rT f ( S I ) Ke F=(S – I)erT F = S e(r-q)T f =S e-qT – K e-rT f=Se(u-y)T.Ke-rT F=Se(r+u-y)T .

Problems 13. The riskfree interest rate is 12% per annum (with continuous compounding). The risk-free rate of interest is 7% per annum (with continuous compounding). A stock index currently stands at 350. What should the futures price for a 4-month contract be? 14.2% per annum. The dividend yield on the index is 4% per annum. The current value of the index is 150. and the dividend yield on a stock index is 3. What is the 6-month futures price? .

What are the forward price and the initial value of the forward contract? .Six months later.15. . the price of the stock is $45 and the risk-free interest rate is still 10%. What are the forward price and the value of the forward contract? . A 1-year long forward contract on a nondividend-paying stock is entered into when the stock price is $40 and the risk-free rate of interest is 10% per annum with continuous compounding.

An investor has taken a short position in a 6-month forward contract on the stock.Three months later. A stock is expected to pay a dividend of $1 per share in 2 months and in 5 months. .What are the forward price and the initial value of the forward contract? . The stock price is $50 and the risk-free rate of interest is 8% per annum with continuous compounding for all maturities.16. the price of the stock is $48 and the risk-free rate of interest is still 8% per annum. What are the forward price and the value of the short position in the forward contract? .

The 2-month interest rate in Switzerland and the US are. What arbitrage opportunities does this 18. respectively.8000. The spot price of the Swiss franc (CHF) is $0.17. The futures price for a contract deliverable in 2 months is $0. The current value of the index is $400. The futures price for a contract deliverable in 4 months is 405. 2% and 5% per annum with continuous compounding. The risk-free interest is 7% per annum with continuous compounding. What arbitrage opportunities does this create? .8100. The dividend yield on a stock index is 4% per annum.

. Calculate the futures price of silver for delivery in 9 months.19.24 per ounce per year payable quarterly in advance. The spot price of silver is $9 per ounce. The interest rates are 10% per annum for all maturities. The storage costs are $0.