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Dr. Nicholas Chen, ICMA centre, 2011 1

**Review of Last Lecture
**

Difference between futures and forward

Difference between futures and options Your own growth option a decision to increase your salary Real options pricing of a growth options for a firm

Dr. Nicholas Chen, ICMA centre, 2011

2

Outline

Determination of Forward and Futures Prices

The value of Forward/Futures Contracts General Formula of the Forward and Futures Prices

Review of Capital Asset Pricing Model (CAPM)

Dr. Nicholas Chen, ICMA centre, 2011

3

Nicholas Chen.Forward vs. ICMA centre. Futures Prices What makes the difference between them? ___________in exchanges reduces the credit risk for the futures contract. We assume forward and futures contracts are the same in this module by ignoring the settlement. 2011 2.4 . Dr.

Nicholas Chen. 2011 2. ICMA centre.5 .Determination of Forward and Futures Price Procedure a) Use no arbitrage rule b) Form riskless portfolio => it should earn risk free rate (compare alternative strategies) c) Solve for forward price Dr.

2011 1.Revisiting the Previous Arbitrage Example Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$390 The quoted 1-year futures price of gold is US$425 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity? Dr. ICMA centre.6 . Nicholas Chen.

Generalizing the Previous Arbitrage Example For any investment Suppose that: The spot price of an investment is S0 The quoted 1-year futures price of this investment is F0 The annual interest rate is r What is the futures price? Dr. ICMA centre. Nicholas Chen. 2011 1.7 .

8 At the time 0.S0 (to buy) => => Time T deliver (or sell ) asset at F0 Pay back the loan -S0erT By no arbitrage. F0 is the delivery price K.Price for a forwards/futures contract 0 Maturity = T |------------------------------------------------| Build a risk free portfolio: Short Forward contract and borrow to buy underlying asset Time 0 Forward: Cash 0 (no upfront cost) : +S0 (borrow) . . 2011 2. which has to be S0erT. ICMA centre. Nicholas Chen. this has to hold ___________ =0 ____________ Dr. since the strategy requires no money down.

9 .Generalization (Con’t) For any investment asset that provides no income and has no T: time until delivery date in a forward contract (in years) S0: price of asset underlying the forward contract today storage costs at time 0 when an contract is entered into. Nicholas Chen. 2011 2. F0 = K = S0erT (spot price) K: delivery price in forward contract F0: forward price today r: risk-free rate per annum (with continuous compounding) for an investment maturing at delivering date (in T years) Dr. ICMA centre.

at the maturity T FT = ST. because e-r(T –t) = 1 (when t -> T) Dr. 2011 2. Ft = Ster(T –t) Why does the futures prices change over time? Because St and time t change. ICMA centre. When t -> T.10 .Prices of Forwards/Futures Change over time At a later date t. Nicholas Chen.

2011 11 . Nicholas Chen.Convergence of forwards/futures to spot price (when t T) Futures price Spot price Spot price Futures price t t Dr. ICMA centre.

Nicholas Chen.Outline Determination of Forward and Futures Prices The value of Forward/Futures Contracts General Formula of the Forward and Futures Prices Review of Capital Asset Pricing Model (CAPM) Dr. 2011 12 . ICMA centre.

Dr.7) The price of a forward contract is not its value. ƒ.13 . The value of a long forward contract. ICMA centre. the value of a short forward contract is f = (K – Ft ) e–r(T-t) where K is delivery price in a forward contract & Ft is forward price that would apply to the contract at time t. at time t is ƒ = (Ft – K )e–r(T-t) Similarly. Nicholas Chen. 2011 2.The value of a Forward/ Contract (Chap 5.

2011 14 . Dr.Futures Value of Margin Account Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600 Taking a Long position in a futures contract does not require the upfront investment. but needs to deposit an initial margin in a futures exchange. Nicholas Chen. ICMA centre. The changes in futures prices change cause the fluctuation of the margin account balance.

ICMA centre. What are the forward price and the value of the forward contract? Dr. 1. Nicholas Chen.Practice Problem: Value of a Forward A one-year long forward contract on a non-dividend- 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. 2011 15 . Six months later. the price of the stock is $45 and the risk-free interest rate is still 10%. What are the forward price of today and the initial value of the forward contract? 2.

b) The forward price is Ft = ___________________ The delivery price in the contract is k = ______________. ICMA centre.Practice Problem (con’t) a) The forward price at . Nicholas Chen. f = ___________. 2011 16 . ƒ = ________________________ Dr. F = ______________ The initial value of the forward contract.

2011 17 . ICMA centre. Nicholas Chen.Outline Determination of Forward and Futures Prices The value of Forward/Futures Contracts General Formula of the Forward and Futures Prices Review of Capital Asset Pricing Model (CAPM) Dr.

When underlying assets pay income 0 Maturity = T |------------------------------------------------| Build a risk free portfolio: Short Forward contract and borrow to buy underlying asset Time 0 Forward: Cash 0 (no upfront cost) : +S0 (borrow) .S0 (to buy) I Time T sell the asset at F0 Pay back the loan -S0erT IerT Income (I) : By no arbitrage. ICMA centre. this has to hold => ________________________ = 0 => F0= (S0-I )erT Dr.18 . 2011 2. Nicholas Chen. since the strategy requires no money down.

Nicholas Chen.S0 (to buy) : I Time T sell the asset at F0 Pay back the loan -S0erT IerT Storage : -U -UerT By no arbitrage.I +U)erT Dr.19 . ICMA centre.When underlying assets need storage fee 0 Maturity = T |------------------------------------------------| Build a risk free portfolio: Short Forward contract and borrow to buy underlying asset Time 0 Forward: Cash Income 0 (no upfront cost) : +S0 (borrow) . since the strategy requires no money down. this has to hold => _______________________ = 0 => F0= (S0. 2011 2.

u. c= r – q + u Dr. r. is the interest costs. 2011 2. c. ICMA centre.General Pricing Formula for a Futures Contract of an Investment Asset A discrete time version F0= (S0. earned plus the proportional storage rate. less the income rate.I +U)erT A continuous time version F0 = S0 e (r – q + u)T = S0 e cT The cost of carry. Nicholas Chen.20 . q.

2011 21 . Nicholas Chen.Cost of Carry in the General Pricing Formula c= r – q + u if the underlying is an investment asset No income (non dividend–paying stock. discount bond) c=r A known cash income rate. q (stock paying known dividend. ICMA centre. u (commodity) c=r–q+u Dr. coupon bearing bond) c=r-q A known storage cost.

F0 S0e ( r r f )T Dr. Nicholas Chen.Futures and Forwards on Currencies A foreign currency is analogous to a security providing an income The holder of the currency can earn interest at the risk free interest rate. ICMA centre. prevailing in the foreign country.22 . 2011 2. rf.

F0 = S0 e(c–y )T Dr. c. Nicholas Chen. Futures is less valuable than the physical asset particularly when such an asset is short of stock so that we replace c with c – y. where y is the convenience yield on the consumption asset.23 .The Cost of Carry for Futures of A Consumption Asset The cost of carry. 2011 2. ICMA centre. is the storage cost plus the interest costs less the income earned For an investment asset F0 = S0ecT For a consumption asset F0 < S0ecT because you can consume such a physical asset.

ICMA centre.2% per annum.Practice Example 1 The risk-free rate of interest is 7% per annum with continuous compounding.07 and q = 0. and the dividend yield on a stock index is 3. Nicholas Chen. 2011 24 . The current value of the index is 150.032 F = ___________________ Dr. What is the six-month futures price? r = 0.

2011 25 .8100. The spot price of the Swiss franc is $0. respectively. ICMA centre.8000. What arbitrage opportunities does this create? 1) The theoretical futures price is F = _______________ 2) The actual futures price is too ________. This suggests that an arbitrageur should buy Swiss francs and short Swiss francs futures.Practice Example 2 The two-month interest rates in Switzerland and the United States are 2% and 5% per annum. Nicholas Chen. The futures price for a contract deliverable in two months is $0. Dr. with continuous compounding.

Nicholas Chen. Assuming that interest rates are 10% per annum for all maturities. ICMA centre. The storage costs are $0. calculate the futures price of silver for delivery in nine months. Dr.Practice Example 3 The spot price of silver is $15 per ounce. 2011 26 .24 per ounce per year payable quarterly in advance.

Practice Example 3 (con’t) The present value of storage cost 0.176) e0. 2011 27 . Nicholas Chen.75 = 16. ICMA centre.10x0.24/4 x(1 + e-0.1x0.25 + e-0.36 Dr.176 The price of the futures is F0 = (15 + 0.10x0.5) = 0.

Nicholas Chen.Outline Determination of Forward and Futures Prices The value of Forward/Futures Contracts General Formula of the Forward and Futures Prices Review of Capital Asset Pricing Model (CAPM) Dr. 2011 28 . ICMA centre.

Nicholas Chen. ICMA centre. 2011 29 .CAPM Intuition Which investment will you pick according to our mean- standard deviation rule? Median Risk No Risk E(R) = 5% E(R) = 5% Investment A Investment B Dr.

ICMA centre. Nicholas Chen.CAPM Intuition (Cont.) You will take the investment B only if you are rewarded with the additional premium of 7% for extra risk you are bearing Risk Premium 7% Median Risk No Risk r = 5% r = 5% E(R) of Investment B = Risk-free rate + Risk premium = 5% + 7% Dr. 2011 30 .

) Risk Premium 7% Risk Premium ? High Risk Median Risk r = 5% r = 5% Investment B Investment C E(R) of Investment C = Risk-free rate + Risk premium = 5% + ? Dr. 2011 31 . Nicholas Chen. ICMA centre.CAPM Intuition (Cont.

or β x 7%. E(R) of Investment B = Risk-free rate + Risk premium of B 12% = 5% + 7% => 7% = 12% . so the risk premium of C should be greater than the one of B by a factor of β> 1.) We know that investment C is riskier than investment B. Nicholas Chen.5%) Dr.5% E(R) of Investment C = Risk-free rate + Risk premium of C = 5% + βx 7% = 5% + βx (12% .CAPM Intuition (cont. 2011 32 . ICMA centre.

We know 5% is the risk free rate r Its expected return is k Its total return of 12% is the expected market return.5%) k = r + β (E(Rm) – r) That is the CAPM that won the Nobel Prize! Dr. Investment C be any investment. 2011 33 . ICMA centre. i. E(Rm) Replacing the numbers with the symbols K of Investment C = 5% + β (12% .CAPM Intuition (cont. Nicholas Chen.) Let investment B be the investment in the market portfolio.

Your personal preference is not priced by the market Dr. Nicholas Chen. ICMA centre. 2011 34 .

β = 1: Portfolio returns mirror returns on market.Interpretation of the CAPM The expected. β = 0.5 times the excess returns on market. for any investment can be calculated as β measures the risk of any investment relative to an k = r + β (E(Rm) – r) investment in the market portfolio.5: Excess returns on portfolio tend to be 1.5: Portfolio’s Excess return tend to be half of excess return on market Dr. β = 1. Nicholas Chen. ICMA centre. or required. 2011 35 .

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