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B,K & M Chapter 22
End-of-chapter problems: 1-10
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delationship to options:
- Options - give the holder the right or option to
exercise the contract
- Futures & Forward Contracts - entail an obligation for
both parties to honor the contract to trade at a specified
date at a price agreed upon today

Long Position: agrees to 6  delivery (buy)

hort Position: agrees to 2  delivery (sell)

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Mt Expiration:
- Profit to long position:  - F0
³Zero um Game´
- Profit to short position: F0 ± 

- 0: spot price today
-  : spot price at expiration
- F0: current price to transact at expiration
- F : the forward or futures price at expiration

Private agreements between 2 parties to transact in the future

at terms agreed to today

E.g. Large financial institutions

- forward contracts can lead to efficiency gains for firms
by eliminating price uncertainty for inputs and/or outputs
- forward contracts require both parties to have
essentially opposite needs, at the same time for a certain
quantity of some good or asset
- often the contract is backed only by the reputation of the
firm(s) involved

Essentially standardized forward contracts which are backed

by an organized exchange

Futures contracts exist for commodities ranging from lumber

to pork bellies, as well as financial assets such as currencies,
stock indices, interest bearing assets, etc.

For certain commodities, specific details of the commodity in

question become important, such as the quality of the good and
the location of delivery

For financial futures the delivery of an actual asset rarely

occurs and contracts are commonly closed out before maturity,
or settled in cash at maturity
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Exchange determines specific details of the contract

Market forces determine the futures price

If long, you agree to buy the commodity at the futures price on

the delivery date

If short, you agree to sell at the futures price on the delivery date

he Wall treet Journal clippings on the following slide illustrate

futures prices for several commodities, as well as financial futures

Below the main title of each commodity are the details of the
contract, such as the exchange on which it¶s traded, the size of the
contract and the denomination
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For example, Corn futures are traded on the CME (Chicago Mercantile
Exchange), with a contract size of 5000 bushels and a price denominated in
cents per bushel. In the left most column are the various months of delivery
which can be contracted for

he ³ettle´ price gives a representative trading price for the last few
minutes of trading. Open interest gives the number of contracts outstanding
at the end of the trading day

Ms with options, the clearing house becomes the seller of the contract for
the ³long´ position, and the buyer for the ³short´ position

demember, the cost of entering into the contract is $0

Initial margin of between 5% and 15% of F0 is required

Daily profits and losses accrue via ³marking to market´ (taxable events)

If the price moves against you, you may receive a margin call

Futures contracts are used by essentially two distinct groups of

economic agents: hedgers and speculators

In fact only a small percentage of futures contracts actually

involve delivery of the underlying commodity

he overwhelming majority of futures positions are closed out

prior to the delivery date, or involve cash settlement for the case
of financial futures
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Most forward and futures contracts can be valued using

simple arbitrage arguments, as the following examples will

- otation: F0: forward price, for delivery at time
0: spot price at time t
r: continuously compounded risk-
risk-free rate
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he forward contract will be valued as follows:

-F0 = 0er( -t) , where ( -t) captures time until delivery in

-ote that the forward price is simply the future value of

the spot price, compounding at the risk-
risk-free rate!

-If this relationship does not hold there is an arbitrage

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We now show why this relationship must hold:

- First note that at expiration, F =  (the futures price and the spot
price must be equal at maturity). his is intuitive, since a
commodity available from two sources (spot or futures market)
must sell at the same price in both. his property is called the
Y Y 
- Consider the value of a portfolio consisting of a long position in a
stock and a short position in a futures contract (0 - F0)
- Mt expiration, any profit in the stock position will be offset by a
loss in the futures position, and vice versa. herefore the portfolio
is perfectly hedged and risk-
- Profit on stock position:  - 0
- Profit on futures position: F0 - F = F0 - 
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Because at expiration F =  , each dollar gained from the stock

position will be offset by a dollar loss on the futures position and vice

Mt expiration, the profit to your position (no matter what happens to

the price of the stock) is: ( - 0) + (F0 -  ) = F0 - 0

he cost of earning the risk-

risk-free profit was 0

herefore the return (F0 - 0) u 0 must be equal to the risk-

risk-free rate
- (F0 - 0) u 0 = er( -t) ±1
- olving for F0: F0 = 0er( -t)

If the portfolio does not earn the risk-

risk-free rate, there will be an
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- uppose now, that the security in question is going to pay a
known cash income between now and the delivery date
- Let I represent the 
  of this cash income
stream, which can be 1 or more payments at known dates in
the future, discounted to the present at the rate r
- he relationship between the spot and futures price in this
case is: (-I)er( -t)
F = (-
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- uppose the spot price of a 5-
5-year bond is currently $900,
and the bond is expected to make coupon payments of $60 6
months from now, and another $60 payment 12 months from
now. If the continuously compounded rate of return is 9%,
what will the forward price on this bond be, if delivery is to
take place 1 year from now?
- First we need to calculate the present value of the coupon
payments: I = 60e-0.09/2 + 60e-0.09 = $112.20
- ow, using I, calculate the forward price of, so as to rule out
arbitrage: F = (900 ± 112.20)e0.09 = $861.99
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—arious futures contracts exist for stock indices as well as certain

sub--indices. &P 500 index futures, which are traded on the CME
are particularly popular

ince it is difficult and expensive to hold &P 500 index through

the direct purchase of the individual stocks comprising the index,
the Futures contract allows portfolio managers and speculators to
easily establish various positions in this asset

his is particularly useful for investors trading PX (&P 500

index) options, who would like to hedge their position
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ince an index has an intrinsic value determined by the prices of the stocks
comprising the index, it must be the case that the futures price mimics the
movement of the index level, even though the index itself is not traded

If this were not true, then opportunities for what is known as index
arbitrage would exist

o rule out index arbitrage, the following relationship must hold between
the futures price F and level of the index  (at least approximately once we
account for transaction costs): F =  e(r-
(r-d)( -t) ,

where d represents the continuous dividend yield for the stocks

comprising the index

ote that this formula differs from that for an asset paying a known cash
income because now we assume the payment is made continuously (rather
than at discrete times)
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[sing the same arguments for a forward contract, if this were

not true, then riskless arbitrage opportunities would exist,
where the arbitrager wither buys or sells the stocks underlying
the index in conjunction with an opposite position in the
futures contract

In practice, index arbitrage may be carried out using a

representative sample of stocks comprising the index. Mlso,
program trading is often used, where the calculations and
actual trades are conducted by computer in real time.
he table below summarizes the Y 6  Y  for various assets:
Msset Cost of Carry

Financial Msset paying no income or r


Financial Msset paying known r-d

dividend yield d

Commodity with no storage cost. r

Commodity with storage costs.


When deriving the fair values for futures and forward contracts
based on arbitrage arguments, we conveniently overlooked
transactions costs such as bid-
bid-ask spreads and commissions charged
for taking on various positions

In practice transactions costs will lead to upper and lower bounds

for the forward or futures prices as a function of the underlying spot
price. he CME has a publication entitled ³Determining the delevant
Fair —alue(s) of &P 500 Futures.´ his publication outlines an
example in which all the relevant transactions costs are factored in.

For a specific example considered, the range of futures prices

consistent with no arbitrage was 651.74 to 659.09. Given that this
particular contract is for 500 times the index value, the two bounds
represent a difference of $3,675 for 1 contract.
     
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Index futures allow investors to participate in broad market

movements without buying or selling large numbers of
stocks (transactions costs of buying and selling futures are
much lower than those of taking the underlying position)

How to replicate the payoff to holding the P500 w/o

buying a stock:
1) Hold as many index futures contracts as you need to
purchase your desired stock position
2) Invest enough money in -bills to cover the payment
of F0 times the number of long positions in the futures
     
     m  

he payoff to this strategy is:

 - F0 profits from contract
+ F0 value of -Bills

ote that a short position in the futures contract and a

corresponding investment in -bills to cover F0 at expiration is
equivalent to selling short the market

Mn advantage here is that you earn interest on the bills (while

in a traditional short-
short-sale you may earn little or no interest on
the proceeds of the short sale)