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Forwards & Futures: Session 2 - Derivatives & Risk Management Prof. Aparna Bhat
Forwards & Futures: Session 2 - Derivatives & Risk Management Prof. Aparna Bhat
Futures rollover figures higher than past 3 months average with high
rollover cost imply bullish sentiment – so opportunity to go long futures
Futures rollover figures lower than past 3 months’ average with low
rollover cost imply bearish sentiment – time to short the futures
Pricing of a forward contract
‘No arbitrage’ is the main assumption
The principle of ‘replication’
Cost of the ‘replicating portfolio’ = cost of the
derivative
Example – Forward price of a painting
Cost of carry model
Spot price of gold is S and current interest rate is denoted
by r
What should be the price for buying or selling gold at the
end of six months from today?
The forward price ‘F’ will be received only on the maturity
date, i.e. at the end of six months
If the seller sells at the spot price S and invests the proceeds at
the current interest rate r, he will receive S*(1 + r*t)
The minimum price F is therefore S *(1 + r*t)
This is the price at which there will be no arbitrage
opportunity
Assumptions of cost-of-carry model
No transaction costs
No restrictions on short sales
Same risk-free rate for borrowing and lending
Violations of forward pricing formula….
Consider a non-dividend paying stock with spot price = 120,
risk-free rate=5%, period= 1 year
As F= S*(1+rt) , F = 126
If actual F = 128 cash-carry arbitrage possible
Buy stock today at 120 by borrowing at 5%
Sell stock one-year forward at 128
Hold stock for 1 year
At maturity, sell stock at 128
Repay borrowing with interest at 126
Net gain is Rs.2 (free lunch ?)
Hence F cannot be greater than S*(1+rt)
Violations of forward pricing formula….
Consider a non-dividend paying stock with spot price = 120,
risk-free rate=5%, period= 1 year
As F= S*(1+rt) , F = 126
If actual F = 123 reverse cash-carry arbitrage possible
Sell stock today at 120 and lend proceeds at 5%
Buy stock one-year forward at 123
At maturity, get back loan with interest at 126
Receive delivery of stock at 123
Net gain is Rs.3 (free lunch ?)
Hence F cannot be less than S*(1+rt)
Pricing with continuous
compounding