Determination of Forward and

Futures Prices

Prof. Sudhakara Reddy

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Investment Assets vs. Consumption Assets
• An Investment asset is an asset that is held solely for investment purposes by at least
some traders. Stocks and bonds are best examples of investment assets. Gold and
Silver are also investment assets as investment assets do not have to be exclusively
held for investment purposes

• A Consumption asset is an asset that is held primarily for consumption purposes. It is

generally not held for investment purposes. Examples of consumption assets are
commodities such as corn, wheat, aluminium, crude oil, etc

• Arbitrage arguments are used in this chapter to determine the forward and futures
prices is applicable only to investment assets and not for consumption assets

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 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

• At some stage you must buy the securities so they can be replaced in the account of the
client

• You must pay dividends and other benefits the owner of the securities receives

• There may be a small fee for borrowing the securities

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The Securities Lending and Borrowing (SLB)Mechanism
• Short selling in equity markets is only in the intraday

• For central government securities, short selling is allowed for a period of 4 days

• SLB mechanism has gained popularity as it augments short selling in the Indian
markets

• SLB is a mechanism where security holder lends eligible securities to borrowers in

return for a fee. This creates income opportunities for security holders

SLB on NSE

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 Assumptions for Pricing Forward/Futures
• The market participants are subject to no transactions costs when they trade

• The market participants are subject to the same tax rate on all net trading
profits

• The market participants can borrow and lend money at the same risk-free rate
of interest

• The market participants take advantage of arbitrage opportunities as they

occur
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Notation for Valuing Futures and Forward Contracts
• S0: Spot price today

• F0: Futures or forward price today

• T: Time until delivery date

• r: Zero coupon risk-free interest rate for maturity T

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Arbitrage Opportunity for no income asset-Example
Consider a long forward contract to purchase a non-dividend paying
stock in 3 months from now. If the current stock price is Rs. 200 and the
3-month risk free interest rate is 7 % per annum. Do you see any
arbitrage opportunity if the current forward price is Rs. 180 or Rs. 230?

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Arbitrage Profit for no income asset
Current Stock Price = Rs. 200

Forward Price = Rs. 180 Forward Price = Rs. 230

Action now: Action now:

Short 1 unit of the asset to realize Rs. 200 Borrow Rs. 200 at 7% interest rate for 3 months
Invest Rs. 200 at 7 % interest for 3 months Buy one unit of the asset

Enter into a forward contract to buy asset in 3 Enter into a forward contract to sell asset in 3 months for
months for Rs. 180 Rs. 230
   

Action After 3 months: Action After 3 months:

Buy asset for Rs. 180 Sell asset for Rs. 230

Close short position Use Rs. 203.53 to repay the loan

Receive Rs. 203.53 from investment  

Profit realized = Rs. 23.53 Profit realized = Rs. 26.47

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A Generalization for Forward/Futures Price on Investment
Assets with no income
• From the previous example, it is clear that:
• If F0 > S0erT, then arbitrageurs can buy the asset and short forward
contracts on the asset

• If F0 < S0erT, then arbitrageurs can short the asset and enter long position
in forward contracts on it

• Hence, there won’t be any arbitrage opportunity if and only if F0 = S0erT,

hence this should be the theoretical forward/futures price
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 If Short Sales are not Allowed
• The Pricing Formula F0 = S0erT still works for an investment asset
because investors who hold the asset will sell it and buy forward
contracts when the forward price is too low

• The only condition is that there should be market participants who hold
the asset purely for investment purposes

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 Price of a Forward/Futures contract when the investment
asset provides a known income
• Generally, investment assets provide a known income such as stocks
paying dividends and bonds paying coupons

• For an investment asset that pays a known income with a present value I,
the price of a forward/futures contract is given by
F0 = (S0 – I )erT`

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 Price of a Forward/Futures contract when the
investment asset provides a known yield
If the investment asset provides a known yield q, which is the average
yield during the life of the contract expressed in continuous
compounding terms, the forward/futures price is given by
F0 = S0 e(r–q )T

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 Value of a Forward Contract
• The value of a forward contract at the time it is first entered into is close to
zero. At a later stage, it may prove to have a positive or negative value
• It is important for banks and other financial institutions to value the contract
each day
• Suppose that K is the delivery price, F0 is the forward price for a contract that
would be negotiated today and f is the value of the forward contract today
• At the beginning of the life of the forward contract, the delivery price, K, is set
equal to the forward price at that time and the value of the contract, f is 0
• As time passes, K stays the same, but the forward price changes and the value
of the contract becomes either positive or negative

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Value of a Forward Contract Contd.
By considering the difference between a contract with delivery price K
and a contract with delivery price F0 we can deduce that:

the value of a long forward contract is

f = (F0 – K )e–rT

the value of a short forward contract is

f = (K – F0 )e–rT

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 Futures Prices on Stock Indices
• A stock index can usually be regarded as the price of an investment asset that pays
dividends. The investment asset is the portfolio of stocks underlying the index, and the
dividend paid by the investment asset are the dividends received by the holder of this
portfolio

• It is usually assumed that the dividends provide a known yield rather than a known cash
income. If q is the average dividend yield rate, then the futures price of the index is given by
F0 = S0 e(r–q )T

• For the formula to be true it is important that the index represent an investment asset

• In other words, changes in the index must correspond to changes in the value of a
tradable portfolio

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 Index Arbitrage
• When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures

• When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying
the index

• Index arbitrage involves simultaneous trades in futures and many different stocks

• Very often a computer is used to generate the trades

• Occasionally simultaneous trades are not possible and the theoretical no-arbitrage
relationship between F0 and S0 does not hold

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 Futures and Forwards on Currencies
• A foreign currency is analogous to a security providing a yield

• The yield is the foreign risk-free interest rate

• It follows that if rf is the foreign risk-free interest rate and r is the

domestic risk-free rate
( r rf ) T
F0  S0e

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Futures on Commodities: Income and Storage Costs
• Gold Lease Rate: Gold owners such as central bank charges interest
rate in this form when they lend gold

• If u is the storage cost per unit time as a percent of the asset value, it
can be treated as negative yield. Then
F0 = S0 e(r+u )T

• Similarly, if U is the present value of the storage costs, it can be

considered as negative income. Then
F0 = (S0+U )erT

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 Futures on Consumption Commodities
• Consumption commodities usually provide no income, but can be subject to
significant storage costs

• Here arbitrage strategy can not be used in some cases

• Individual and companies are reluctant to sell the commodity stored in inventory

• Hence for consumption commodity the valid equations are

F0  (S0+U )erT
F0  S0 e(r+u )T

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 Convenience Yields
• Ownership of the physical asset enables a producer to keep a production process running
and perhaps profit from temporary local shortages

• The benefits from holding the physical asset are referred to as the convenience yield
provided by the commodity

• If the rupee amount of storage costs is known and has a present value U and the
convenience yield is y, then
F0 eyT = (S0+U )erT

• If the storage costs per unit are a constant proportion u of the spot price
F0 eyT = S0e(r+u)T
or, F0 = S0e(r+u – y)T
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 Convenience Yields Contd.
• The convenience yield reflects the market's expectations concerning the future availability of
the commodity

• The greater the possibility that shortages will occur, the higher the convenience yield

• If users of the commodity have high inventories, there is very little chance of shortages in the
near future and the convenience yield tends to be low

• On the other hand, low inventories tend to lead to high convenience yields

• For investment assets the convenience yield must be zero; otherwise, there are arbitrage
opportunities.

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 The Cost of Carry
• The cost of carry, c, is the storage cost plus the interest costs less the
income earned

• For an investment asset F0 = S0ecT

• For a consumption asset F0  S0ecT

• For a consumption asset with convenience yield F0 = S0 e(c–y )T

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 Futures Prices & Expected Future Spot Prices
• Suppose k is the expected return required by investors in an asset

• We can invest F0e–r T at the risk-free rate and enter into a long futures
contract to create a cash inflow of ST at maturity

• This shows that F0 e  rT e kT  E ( ST )

or
F0  E ( ST )e ( r  k )T

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Futures Prices & Expected Future Spot Prices Contd.

No Systematic Risk k=r F0 = E(ST)

Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic Risk k<r F0 > E(ST)

Positive systematic risk: stock indices

Negative systematic risk: gold (at least for some periods)

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 Contango and Normal Backwardation
• When the futures price is above the expected future spot price, the
situation is known as contango

• When the futures price is below the expected future spot price, the
situation is known as normal backwardation

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Multiple Choice Question 1
If F0 > S0erT, to make profit arbitrageurs can
A. Buy the asset and short forward contracts on the asset
B. Sell the asset and short forward contracts on the asset
C. Buy the asset and long forward contracts on the asset
D. Sell the asset and long forward contracts on the asset

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Multiple Choice Question 1 (Ans.)
• Answer: A. Buy the asset and short forward contracts on the asset

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Multiple Choice Question 2
• When a known future cash outflow in a foreign currency is hedged by a company using a forward contract,
there is no foreign exchange risk. When it is hedged using futures contracts, the marking-to-market process
does leave the company exposed to some risk. Consider whether the company is better off using a futures
contract or a forward contract when
• a. The value of the foreign currency falls rapidly during the life of the contract
• b. The value of the foreign currency rises rapidly during the life of the contract
• c. The value of the foreign currency first rises and then falls back to its initial value
• d. The value of the foreign currency first falls and then rises back to its initial value
• Assume that the forward price equals the futures price.
• Options:
A. Forward better – a, b; Futures better – c, d
B. Forward better – a, c; Futures better – b, d
C. Forward better – a, d; Futures better – b, c
D. Forward better – a, b, d; Futures better – c

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Multiple Choice Question 2 (Ans.)
• Answer : C. Forward better – a, d; Futures better – b, c
• Explanation:
• a. If the value of the foreign currency falls rapidly during the life of the contract
co. takes loss on its hedge. If forward contract is used loss is realized at the end. If
futures is used loss is realized day by day. On present value basis former is
preferable.
• b. If the value of the foreign currency rises rapidly during the life of the contract
co. makes gain on its hedge. If forward contract is used gain is realized at the end.
If futures is used gain is realized day by day. On present value basis latter is
preferable.

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Multiple Choice Question 2 (Ans.)
• c. If the value of the foreign currency first rises and then falls back to
its initial value futures leads to slightly better outcome. This is
because early cash flows are positive and later cash flows are
negative.
• d. If the value of the foreign currency first falls and then rises back to
its initial value forward leads to slightly better outcome. This is
because, when futures is used, early cash flows are negative and later
cash flows are positive.

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Multiple Choice Question 3
• Which of the following statements about arbitrage is FALSE?
A. If an arbitrage opportunity exists, making a profit without risk is possible.
B. Arbitrage is selling an asset and simultaneously buying the same asset for a
lower price.
C. No investment is required when engaging in arbitrage.
D. Arbitrage can cause markets to be less efficient.

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Multiple Choice Question 3 (Ans.)
• Answer: D. Arbitrage can cause markets to be less efficient.
• Explanation:
• Arbitrage is defined as the existence of riskless profit without investment and
involves selling an asset and simultaneously buying the same asset for a lower
price. Since the trades cancel each other, no investment is required. Because it is
done simultaneously, a profit is guaranteed, making the transaction risk free.
Arbitrage actually helps make markets more efficient because price discrepancies
are immediately eradicated by the actions of arbitrageurs.

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Multiple Choice Question 4
Is the following statement TRUE or FALSE?

When working with consumption commodities arbitrage strategy can

not be used in some cases.

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Multiple Choice Question 4 (Ans.)
• Answer: TRUE
• Explanation:
• Individual and companies who use certain commodity as raw material
or for resource purpose might be reluctant to sell that commodity
stored in inventory.
• Hence for consumption commodity following inequalities are valid:
F0  (S0+U )erT
F0  S0 e(r+u )T

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Multiple Choice Question 5
• Which of the following is NOT VALID assumption for valuing forward
and futures contracts:
A. The market participants are subject to no transactions costs when they trade.
B. The market participants are subject to the same tax rate on all net trading
profits.
C. The market participants can borrow money at the same risk-free rate of
interest as they can lend money.
D. The market participants can not take advantage of arbitrage opportunities as
they occur.

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Multiple Choice Question 5 (Ans.)
• Answer: D. The market participants can not take advantage of
arbitrage opportunities as they occur

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Problem No. 5.9 (Hull – 7th Ed.)
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.
a. What are the forward price and the initial value of the forward contract?
b. Six months later, 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?

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Problem No. 5.9 (Ans.)
Part a:
Forward price = $44.21
Initial forward contract value is zero.
Part b:
Forward price = $47.31
Value of forward contract = $2.95

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Problem No. 5.9 (Explanation)

Part a :
F0  Forward price  40e 0.1  44.21
Part b :
K  The delivery price in the contract  $44.21
f  The value of contract after six months
 45  44.21e 0.1( 6 /12)  2.95
F  Forward price  45e 0.10.5  47.31

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Problem No. 5.14 (Hull – 7th Ed.)
The 2-month interest rates in Switzerland and the United States are
2% and 5% per annum, respectively, with continuous compounding.
The spot price of the Swiss franc is $0.8000. The futures price for a
contract deliverable in two months is $0.8100. What arbitrage
opportunities does this create?

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Problem No. 5.14 (Ans.)

The theoretical futures price is

 0.8000e(0.050.02)( 2 / 12)  0.804  0.8100
The actual futures price is higher.
This suggests:
An arbitrageur should borrow U.S. dollars,
buy Swiss francs, and short Swiss franc futures

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Problem No. 5.19 (Hull – 7th Ed.)

Show that the growth rate in an index futures price equals the excess
return of the index over the risk-free rate. Assume that the risk-free
interest rate and the dividend yield are constant.

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Problem No. 5.19 (Ans.)
 Suppose that F0 is the futures price at time zero for
a contract maturing at time T and F1 is the futures price
for the same contract at time t1 . Hence,
F0  S0 e (r -q)T
F1  S1 e (r -q)(T - t1 )
where, S0 and S1 are the spot prices at times zero and t1
r  the risk free rate; q  the dividend yield
 From the equations,
F1 S1 -(r - q)t 1
 e
F0 S0

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Problem No. 5.19 (Ans. – contd.)

 Define the excess return of the index over the risk - free rate as x
 The total return  r  x
 Return realized in the form of capital gains  r  x - q
 It follows that
S1  S0 e (r  x - q)t 1
 The equation for F1 /F0 reduces to
F1 /F0  e xt1

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Problem No. 5.23 (Hull – 7th Ed.)
A U.S. company is interested in using the futures contracts traded on the CME to
hedge its Australian dollar exposure. Define r as the interest rate (all maturities)
on the U.S. dollar and rf as the interest rate (all maturities) on the Australian
dollar. Assume that r and rf are constant and that the company uses a contract
expiring at time T to hedge an exposure at time t (T > t).
a. Show that the optimal hedge ratio is e^(rf –r)(T-t)
b. Show that, when t is one day, the optimal hedge ratio is almost exactly So/Fo, where So is the
current spot price of the currency and Fo is the current futures price of the currency for the
contract maturing at time T.

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Problem No. 5.23 (Ans.)
Part a :
The relationship between the futures price Ft
and the spot price St at time t is

 Ft  St e(r  rf )(T  t )
Suppose the hedge ratio is h
F0 is the initial futures price
The price obtained with hedging is
 h(F0  Ft )  St

 hF0  St - hSt e(r  rf )(T  t )

If h  e(rf  r )(T  t ) , this reduces to hF0 and

a zero variance hedge is obtained

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Problem No. 5.23 (Ans.)

Part b :
When t is one day, h is approx.e(rf  r)T  S0 /F0
The appropriate hedge ratio is therefore  S0 /F0

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