LECTURE 3:

DETERMINATION
OF FORWARD
AND FUTURES
PRICES

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DERIVATIVES BY RAFF
LEARNING OBJECTIVES
1) Differentiate between “pricing” versus “valuing” a Forward contract
2) Determine the theoretical Forward contract prices: the cost-of-carry models
3) Identifying the arbitrage opportunities in Forward contracts
4) Understand different explanations for the relationship between “expected future spot price” and “forward
contract price” at time T0
5) Valuing forward contracts.

Learning structure
 Concept review: compounding interest rates, short selling, price vs. value
 Different versions of cost-of-carry models to determine fair forward price
 Valuation of forward contracts
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
CONCEPT REVIEW ON INTEREST RATE
FREQUENCIES

THE COMPOUNDING FREQUENCIES, DISCOUNTING FREQUENCIES

AND
CONTINUOUS COMPOUNDING AND DISCOUNTING

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 COMPOUNDING FREQUENCY OF INTEREST RATE

 To be unambiguous, an interest rate must be quoted with a compounding frequency, 10% annually compounded rate
gives a different outcome than 10% quarterly compounded /or continuously compounded frequency
 For 10% annually compounded, $100 bank deposit grows to 100(1+10%)= $110 in 1 year’s time.
 For 10% semi-annually compounded, $100 bank deposit grows to 100(1+10/2)2 = $110.25 in 1 year’s time.
 For 10% quarterly compounded, $100 bank deposit grows to 100(1+10/4)4= $110.38 in 1 year’s time

 General formula: FV = PV(1 + R/m)mn FV = Future Value; PV = Present Value

 Where: m=compounding frequency, n = number of periods of investment
 This compounding frequency is known as discrete compounding (there is a frequency limit)

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 CONTINUOUS COMPOUNDING OF INTEREST RATE

 When the limit of the compounding frequency m becomes infinity, it is known as continuous
compounding.
 The Future value (FV) and Present value (PV) formula then becomes:

FV = PVeRn ( where: e is the exponential value, R = compounding rate, n = number of periods ) .

or

PV = FVe–Rn ( where: e is the exponential value, - R = discounting rate, n = number of periods ) .

For the purpose of forward contract price determination (unless it is stated otherwise) we always use
continuous compounding or discounting rate to calculate the fair forward price.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
THE CONCEPT OF “PRICE” VERSUS “VALUE”
 Price is what you pay, value is what you get, which is often computed as the Present Value (PV) of future cash-
flows / payoffs
 Normally in an efficient market, price = value.
 However, the markets are not efficient for various reasons, therefore, price ≠ value

 In forward contracts, the forward price (F0) is the price fixed (locked in) today at T0 for a deferred date purchase
(F0 is not equal to current spot price S0 or the forward date spot price ST ).

 Value of a forward contract is the value in the normal sense, i.e. PV of future payoff (Time value of money is
involved). Based on price concept F0 = FT as the forward price is fixed today and stays same until the delivery
date. Based on value concept S0 = PV (FT)

 A forward contract is designed such that its VALUE is zero at the time the contracted is entered (because the
underlying asset/product is not consumed at time T0).
 REVIEW ON SOME NOTATIONS
AND
ASSET CONDITIONS
TIME NOTATIONS AND PRICE NOTATION
INVESTMENT ASSET AND CONSUMPTION ASSET

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 INVESTMENT ASSETS VS. CONSUMPTION ASSETS
Investment Assets: Assets that are held for investment purpose only
 It can be classified as:
1. No income earning assets
2. Known $ value income earning assets
3. Known income yielding % assets.

 E.g. Stocks and Stock Indices, Bonds, Gold and Silver etc.
 We can use arbitrage arguments to determine the forward prices from its current spot price and other observable
market variables.

Consumption Assets: Assets held primarily for consumption purpose (not for investment)
 E.g. Copper, Crude oil, Corn, Wheat….etc. used as raw material in production process.
 We cannot use arbitrage arguments to determine the forward prices.
 NOTATIONS
 Time notations:
 0 : Current time / today

 T : Delivery (maturity) date of forward contract, expiry date of an option contract, expressed in terms of
decimalized fraction of the number of years (e.g. 3 month contract has T=0.25, 6 month contract has T = 0.5)
 t : some time between 0 and T: 0 ≤ t ≤ T

0 t T

 Price Notations:

 S0 : Spot price today

 F0 : Forward price FIXED today
 V0 : value of forward contract today (always = 0)
 r : Risk-free interest rate for maturity T
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
FORWARD (F0) PRICE DETERMINATION
 The main objective of this lecture is to understand how forward price is determined. In other words, what should be
the contracted price fixed today for a forward that makes both parties, long and short, equally happy to be
transacted in a forward date.
 Equivalently, what should be the forward price that gives zero initial value for the contract (i.e. the PV of the
forward price should be not different from current spot price). S0 = F0 = PV(FT)
 Forward contracts are much easier to analyze than futures since there is no daily settlement.
 Luckily it can be shown that if interest rates are constant or deterministic, futures price and forward price for the
same contract are in theory should be same
 Let’s therefore derive the forward price first.

 S0 = PV (FT ) t1 t2 T = F0

 We use the Cost-of-Carry model to identify the theoretical (no-arbitrage) forward price on an asset.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 COST-OF-CARRY MODEL
 Cost-of-carry model is used to determine the fair (theoretical) forward price the holder in long position must pay to
the holder in short position at delivery date to compensate for:

 (1) the cost of immediately securing the asset i.e. S0 plus

 (2) any other costs of carrying the asset up to the delivery date

 Forward price = Spot price + cost-of-carry (i.e. cost of holding the asset minus any income
derived through holding the asset)
 Depending on the nature of the underlying asset, the form of cost-of-carry may include some, or all of the following:
 Financing cost (risk free interest rate)
 Storage cost (space rental, insurance and other maintenance)
 Less income ( dividend or benefits received) during the holding period.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 COST- OF- CARRY MODELS (ASSUMPTIONS)
 Main assumption: Market does not permit arbitrage.
 What is "arbitrage?"

A profit opportunity which guarantees net cash inflows with no net cash outflows.

 Assumption is not that arbitrage opportunities can never arise, but that they cannot persist.

 This is a minimal market rationality condition: it is impossible to say anything sensible about a market where such

opportunities can persist.

 Other assumptions:

(1) No transaction costs;

(2) No restrictions on short sales. In particular, full proceeds of short sales are available
immediately for investment;
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

(3) Investors can borrow and lend at the same rate which is risk-free rate
COST-OF-CARRY MODEL(1):
FORWARD PRICE FOR A NON-INCOME EARNING ASSET OR (ZERO COUPON BOND)

 Assuming that the forward contract is written on a security that pays no income during the life time of the contract or
on a Zero coupon bond:

 We use the Cost-of-carry model to determine the fair / theoretical / no-arbitrage forward price at T0
 Cost of carry = ONLY financing cost = S0erT – F0
 Then the link between the spot and fair forward price is: F0 = S0erT
 Cost-of-carry is based on an arbitrage relationship: if the above relationship does not hold, subject to assumptions
discussed in previous slide, arbitrageurs will be able to make profit from the differences between F0 and FT prices.
 FT is the forward price quoted by the counter party (seller / buyer) to transact at the maturity time.
 If the F0 ≠F there is an arbitrage opportunity to be exploited
TAPPLICATIONS OF DERIVATIVES BY RAFF
FIN3074 RISK MANAGEMENT
 THE FAIR FORWARD PRICING FORMULA
 Fair-Forward price is the forward price that should be the rightful price or theoretical price and it should not create any arbitrage
possibilities.
 To determine the no-arbitrage forward price through Cost-of-Carry model (1).

F0 = S0 erT
 Suppose the current gold price is S0 = $350/oz., 3-month risk free interest rate is 8% p.a.; no holding costs involved. What should be
the 3-month forward price of gold (or the no-arbitrage forward price)?
F0 = 350e(0.08)(0.25) = $357.07

 Suppose the quoted F > 357.07, lets say $370, then the forward is said to be overpriced (OP) relative to the spot price today by $370 –
T
357.07 = $12.93 (short the forward and long the spot)

 Or suppose quoted the F0 < 357.07, lets say $340, then the forward is said to be underpriced (UP) relative to spot price today by $357.07 – 340
= $17.07 (long forward and short spot)

 REMEMBER IN THIS CASE THE ASSET (GOLD) HAS ZERO INCOME. THEREFORE, THE ONLY COST IS
COMPOUNDED INTEREST COST
 ARBITRAGE STRATEGY IN FORWARD CONTRACTS
When the FT is overpriced (i.e. FT > S0erT), the arbitrageur can make profit by
selling (short) the forward and buying (long) the spot.

When the FT is underpriced (i.e. FT < S0erT), the arbitrager can make profit by
buying (long)the forward and selling (short) the spot.

S0 FT

$370.00 (OVERPRICED)

$350 $357.07 (NO ARBITRAGE)

$340.00 (UNDERPRICED)

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

COST-OF-CARRY (1) AND ARBITRAGE OPPORTUNITY
Example 1:
Consider a long forward contract to purchase a non-dividend paying stock in 6 months time. Assume
S0=$40, 6-month interest rate r=8% p.a. Identify the arbitrage opportunity if forward price is quoted as
$43 by the seller.
Answer:
According to cost-of carry model, F0 should be 40e0.08 x 0.5 = $41.63, thus the observed forward price of
$43 implies the forward is overpriced compared to current spot price.
Arbitrageurs make profit by selling the “overpriced” (forward) and buying the underpriced (spot), provided
the previously stated assumptions hold
**Always sell (short) the OP and buy (long) the UP **
Between current time F0 and FT
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
COST OF CARRY (1) AND ARBITRAGE OPPORTUNITY
If the Forward Price = $43 (OP)
Action Now: (Buy Spot, Sell Forward)
1) Borrow $40 at 8% for 6 months
2) Buy one unit of the asset for $40 (spot)
3) Enter into 6-month forward contract
to sell this asset for $43
Action in 6 months:
1) Sell asset for $43 (as fixed at inception)
2) Use $41.63 to repay the loan with interest
( $40 e 0.08 x 0.5 = $41.63)
Profit realized = $1.37 = (43 – 41.63)
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
If the Forward Price = $38 (UP)
Action Now: (Buy Forward, Sell Spot )
1) Sell one unit of asset to realize $40 (spot)
2) Invest $40 at 8% for 6 months
3) Enter into a 6-month forward contract
to buy asset in for $38 (as fixed at inception)
Action in 6 months:
1) Buy asset for - $38 (forward)
2) Receive $41.63 from investment
($40 e 0.08 x 0.5 = $41.63)
Profit realized = $3.63 = (41.63 – 38)
COST OF CARRY (1) AND ARBITRAGE OPPORTUNITY
PAYOFF TABLE
CF Today at (T = 0) CF in 6 mts. (T = 0.5)

Short forward 0.00 43.00 - ST

Long Spot - 40.00 ST

Borrow spot amount + 40.00 - 41.63 (payback)

Net cash flow 0.00 + 1.37

 Arbitrage profit of $1.37 per forward contract is realized at maturity

 Similarly, if FT =$38 ,.....

CF Today at (T = 0) CF in 6 mts. (T = 0.5)

Long Forward 0.00 ST – 38.00

Short Spot +40.00 - ST

Invest Spot amount - 40.00 +41.63 (ROI)

Net Cash Flow 0.00 + 3.63

 Arbitrage profit of $3.63 per forward contract is realized at maturity

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
COST-OF-CARRY MODEL (2)
FORWARD PRICE ON ASSET THAT PAYS KNOWN $ INCOME
 If the security pays known $ income with PV (div) = I, using the intuitive explanation,
the cost of carry model, the short holder (seller) gets compensated by the financing
cost less the income paid while holding the asset.
 In other words, the cost-of-carry in this case is financing cost minus the present value
of the known $ income, where I is the PV of that known $ income.

 This version of cost of carry model can be applied to:

 Forward written on single stocks paying known $ dividend
 Forward written on coupon paying bonds

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

EXAMPLE 2

 Consider a forward contract entered on a coupon paying bond.

 Suppose that:

 Spot price of bond: S0 = $95.

 Contract length: T = 6 months.

 Interest rate: r = 10% (continuously compounded) for all maturities.

 Coupon of $5 will be paid to bond holders in 3 months.

 What is the fair-forward price of this bond?

Step 1: determine the PV of the dividend $5 that will be received in 3 months ( let the PV of the div. = I)
I = 5e -(0.10)(0.25) = $4.88 [ it is important to observe the timelines of the Div. payments]
Step 2: Thus, the arbitrage-free forward price F0 must satisfy
F0 = (S0 - I)erT = (95 – 4.88)e (0.10 x 0.5) = $94.74

Any other quoted forward price (either higher or lower than $94.74) leads to an arbitrage.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

Therefore at Time T0 now: S0 = $95 and F0 should be $94.74

ARBITRAGE WITH AN OVERPRICED FORWARD (EXAMPLE 2 CONT’D.)

 Based on previous example, suppose the quoted FT = $98.

 (given that the fair-forward price as calculated is $94.74) and the S0 = $95

 Then, the forward is termed as overpriced ($98 > $94.74, relative to spot, so we should to sell
forward, borrow to buy spot).
 Buying and holding the spot asset leads to a cash outflow of $95 today, but we will receive a coupon
of $5 in 3 months.
 There are a few ways to structure the arbitrage strategy.

 Here is one. We split the loan repayment of $95 into two parts, with

 one part repaid in 3 months from the $5 coupon, and

 the balance repaid in six months with the delivery price received on the forward contract.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 THE ARBITRAGE STRATEGY ON EXAMPLE 2

 So the arbitrage strategy is:

 Enter into short forward with the delivery price of $98 (cash will be realized at maturity)
 Buy the bond for $95 in spot and hold for 6 months.
 Finance spot purchase by
 borrowing PV (Div.) $5e –(0.1 x 0.25) = $4.88 for 3 months at 10% (repaid as $5 in 3 months
time)
 borrowing ($95 – 4.88) = $90.12 for 6 months at 10%.(repaid as $94.74 in 6 months time)
 In 3 months:
 receive coupon of $5
 repay the 3-month borrowing with interest.
 In 6 months:
 deliver bond on forward contract and receive $98
 repay 6-month borrowing with interest as $94.74.
 Therefore, $98 - $94.74 = $3.26 (arbitrage profit per bond)
Note: We are calculating for one bond, imagine if you are dealing with 10,000 bonds i.e. = $32,600 gain
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 THE ARBITRAGE PAYOFF TABLE ON EXAMPLE 2

Trades CF @ T0 CF @ 3mts. CF @ T

Short Forward (6mnts) 0 0 $98 - ST

Long Bond (Spot) -$95 0 ST

Receive Coupon (3mnts) 0 +$5 0

Pay 3-month borrowing $4.88 -$5 0

Pay 6-month borrowing $90.12 0 -$94.74

Net CF 0 0 $3.26

 Arbitrage Strategy and its cash flows:

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

CONCEPT CHECK
Consider a 10-month forward contract on a $50 stock that pays $2.00 dividend in 6 months. The
continuously compounded risk free interest rate is 8 % p.a. for all maturities . At what price should this
forward be traded?
▪ Answer:
Step 1: Determine the PV of the $2.00 dividend that will be received in 6 months:
I = 2.00e -(0.08 x 0.5) = 2.00 (0.9608) = $1.92
Step 2: Hence F0 = (50.00 – 1.92)e0.08x10/12 = 48.08 (1.0689) = $51.39 (this is the arbitrage-free forward
price)

If the observed / quoted forward price of this stock is anything (higher or lower) than $51.39 will lead to an
arbitrage

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 CONCEPT CHECK (CONT’D)
What if the forward price of this stock is quoted as $50?
It implies FT < (S0 - I)erT ($50 < $51.39), FT is underpriced, therefore buy forward and sell spot

Trades CF @ T0) CF @ T Trades CF @ T0) CF @ T

Long forward 0.00 ST – 50.00 Long forward 0.00 ST – 50.00

Short spot +50.00 - ST Short spot +50.00 - ST

OR
Pay the PV (div) I - 1.92 0.00 Pay the PV (div) I - 1.92 0.00

Invest PV (FT) @ r - 46.78 50.00 Invest PV (FT) @ r - 48.08 +51.39

Net cash flow + 1.30 0.00 Net cash flow 0.00 1.39

Either an arbitrage profit of $1.30 is realized now or 1.30e(0.08x 10/12) of $1.39 is realized at the maturity.
Either way the same arbitrage value can be exploited!
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
COST-OF-CARRY MODEL (2A):
FORWARD PRICE FOR ASSET THAT PAYS YIELD (IN %)
If the security pays a known income which is expressed in terms of yield q (instead of dollar amount), the
cost of carry model becomes:

Example: Suppose that the risk-free interest rate is 10% per annum with continuous compounding and that the
dividend yield on a stock index is 4% per annum. Currently, the index is trading at 400 points, calculate the forward
price for a contract deliverable in four months

F0 = S0e(r – q)T
F0 = 400e(0.1 – 0.04)0.25 = 408.8
Any other index point quoted for FT (either higher or lower) than 408.8 will lead to an arbitrage.
Two points to note:
(1) the q % should always be lower than the r % in order to determine the F 0 in this model.

(2) The trading index is always given in points, to convert it to $ value you must multiply it with the multiplier $ of each point.
COST-OF-CARRY MODEL (3):
FORWARD PRICE FOR ASSET THAT INCURS STORAGE COSTS

If the asset incurs known storage cost, the storage costs can be treated as negative income that can add to the
current spot price. If U is the present value of all storage costs during the life of a forward contract, the cost-
of-carry model becomes:

The storage cost, insurance and other cost of holding the asset to the forward date could incur at different timelines
within the holding period: it may incur at the beginning or at the end of the contract or periodically during the holding
period, therefore it is important to calculate the PV(U) appropriately to the timelines of incurrence.

If the costs are expressed as percentage of spot price, the cost of carry model is:

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 EXAMPLE 3
 Currently the 24K Gold is priced at $500/oz. It costs $20/oz. p.a. to store gold, and the cost is payable
at the end of each year, r =7% p.a. What should be the one year forward price of per ounce of gold?
PV(U) = 20(e -0.07) = $18.65
F0 = (S0 + 18.65)e 0.07 = (500 + 18.65) (1.0725) = $556.26
 If the storage costs of $20/oz. is to be paid proportionately at the beginning of each quarter of the
year, than its PV will be:
 $20/4 = $5.00 per quarter, (Q1) = 5 x 1, (Q2)= 5e -0.07x0.25, (Q3) = 5e - 0.07x0.5 , (Q4)= 5e -0.07x0.75
 PV(U) = 5 + 4.91 + 4.83 + 4.74 = $19.48
 F0 = (500 + 19.48)e 0.07 = $557.15
 If the storage costs of $20/oz. is to be paid at the beginning of the contract, than its PV will be:
 F0 = (500 + 20)e 0.07 = 520 x 1.0725 = $557.70
 Such variations in the F0 value is very important to determine the arbitrage opportunity.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
 ▪EXAMPLE
What if we observe3the(CONT’D)
One year forward price of gold is FT = $520 compared to F0 = $556.25
▪ It implies F0 < (S0+U)erT , forward is underpriced, i.e. buy forward and sell spot

CF @T0 CF at T CF @T0 CF at T

Long Forward 0.00 ST - 520 Long Forward 0.00 ST - 520

Short spot + 500.00 - ST Short spot + 500.00 - ST

OR

Save storage cost + 18.65 0.00 Save storage cost + 18.65 0.00
Invest PV (Ft) @ r - 484.84 + 520 Invest @ r - 518.65 + 556.26
Net cash flow $33.81 0 Net cash flow 0.00 $36.26

Either you can realize a profit of $33.81 now or 33.81e0.07 = $36.26 at the maturity
Either way the same arbitrage value to be exploited

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 COST OF CARRY MODEL (4):
FORWARD PRICE FOR ASSET THAT IS HELD FOR OWN
CONSUMPTION

There are cases where consumption assets are stored to have an immediate use in production process rather that holding an
equivalent derivative that may be delivered in a deferred date, e.g. oil refiners hold crude oil for production, heating oil is
stored to use in winter season, Christmas tree to be decorated on 25 th December or bunch of Roses for valentines day.
The benefit of owning the actual physical asset at the most needed time is translated as Convenience Yield.
Just like the dividend benefit in the Cost-of Carry model, Convenience Yield is a benefit that can reduce the forward price
F0.
▪ Convenience yield measures the extent to which there are benefits obtained from ownership of the physical asset that are not
obtained by owners of long forward contracts. The cost of carry is the interest cost plus storage cost less the income earned.
In this case the convenience yield is an income earned.
Let y be the convenience yield %. The cost-of-carry model then becomes:
F0 = (S0 + U)e(r – y)T
To be expressed as % yield, the equation becomes : F0 = S0 e(r + u – y)T
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

Or
 COST OF CARRY MODEL (4): CONCEPT CHECK

 Assuming your firm is keeping (storing) a barrel of Heating oil to consume in the current winter
season. The current price per barrel of heating oil is $100. The storage and other associated costs
are 5% of the S0. The risk-free interest rate is 4% p.a. and the Convenience yield is 3.5% of the
S0. You are required to calculate the theoretical six-month forward price of this heating oil.

S0 = 100; U = 0.05; r = 0.04; y = 0.035 and T = 0.5

 F0 = 100e(0.04 + 0.05 - 0.035)0.5 = $102.79

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF

 VALUING FORWARD CONTRACTS
 Value of a forward contract is always zero at the time the contract is entered, because at the inception S0 = F0 there is
no value in the contract.
 As time goes by, the S0 will move either upwards or downwards, and it may prove to have either a positive value (if
move upwards) or negative value (if move downwards) depending on the way the S0 will change against the fixed
delivery price K. (K = F0 )

 For all long forward contracts: based on the PV of the K and the S0 at the time of determination:
 The value of a forward contract f will be: f = (F0 – K)e-rT that can be directly interpreted as: f = S0 – Ke
-rT

 For a short forward contract the f will be: f = Ke -rT - S0

 FIN3074
LetsRISK
usMANAGEMENT
do a concept check in the next slide:
APPLICATIONS OF DERIVATIVES BY RAFF
VALUING FORWARD CONTRACTS: CONCEPT CHECK
 A long forward contract on a non-dividend paying stock was entered sometime ago. Now it has 6
months to maturity. The risk-free interest rate (continuous compounding) is 10% p.a. Currently the stock
price is St = $25 and its delivery price K was fixed as $24. Determine the value of this forward contract
for the long position at this point of time.
 Take the spot price on that date of valuation and minus it from the PV of the delivery price K.
 f = 25 – 24e -(0.1 x 0.5) = 25 – 22.83 = $2.17 gain for the long position and loss for the short position.
 When we value an investment asset with known $ income, then we make an adjustment to that S 0 with the
PV of the Income (I)
 f = S0 – I - Ke -rT
 When it is on an Investment asset with know yield %, then: f = S0e –qT – Ke -rT
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
CONCLUSION: DOES THE COST-OF-CARRY MODEL HOLD IN REALITY?

▪ Not exactly due to market frictions:

 Transaction costs cannot be avoided.
 The ability to borrow assets to short-sell, especially commodities is not possible.
 The ability to execute various transactions simultaneously: the case of stock index arbitrage is not
possible.
Empirical research (Stoll and Whaley, 1986, MacKinlay and Ramaswamy , 1988) report that, based
on intraday data of S&P 500 index futures, the cost of carry model on stock index futures is violated
around 15% of the times.

FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF