Chapter 4

SS
2009
Futures and Forwards pricing

Futures and Option Markets - Department for Financial Management and Capital Markets 4.1
 Overview

(1) Futures and Forwards pricing

a. Introduction

b. Forward price
a. Investment assets without income

b. Investment assets with known income

c. Investment assets with known yield

d. Currencies

e. Commodities

c. Valuing of forward contracts

d. Forward price and Futures Price

Futures and Option Markets, SS 2009 4.2

 Chapter Outline

ƒ In this chapter, we examine how forward prices are related to the

spot price of an underlying asset
ƒ We investigate forward prices because they are easier to analyze
than futures prices
ƒ No daily settlement
ƒ Only one single payment at the end of the lifetime
ƒ We find out that forward prices and futures prices are usually very
close for identical maturities

Futures and Option Markets, SS 2009 4.3

 Consumption vs. Investment Assets

ƒ Investment assets are assets held by a significant numbers of

investors solely for investment purposes.
ƒ Examples: Stocks, bonds and some commodities like gold or silver
ƒ Consumption assets are assets held primarily for consumption
ƒ Examples: Copper, oil, timber, …
ƒ Very important distinction for forward pricing
ƒ For investment assets, we can derive the forward price with help of no-
arbitrage arguments
ƒ For consumption assets, we have to consider some restrictions with
arbitrage

Futures and Option Markets, SS 2009 4.4

 Short Selling

ƒ Short selling (“shorting” ) involves selling an asset that is not owned

ƒ Short selling is possible for some – but not all – investment assets
ƒ Procedure of shorting
ƒ Investor wants to short 500 shares of Intel
ƒ The broker of the investor borrows 500 shares of Intel from somebody
ƒ At some point, the investor closes his position by buying 500 shares
ƒ Profit if the stock price declined and vice versa (Attention: Dividends!)
ƒ Restrictions
ƒ Short – squeezed
ƒ Some legal regulations

Futures and Option Markets, SS 2009 4.5

 Assumptions for Forward Pricing

ƒ The market participants are subject to no transaction costs when

they trade
ƒ The market participants are subject to the same tax rate on all net
trading profits
ƒ The market participants can borrow money at the same risk-free rate
of interest as they can lend money
ƒ The market participants take advantage of arbitrage opportunities as
they occur

Futures and Option Markets, SS 2009 4.6

 Notation

ƒ The following notation is used

ƒ T = time until delivery for a forward or futures contract [years]
ƒ St = Price of the underlying asset at time t
ƒ Ft = Forward or futures price at time t
ƒ r = Risk-free rate of interest for an investment maturing in T years
[% p.a., cont. comp.]

Futures and Option Markets, SS 2009 4.7

 Investment Asset without Income 1 / 3

ƒ Base case: Forward on an investment asset without income

ƒ Intuitive Illustration
ƒ Long forward contract to buy a non-dividend paying stock
ƒ T = 0.25, S0 = 40 $ and r = 5 %
ƒ (a) What would happens if F0 = 43 $ ?
ƒ An arbitrageur would borrow 40 $, buy one share and short one forward
contract to sell a share in 3 month
ƒ After 3 month, the arbitrageur delivers the share and receives 43 $
ƒ For the loan, he pays: 40 $ * e0.05*0.25 = 40.50 $
ƒ Hence, he obtains a risk-less profit of 2.50 $ per share

Futures and Option Markets, SS 2009 4.8

 Investment Asset without Income 2 / 3

ƒ (b) What would happen if F0 = 39 $ ?

ƒ An arbitrageur would short one share, invest the money at the risk-less
interest rate and take long position in the forward contract
ƒ After 3 month, the arbitrageur pays 39 $ for the share and closes out his short
position
ƒ The terminal value of his investment is: 40 $ * e0.05*0.25 = 40.50 $
ƒ Hence, he obtains a risk-less profit of 1.50 $ per share

ƒ Only for a forward price of 40.50 $, there is no arbitrage opportunity!

ƒ Smaller F0: Short share, invest money and enter into long forward
ƒ Higher F0: Borrow money, buy share and enter into short forward
ƒ Hence, the market is solely in equilibrium if F0 equals 40.50 $

Futures and Option Markets, SS 2009 4.9

 Investment Asset without Income 3 / 3

ƒ Generalization for investment assets without income

ƒ The relation between the current spot price and the forward price in
equilibrium is :
F0 = S 0 e rT
ƒ For the example, the equilibrium price would be: F0 = 40e 0.05*0.25 = 40.50
ƒ Forward price is higher than spot price because of the costs of financing
the spot purchase
ƒ What if short sales are not possible?
ƒ Because a significant number of investors hold the asset solely for
investment purposes, they will sell the asset and go long in a forward if
forward prices are too low.

Futures and Option Markets, SS 2009 4.10

 Investment Asset with known income 1 / 2

ƒ Forward on an investment asset with a perfectly predictable cash

income
ƒ Intuitive Illustration
ƒ Long forward contract to buy a coupon bearing bond
ƒ T = 1, S0 = 900 $, r = 5 %
ƒ Coupon of 40 $ after 0.5 years; risk-free interest rate for 0.5 years = 4% p.a.
ƒ (a) What would happens if F0 = 920 $ ?
ƒ An arbitrageur would borrow 900 $, buy the bond and short one forward
ƒ The coupon payment has a present value of 40e-0.04*0.5 = 39.21 $
ƒ The investor borrows 39.21 $ for 6 months and 860.79 $ for 1 year
ƒ The remaining loan after 1 year is 860.79*e0.05*1= 904.92 $
ƒ Profit: 920 $ - 904.92 $ = 15.08 $

Futures and Option Markets, SS 2009 4.11

 Investment Asset with known income 2 / 2

ƒ (b) What would happens if F0 = 870 $ ?

ƒ An arbitrageur short the bond and enter into a long forward contract
ƒ Of the 900 $ from shorting, 39.21 $ are invested for 6 month to pay the coupon
ƒ The remaining 860.79 $ are invested for 1 year at 5 % interest rate
ƒ After one year, the investor pays 870 $ to buy the bond and closes out his short
position
ƒ Profit: 860.79*e0.05*1 - 870 = 904.92 – 870 = 34.92 $

ƒ Only for a forward price of 904.92 $, there is no arbitrage opportunity!

Hence, the market is solely in equilibrium if F0 equals 904.92 $
ƒ Generalization for investment assets with known income
F0 = ( S 0 − I )e rT
I = Present value of income during life of forward contract

Futures and Option Markets, SS 2009 4.12

 Investment Asset with Known Yield 1 / 3

ƒ Known yield instead of a known cash income

ƒ Yield are normally measured in continuous compounding
ƒ The average yield per annum is denoted as “q”
ƒ The equilibrium forward price is given by:
F0 = S 0 * e ( r − q )T

ƒ What is the economic intuition expressed in this formula?

Futures and Option Markets, SS 2009 4.13

 Investment Asset with Known Yield 2 / 3

ƒ A stock index is an investment asset that provides a know yield (due

to dividend payments)
ƒ Example
ƒ Specifications of a forward contract
ƒ Forward contract on the S&P 500 index
ƒ 3-month contract: T = 0.25
ƒ Stocks in the index provide a yield of 1% p.a.: q = 0.01
ƒ Current value of the index: S0=800 $
ƒ r = 0.06
ƒ What is the forward price?
F0 = S 0 e ( r − q )T = 800e ( 0.06−0.01)*0.25 = 810.06$

Futures and Option Markets, SS 2009 4.14

 Investment Asset with Known Yield 3 / 3

ƒ Index Arbitrage
ƒ If the actual index forward price is higher or lower than the equilibrium
index forward price, investors can obtain risk-less profits!
ƒ Situation a: F0 > S 0 e ( r − q )T
ƒ Strategy: Go short in index forward contract and buy stocks
ƒ Situation b: F0 < S 0 e ( r − q )T
ƒ Strategy: Go long in index forward contract and sell stocks
ƒ Investors who do not own the stocks must short them!
ƒ Complex trading because of the many stocks usually involved
ƒ Sometimes index arbitrage is not possible (e.g. “Black Monday”)
ƒ Equilibrium relationship between Forward and Spot price does not hold!

Futures and Option Markets, SS 2009 4.15

 Currency 1 / 2

ƒ We investigate currencies from the perspective of a Eurozone investor

ƒ The exchange rate is the price of the foreign currency in Euro
ƒ Hence, the spot price S and forward price F is the price of one unit of
the foreign currency measured in euros
ƒ Examples: USD/EUR = 0.75; AUD/EUR = 0.61; GBP/EUR = 1.46
ƒ For a foreign currency, a holder can earn interest at the risk free
interest rate of the foreign country
ƒ We denote the risk free interest rate of the foreign country as rf
ƒ The relationship between S0 and F0 is:
( r − r f )T
F0 = S 0 * e

ƒ A foreign currency is nothing else than an investment asset with q = rf

Futures and Option Markets, SS 2009 4.16
 Currency 2 / 2

ƒ Why must this relationship (interest rate parity) hold?

ƒ Example
ƒ An investor owns 1.000 GBP
ƒ At time T, he wants to have EUR instead of GBP
ƒ Therefore he has two possibilities
ƒ (a) Invest the GBP at rf for time T and enter into a forward to sell the proceeds
for EUR at time T.
TVT [ EUR] = 1.000e
r f *T
* F0
ƒ (b) Change the GBP for EUR in spot market and invest the EUR at r for time T
TVT [ EUR] = 1.000 * S 0 e rT
F0 = 1.000 * S 0 e rT
rf T
ƒ Without arbitrage opportunity: 1.000 * e

Futures and Option Markets, SS 2009 4.17

 Currency - Example

ƒ Specifications
ƒ 3 year interest rate in the Eurozone: 6 % p.a.
ƒ 3 year interest rate in USA: 4 % p.a.
ƒ S0 [USD/EUR] = 0.75
ƒ 3 year forward exchange rate contract
ƒ Equilibrium price
( r − r f )T
F0 [USD / EUR] = S 0 e = 0.75e ( 0.06−0.04 )*3 = 0.80

ƒ Arbitrage opportunities
ƒ What would an investor do if the Forward rate would be 0.70?
ƒ What would an investor do if the Forward rate would be 0.90?

Futures and Option Markets, SS 2009 4.18

 Commodities 1 / 3

ƒ Income and storage costs

ƒ Storage costs in absolute terms can be treated as negative income
ƒ We denote the NPV of all storage costs as U
F0 = ( S 0 + U )e rT

ƒ If the storage costs are proportional to the price of the commodity, they
can be interpreted as a negative yield
ƒ We denote the storage costs p.a. as a proportion of the spot price as u
F0 = S 0 * e ( r +u )T

ƒ Consumption commodities
ƒ Unlike investment commodities, they are primary for consumption
ƒ They usually do not provide income, but are subject to storage costs

Futures and Option Markets, SS 2009 4.19

 Commodities 2 / 3

ƒ Arbitrage opportunities with consumption commodities

ƒ Forward price > Equilibrium Forward price: F0 > ( S 0 + U )e rT
ƒ Borrow S0+U at r, purchase one commodity and pay storage costs
ƒ Go short in one forward contract => Risk less profit => Equilibrium price
ƒ Forward price < Equilibrium Forward price: F0 < ( S 0 + U )e rT
ƒ Sell commodity, save storage costs and invest proceeds at risk free rate
ƒ Go long in one forward contract
ƒ BUT: Consumption asset is hold for consumption! No short selling possible!
ƒ For consumption commodities, we get:
ƒ Fixed storage costs: F0 ≤ ( S 0 + U ) * e rT

ƒ Relative storage costs: F0 ≤ S 0 * e ( r +u )T

Futures and Option Markets, SS 2009 4.20

 Commodities 3 / 3

ƒ We do not necessarily have equality in the forward price equitation

for consumption assts (limited arbitrage)
ƒ Physical ownership provides benefits that are not obtained by a forward
ƒ Example: Physical ownership of timber enables a sawmill to produce
ƒ The benefits form holding the assets are called convenience yield y
ƒ Market’s expectations about the availability of a commodity in the future
ƒ Formally, it measures the extend to which the S0e(r+u)T is higher than F0
ƒ For all investment assets, y must be zero
ƒ For consumption commodities with relative storage costs, we get:
F0 = S 0 * e ( r +u − y )T

Futures and Option Markets, SS 2009 4.21

 Commodities – Forward Curve

ƒ Contango
ƒ Upward sloping curve
ƒ y < r +u

ƒ Example: Investment assets

ƒ Backwardation
ƒ Downward sloping curve
ƒ y > r +u

ƒ Example: Copper, Cattle, …

Futures and Option Markets, SS 2009 4.22

 Cost of Carry

ƒ We can summarize the no-arbitrage relationship between spot and

forward prices by the cost of carry c
ƒ Investment asset without income: c = r
ƒ Investment asset with income: c = r - q
ƒ Foreign Currency: c = r – q = r - rf
ƒ Commodity: c = u + r (- q)
ƒ r = interest rate, rf = foreign interest rate, u = relative storage costs,
q = yield
ƒ For investment assets, we have: F0 = S 0 e cT

ƒ For consumption assets, we have: F0 = S 0 e ( c − y )T

Futures and Option Markets, SS 2009 4.23

 Valuing of Forward Contracts

ƒ The value of a forward contract, which is denoted f, at time t=0 is zero

ƒ The value at a later stage can be different from zero
ƒ Value of a long forward position at time t
= ( Ft − F0 )e − r (T −t )
long
ft
ƒ Value of a short forward position at time t
= ( F0 − Ft )e − r (T −t )
short
ft

ƒ Example: Long forward contract

ƒ We entered the contract 0.5 years ago (at time t=0)
ƒ How much is the contract worth today (t = 0.5)
ƒ Contract specifications: F0 = 24 €, T = 1, r = 10 %, F0.5 = 26.28 €

= (26.28 − 24)e −0.1(1−0.5) = 2.17€

long
f 0.5
Futures and Option Markets, SS 2009 4.24
 Futures Price = Forward Price?

ƒ The forward price equals the futures price if interest rates are a
known function of time
ƒ If interest rates vary unpredictably, forward and futures prices differ
ƒ If the spot price is positively (negatively) correlated with interest rates,
futures prices tend to be higher (lower) than forward prices.
ƒ Idea: Daily settlement leads to a gain (loss) for the long position if spot
price raises (decreases). The gain can be invested at a higher interest
rate and the loss can be compensated at a lower interest rate. Hence,
the long position in a futures contract is preferable compared to a
forward contract!
ƒ Other influencing factors: Transaction costs, default risk, taxes, …
ƒ However, we will assume that forward and futures prices are equal!

Futures and Option Markets, SS 2009 4.25

 Questions (Forwards Pricing) 1 / 2

(1) What is the difference between the forward price and the value of a
forward?
(2) Suppose you enter today into a 6-month forward contract on a non-
dividend paying stock when the stock price is 30 € and r = 12%. What
is the forward price? What is the value of the forward today?
(3) Explain why the forward price of gold can be calculated form its spot
price and other observable variables whereas the forward price of
copper can not
(4) Why can a foreign currency be treated as an asset with a know yield?
(5) Assume that the spot price of an underlying is positively correlated
with the interest rate. Is the futures price higher, lower or equal to the
forward price? Why?

Futures and Option Markets, SS 2009 4.26

 Questions (Forwards Pricing) 2 / 2

(6) Suppose that r =10 % and that the dividend yield on a stock index is
4%. The index is standing at 400, and the forward price for a contract
with maturity in 4 month has a price of 405. Are there arbitrage
opportunities?
(7) The spot price of silver is 9 $ per ounce. The storage costs per ounce
are 0.24 $ per year, payable quarterly in advance. Assume that r =
10% for all maturities. What is the equilibrium forward price for
delivery in 9 month?

Futures and Option Markets, SS 2009 4.27