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A Forward Contract is a contract made today for delivery of an underlying asset at a future time, T. The buyer agrees to take delivery at a price agreed upon today. The seller agrees to deliver the underlying asset to the buyer at a pre-specified time in the future.
A Forward Contract is a contract made today for delivery of an underlying asset at a future time, T. The buyer agrees to take delivery at a price agreed upon today. The seller agrees to deliver the underlying asset to the buyer at a pre-specified time in the future.
A Forward Contract is a contract made today for delivery of an underlying asset at a future time, T. The buyer agrees to take delivery at a price agreed upon today. The seller agrees to deliver the underlying asset to the buyer at a pre-specified time in the future.
Contracts Marcela Valenzuela 2/39 Forward Contract A Forward Contract is a contract made today for delivery of an asset at a pre-specied time in the future at a price agreed upon today: The buyer of a forward contract agrees to take delivery of an underlying asset at a future time, T, at a price agreed upon today. No money changes hands until time T. The seller agrees to deliver the underlying asset at a future time, T, at a price agreed upon today. A forward contract, therefore, simply amounts to setting a price today for a trade that will occur in the future. 3/39 Forward Contract Suppose that on February 1 you want to buy a book, go to the bookstore but the book is sold out. The cashier tells you that he will reorder the book for you. The cost of the book is $10. If you agree on February 1 to pick up and pay $10 for the book when called, you and the cashier have engaged in a forward contract. February 1 Date when Book Arrives Buyer Buyer agrees to: Buyer: 1. Pay the purchase price of $10 1. Pays purchase price of $10 2. Receive book when book arrives 2. Receives the book Seller Seller agrees to: Seller: 1. Give up book when book arrives 1. Gives up book 2. Accept payment of $10 when book arrives 2. Accepts payment of $10 4/39 Long and Short Positions The buyer (long position) of a forward contract is obligated to: take delivery of the asset at the maturity date. pay the agreed-upon price at the maturity date. The seller (short position) of a forward contract is obligated to: deliver the asset at the maturity date. accept the agreed-upon price at the maturity date. 5/39 Forward Contract Forwards can be used for hedging: Commodity price risk Foreign exchange risk Stock market risk Interest rate risk 6/39 Hedging with Commodity Forwards A farmer is currently growing 1 ton of wheat for harvest and sale in September. The farmer needs to plan his September budget now, because of upcoming expenses. Wheat currently sells for $100 per ton. There is no current trend (expected increase or decrease) in wheat prices. Wheat prices can change unexpectedly. 7/39 Hedging with Commodity Forwards A cereal maker plans to purchase 1 ton of wheat in September to make cereal. The cereal maker would like to set its sales price for September now (e.g. for marketing purposes). The farmer and cereal maker can both hedge their September cash ows by signing a forward contract. 8/39 Hedging with Commodity Forwards Commodity forward Cereal maker promises to purchase 1 ton of wheat from the farmer on September 1 st at $100. This is called going long or buying a forward contract. Farmer promises to sell the same amount and price. This is called going short or selling the forward contract. No money changes hands at contract signing The delivery price is set so that the contract has a value of zero at time 0. 9/39 Cash Settlement vs. Delivery On September 1 st the spot price of wheat is $110 per ton. The cereal maker and farmer have a forward contract to trade at $100. Cash settlement saves transport costs: Farmer sells his wheat for $110 to his local grainstore. Cereal maker purchases his wheat for $110 from his local depot. The farmer sends the cereal maker a check for $10. Both parties eectively traded at $100, as agreed. 10/39 Payos from Forward Contracts The payo from a long position in a forward contract on one unit of an asset is: S T K The payo from a short position in a forward contract on one unit of an asset is: K S T where K is the delivery price and S T is the spot price of the asset at maturity of the contract. As it costs nothing to enter into a forward contract, the payo is also the traders total gain or loss from the contract. 11/39 Forward Prices How forward prices are related to the spot price of the underlying asset? First, it is important to distinguish between investment assets and consumption assets. An investment asset is an asset that is held for investment purposes, for instance stocks and bonds. A consumption asset is an asset that is held primarily for consumption. It is not usually held for investment. For instance oil, pork bellies, etc. 12/39 Forward Prices Second, it is important to understand what short selling is. Short selling involves selling an asset that is not owned. Suppose an investor instructs a broker to short 500 IBM shares. The broker, then, will borrow the shares from another client. At some stage, the investor will close out the position by purchasing 500 IBM. These are then replaced in the account of the client from which the shares were borrowed. The investor takes a prot if the stock price has declined and a loss if it has risen. 13/39 Forward Prices Notation: T: Time until delivery date in a forward contract (in years). S 0 : Price of the asset underlying the forward contract today. F 0 : Forward price today. r : Risk-free rate of interest per annum for an investment maturing at the delivery date (i.e., in T years). 14/39 Forward ContractsNo Income Forward contract written on an investment asset that provides the holder with no income. For example: non-dividend-paying stocks and zero-coupon bonds. Consider a long forward contract to purchase a non-dividend-paying stock in three months. Assume that the current stock price is $40 and the 3-month risk-free interest rate is 5% per annum. Suppose that the forward price is $43. This price is too high, why? How can an arbitrageur make prot? 15/39 Forward ContractsNo Income An arbitrageur can: borrow $40 at the risk-free interest rate of 5% per annum. buy one share. short a forward contract to sell one share in 3 months. At the end of three months, the arbitrageur: delivers the share and receives $43. the sum of the money required to pay o the loan is: 40e 0.05 x 3/12 = $40.5 Prot: $43 $40.5 = $2.50 16/39 Forward ContractsNo Income If the forward price is instead $39, an arbitrageur can: short one share. invest the proceeds at 5% per annum for 3 months. take a long position in a 3-month forward contract. At the end of three months, the arbitrageur: pays $39 (forward contract). takes delivery of the share, and uses it to close put the short position. He gets from the savings: 40e 0.05 x 3/12 = $40.5 Prot: $40.5 $39 = $1.5 Under what circumstances do arbitrage opportunities do not exist? 17/39 GeneralizationNo Income Forward contract on an investment asset with price S 0 that provides no income. Then: F 0 = S 0 e rT If F 0 > S 0 e rT , arbitrageurs can buy the asset and short forward contracts on the asset. If F 0 < S 0 e rT , they can short the asset and enter into long forward contracts on it. In our example: F 0 = 40e 0.05 x 3/12 = $40.5 18/39 Example Consider a 4-month forward contract to buy a zero-coupon bond that will mature 1 year from today. The current price of the bond is $930. We assume that the 4-month risk-free rate of interest (continuously compounded) is 6% per annum. What is the forward price, F 0 ? In this case T = 4/12, r = 0.06, and S 0 = $930 F 0 is given by: F 0 = S 0 e rT = 930e 0.06 x 4/12 = $948.79 This would be the delivery price in a contract negotiated today. 19/39 Forward ContractsKnown Income Forward contract written on an investment asset that provides the holder with a predictable cash income. Consider a long forward contract to purchase a coupon-bond whose current price is $900. The forward contract matures in 9 months. The coupon payment of $40 is expected after 4 months. We assume that the 4-month and 9-month risk-free rates are, respectively, 3% and 4% per annum (continuously compounded). Suppose that the forward price is $910. This price is too high, why? How can an arbitrageur make prot? 20/39 Forward ContractsKnown Income The coupon payment has a present value of: PV($40) = 40e 0.034/12 = $39.6 An arbitrageur can: borrow $900 to buy the bond. $900 comes from: borrowing $39.6 at 3% per annum for 4 months so that it can be repaid with the coupon payment. borrowing $860.4 at 4% per annum for 9 months. enter into a short forward contract. At the end of nine months, the arbitrageur: pays the loan: 860.4 e 0.04 x 9/12 = $886.6. delivers the bond and receives $910 from the forward contract. He gets: $910 $886.6 = $23.4. 21/39 Forward ContractsKnown Income Suppose instead that the forward price is $870. This price is too low, an arbitrageur can: short the bond enter into a long forward contract. At t = 0 the arbitrageur: receives $900 from the bond. invest PV($40)=$39.6 to pay the coupon on the bond. The remaining $900-$39.6=$860.4 is invested for 9 months at 4% per annum. At the end of nine months, the arbitrageur gets: 860.4e 0.04 x 9/12 870 = $886.6 $870 = $16.6 22/39 GeneralizationKnown Income Forward contract on an investment asset with price S 0 that provides an income with a present value of I . Then: F 0 = (S 0 I )e rT If F 0 > (S 0 I )e rT , arbitrageurs can buy the asset and short forward contracts on the asset. If F 0 < (S 0 I )e rT , they can short the asset and enter into long forward contracts on it. 23/39 Exercise Consider a 10 month forward contract on a stock when the stock price is $50. We assume that the risk-free rate of interest (continuously compounded) is 8% per annum for all maturities. We also assume that dividends of $0.75 per share are expected after 3 months, 6 months, and 9 months. What is the forward price, F 0 ? 24/39 Forward ContractsKnown Yield Here we consider the situation where the asset underlying a forward contract provides a known yield rather than a known cash income. Dene q as the average yield per annum on an asset during the life of a forward contract with continuous compounding. Then: F 0 = S 0 e (r q)T 25/39 Example Consider a 6-month forward contract on an asset. The asset price is $25. The risk-free rate of interest (with continuous compounding) is 10% per annum. The yield is 3.96% per annum. What is the forward price F 0 ? In this case S 0 = 25, r = 0.1, T = 0.5 and q = 0.0396. The price of the forward is given by: F 0 = S 0 e (r q)T = 25e (0.10.0396)0.5 = $25.77 26/39 What is a Forward Price? The Forward Price (F t ) is the price such that the present value of the contract payo at time t equals zero. At the beginning of the life of the forward contract, the delivery price, K, is set equal to the forward price F 0 . As time passes, K stays the same (because it is part of the denition of the contract), but the forward price changes and the value of the contract becomes either positive or negative. F t = S t e (r q)(Tt) The price of the forward today is: F 0 = S 0 e (r q)T 27/39 Valuing Forward Contracts The value of a forward f contract at the time it is rst entered into is zero. At a later stage, it may prove to have a positive or negative value. Notation: Let K be the delivery price for a contract that was negotiated some time ago. The delivery date is T years from today. r is the T-year risk-free rate. F 0 is the forward price that would be applicable is we negotiated the contract today. f : value of the forwad contract today. 28/39 Valuing Forward Contracts The value of a long forward contract (f ) is given by: f = (F 0 K)e rT The value of a short forward contract is given by: (K F 0 )e rT At the beginning, the value of the contract is 0 since F 0 = K. 29/39 Exercise A long forward contract on a non-dividend-paying stock was entered into some time ago. It currently has 6 months to maturity. The risk-free rate of interest (with continuous compounding) is 10% per annum, the stock price is $25, and the delivery price is $24. 30/39 Valuing Forward Contracts Value of a forward contract on an asset that provides no income: f = S 0 Ke rT Value of a forward contract on an asset that provides a known income with present value I : f = S 0 I Ke rT Value of a forward contract on an asset that provides a known yield at rate q: f = S 0 e qT Ke rT 31/39 Future Contracts When a standardized forward contract is traded on an exchange, it is called a futures contract same contract, but a dierent label. The exchange is called a futures exchange. The distinction between futures and forward does not apply to the contract, but to how the contract is traded. 32/39 Dierences between Forwards and Futures Forward Futures Private contract between two parties Traded on an exchange Not standarized Standarized contract Usually one specied delivery date Range of delivery dates Settled at end of contract Settled daily Some credit risk Virtually no credit risk 33/39 The Mechanics of Futures Trading When you buy or sell a futures contract, the price is xed today but payment is not made until later. You will, however, be asked to put up margin to demonstrate that you have the money to honor your side of the bargain. Margin is typically set at an amount that is larger than a usual one-day moves in the futures price. Futures contracts are marked to market. This means that each day any prots or losses on the contract are calculated; you pay the exchange any losses and receive any prots. 34/39 Margin The futures exchange guarantees the contracts and protects itself by settling up prots or losses each day. The margin ensures that both parties will have sucient funds available to mark to market. Futures trading eliminates counterparty risk. The whole purpose of the margining system is to eliminate the risk that a trade who makes a prot will not be paid. 35/39 Margin Margin rules are stated in terms of: Initial margin (which must be posted when entering the contract). Maintenance margin (which is the minimum acceptable balance in the margin account). If the balance of the account falls below the maintenance level, the exchange makes a margin call upon the individual, who must then restore the account to the level of initial margin before the start of trading the following day. 36/39 Futures Contracts - Marking to Market Futures Marking to Market: Buy 200 Futures at $600. Initial Margin = $4,000 per contract. At the end of each trading day, the margin account is adjusted to reect the investors gain or loss. If the futures price dropped from $600 to $597, loss of $600(= 200 x $3). Margin account balance: $3,400. If the futures prices dropped from $597 to $596.1, loss of $180(= 200 x $(597 596.1)). Cumulative loss: 600 + 180 = 780. Margin account balance: $3,220. Assume that the maintenance margin is $3,000. On June 13, the margin in the balance account falls $340 below the maintenance margin level margin call from the broker for an additional $1,340. 37/39 Futures Contracts - Marking to Market Day Futures Daily gain Cumulative Margin Account Margin Price (loss) gain (loss) Balance call ($) ($) ($) ($) ($) 600.0 4,000 June 5 597.0 (600) (600) 3,400 June 6 596.1 (180) (780) 3,220 June 9 598.2 420 (360) 3,640 June 10 597.1 (220) (580) 3,420 June 11 596.7 (80) (660) 3,340 June 12 595.4 (260) (920) 3,080 June 13 593.3 (420) (1,340) 2,660 1,340 June 16 593.6 60 (1,280) 4,060 June 17 591.8 (360) (1,640) 3,700 June 18 592.7 180 (1,460) 3,880 June 19 587.0 (1,140) (2,600) 2,740 1,260 June 20 587.0 0 (2,600) 4,000 June 23 588.1 220 (2,380) 4,220 June 24 588.7 120 (2,260) 4,340 June 25 591.0 460 (1,800) 4,800 June 26 592.3 260 (1,540) 5,060 38/39 Futures Prices of Stock Indices Here we consider a situation where the asset underlying a forward contract provides a known yield rather than a known cash income: F 0 = S 0 e (r q)T 39/39 Example Consider a 3-month futures contract on the S&P500. Suppose that the stocks underlying the index provide a dividend yield of 1% per annum, that the current value of the index is $1,300, and that the continuously compounded risk-free interest rate is 5% per annum. The futures price, F 0 , is given by: F 0 = 1, 300e (0.050.01) x 0.25 = $1, 317.07