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19/02/2017

Short Selling (Page 105-106)

Short selling involves selling securities
you do not own
Chapter 5 Your broker borrows the securities
Determination of Forward and from another client and sells them in
Futures Prices the market in the usual way

Options, Futures, and Other Derivatives, 9th Edition, Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014 1 Copyright John C. Hull 2014 2

Short Selling (continued) Example

At some stage you must buy the You short 100 shares when the price is \$100 and
securities so they can be replaced in the close out the short position three months later
account of the client when the price is \$90
You must pay dividends and other During the three months a dividend of \$3 per
benefits the owner of the securities share is paid
There may be a small fee for borrowing pay dividend (3) and any premium 7x100=700
the securities What would be your loss if you had bought 100
shares? Made a loss of 1000 on assets
Options, Futures, and Other Derivatives, 9th Edition, Options, Futures, and Other Derivatives, 9th Edition,
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The Forward Price Pricing an Investment Asset that

If the spot price of an investment asset is S0 and Provides a Known Income (page 110,
the futures price for a contract deliverable in T equation 5.2)
years is F0, then
F0 = S0erT
where r is the T-year risk-free rate of interest.
F0 = (S0 I )erT
In our examples, S0 =40, T=0.25, and r=0.05 so where I is the present value of the income
that during life of forward contract
F0 = 40e0.050.25 = 40.50

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19/02/2017

When an Investment Asset Provides Valuing a Forward Contract

a Known Yield (Page 112, equation 5.3)
A forward contract is worth zero (except for
F0 = S0 e(rq )T bid-offer spread effects) when it is first
negotiated
where q is the average yield during the life
of the contract (expressed with continuous Later it may have a positive or negative value
compounding) Suppose that K is the delivery price and F0 is
the forward price for a contract that would be
negotiated today

Options, Futures, and Other Derivatives, 9th Edition, Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014 7 Copyright John C. Hull 2014 8

Valuing a Forward Contract

(pages 112-114) Forward vs Futures Prices
By considering the difference between a When the maturity and asset price are the same, forward
contract with delivery price K and a contract and futures prices are usually assumed to be equal.
with delivery price F0 we can deduce that: (Eurodollar futures are an exception)
the value of a long forward contract is In theory, when interest rates are uncertain, they are
(F0 K )erT slightly different:
the value of a short forward contract is A strong positive correlation between interest rates and the asset
price implies the futures price is slightly higher than the forward
(K F0 )erT price
A strong negative correlation implies the reverse

Options, Futures, and Other Derivatives, 9th Edition, Options, Futures, and Other Derivatives, 9th Edition,
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Stock Index (Page 115-117)

Stock Index (continued)
Can be viewed as an investment asset paying a
dividend yield (q=.025) is calculated as the For the formula to be true it is important that
average yield on the portfolio represented by the the index represent an investment asset
index during life of contract (T=.5) In other words, changes in the index must
The futures price and spot price relationship is correspond to changes in the value of a
F0 = S0 e(rq )T The Nikkei index viewed as a dollar number
does not represent an investment asset (See
where S0 = 5000 and r=.05 Business Snapshot 5.3, page 116)
F0 = 5000e(.025 )/2 = 5062.89
times 10 per point is portfolio of 50628.9
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19/02/2017

Index Arbitrage Index Arbitrage

(continued)
When F0 > S0 e(r-q)T an
stocks underlying the index and sells futures in futures and many different stocks
When F0 < S0e(r-q)T an arbitrageur buys futures Very often a computer is used to generate the
and shorts or sells the stocks underlying the
index
possible and the theoretical no-arbitrage
relationship between F0 and S0 does not hold
(see Business Snapshot 5.4 on page 117)

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Futures and Forwards on Futures and Forwards on

Currencies (Page 117-120) Currencies continued
A foreign currency is analogous to a The is worth \$1.5
security providing a yield The continuous dividend yield is the foreign
The yield is the foreign risk-free interest risk-free interest rate rf = 0.005
rate The rate for the UK is r=.0075
It follows that if rf is the foreign risk-free The Futures price for the , 6 months ahead is:
interest rate ( r r )T
( r rf ) T F0 S 0 e f 1.5e (.0075 .005) / 2
F0 S 0 e
1.5e (.00125) 1.5019
Options, Futures, and Other Derivatives, 9th Edition, Options, Futures, and Other Derivatives 6th Edition, Copyright
Copyright John C. Hull 2014 15 John C. Hull 2005 8.16

Explanation of the Relationship Consumption Assets: Storage is

Between Spot and Forward (Figure 5.1) Negative Income
F0 S0 e(r+u )T
1000 units of where u is the storage cost per unit time as a
foreign currency
(time zero) percent of the asset value.
r T
Alternatively,
1000 e f units of
1000S0 dollars
foreign currency
at time T
at time zero F0 (S0+U )erT
where U is the present value of the storage
r T
1000S0erT
costs.
1000 F0 e f
dollars at time T dollars at time T

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Futures Prices & Expected Future

The Cost of Carry (Page 123)
Spot Prices (Page 124-126)
The cost of carry, c, is the storage cost plus Suppose k is the expected return required by
the interest costs less the income earned investors in an asset
We can invest F0er T at the risk-free rate and enter
For an investment asset F0 = S0ecT
into a long futures contract to create a cash inflow of
For a consumption asset F0 S0ecT ST at maturity
The convenience yield on the consumption This shows that
asset, y, is defined so that F0 e rT e kT E ( ST )
F0 = S0 e(cy )T or
F0 E ( ST )e ( r k )T
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Futures Prices & Future Spot

Prices (continued)
Testing Efficiency(Future/Forwards)
A regression of F on S:
No Systematic Risk k=r F0 = E(ST) St Ft T t
Positive Systematic Risk k>r F0 < E(ST) where E(t s ) 0, 0 and =1.
Negative Systematic Risk k<r F0 > E(ST) Problems with this form of analysis:
a) The Financial Data follow random walks
b) It is very unusual to find uncorrelated errors
Positive systematic risk: stock indices
Negative systematic risk: gold (at least for some periods) Tests of =0 and =1 were ill-formulated as the
models serially correlated so tests wrong.
Options, Futures, and Other Derivatives, 9th Edition, Options, Futures, and Other Derivatives 6th Edition, Copyright
Copyright John C. Hull 2014 21 John C. Hull 2005 8.22

Testing Continued Findings

Test efficiency by determining whether St - Ft has Often futures contracts are traded continuously, but
bounded variation (stationary) reported data (see DataStream) for more than one
Imposes the restriction of St on Ft (=0 and =1). contract.
Test an effectively functioning market, using t-value Often analysis done for 1-6 months before
on the restricted regression on et =St Ft: expiration and efficiency/stationarity is rejected for
3-6 months before expiration.
et et 1 errort
Compare t-value on by a one sided test that is
less than -2.89 (T=100).
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Futures in Medieval times Developed into Exchange trading

From 1100 trades were undertaken in medieval The Royal Exchange in London is the first recorded
fairs on a spot basis as permitting forward contracting.
A lettre de faire was a forward contract spe-cifying 1610-1611 records of future and forward contracts
delivery of a good at a later date. in Holland and tulip bulbs were bought forward to
The contracts were often seasonal around harvests secure supply for the producers (tulip bulb mania or
Irregularity meant no formal market so are these bubble).
are derivative markets? 1650 Futures contracts can be traced to the
Yodoya rice market in Osaka.
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John C. Hull 2005 8.25 John C. Hull 2005 8.26