102 Session 11

Calculate forward price

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 Jargon: What’s a forward price?

It’s a price fixed in advance.

Once you agree a forward, you are committed to buy or sell.

When you buy a house, you agree a forward price (you don’t
renegotiate the price on the day of completion).

You could call the redemption payment on a 20 year bond the

“20-year-forward price”.

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Gossip: Was there a fuss about this?
Once upon a time, we confused forward prices
with expected prices.

But then some people pointed out what actually

happens. (Coupons, transaction, tax, storage
costs etc aside), if you buy a risky asset, and sell
it forward one month you end up with a
predictable amount of cash in exactly one month.
Your counter-party is the market clearing house
BUY ASSET SELL FORWARD so you run next to no risk. (Your risky asset has
become a risk-free asset.)

Or, if you sell at today’s price (and make your

risky asset a risk-free asset like cash), and lend
the cash for one month at the one-month risk-free
rate, you will also end up with a predictable
amount of cash in exactly one month. You lend
the cash “risk-free” so you run next to no risk.
Déjà vu?

Credit risk etc aside, would you prefer one form of

LEND CASH GET PAID BACK predictable cash to the other? Will the market (ie
other people) give you more one way or the 328
other?
 Jargon: No arbitrage
“No arbitrage” assumes that things that
pay the same cost the same. (Equivalently, it
assumes that you can’t make risk-free profits
(aka “free lunches”) by trading.

e.g. transaction costs aside,

LEND CASH GET PAID BACK
if you want a risk free return in one month,
then it costs the same whether you
arrange it by lending cash at a known rate,
or by buying a risky asset which you
make risk-free by selling it forward for a
known forward price.

If, someday, things that pay the same don’t

cost the same, buy the cheap one, sell the
dear one and pocket the difference. Do no
work and retire somewhere pleasant.
BUY ASSET SELL FORWARD Trouble is, you’ll drive up the price of the
cheap one and push down the price of the 329
dear one. So, soon the free lunch is all gone.
So what’s new?

Nothing,

We’ve been assuming no arbitrage all along,

when we wrote down formulae like

Price = 10v(1) + 10v(2) + 110v(3),

we assumed that there was only one price,

Ie we assumed that no one could make risk-

free profits by selling at one price and buying
at another.

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Specimen Q16(iii)

Cash if held to redemption

120 What is price at time 1?

100
80
Upper bound: If price were 110, net yield would be
60 (1 – 25%) * 10% / 110 = 6.8%.
40 But net redemption yield (10%) >> 6.8%
20
⇒Must be capital gain
0
⇒ price << redemption amount = 110
1 1.5 2 … 19 19.5 20
Guess duration = 10
Guess 1% fall in yield increases price by about 10%.
⇒Guess price = 110 / {1 + (10% - 6.8%) * 10}
= 83.

Exact price at time 1 = 3.75 a38 + 110 v38 @ √1.10 – 1

= 3.75 * 17.138 + 110 * 0.1635 = 82.254% 331
Specimen Q16(iii)

Value if held to redemption Cash-flow if buy a bond and sell it forward

120
= -Current price + 3.75 a4(2) + Forward v4
100 = -82.254 + 3.75 a4(2) + Forward v4
80
60
The risk free rate is 10% ie
40
20 82.254 = 3.75 a8 + Forward v8 @ √1.10 – 1
0 = 3.75 * 6.4944 + Forward * 0.68301
1 1.5 2 … 19 19.5 20
Value if sold forward
⇒Forward = (82.254 – 3.75 * 6.4944) / 0.68301 = 84.77%
140
120
If forward price were higher than 84.77, borrow at 10%, buy the
100 bond, sell it forward and in four years, pocket a risk-free profit.
80
60
40 If forward price were less than 84.77, pocket a risk-free profit
20
0
NOW by selling (or shorting) the bond, lending some of the332
proceeds at 10% and buying the bond forward.
1 1.5 2 … 3.5 4
Specimen Q16(iii)

333
 Apr 2000 Q9

80
60
Roughly: dividend yield is 4/60 in just
40 7 months (ie more than 7% pa).
20
0
So make a capital loss (to get risk-free 7%)
-20 0 1 2 3 4 5 6 7
-40
Ie forward price < 60.
-60
-80

Exactly, 60 = 2v3/12 + 2v6/12 + Forward v7/12

i.e. 60 = 2e-(7% x 3/12) + 2e-(7% x 6/12) + Forward e-(7% x 7/12)

60 = 2 * 0.98265 + 2 * 0.965605 + Forward * 0.959989
⇒Forward = £58.44 334
Apr 2000 Q9

335
Sep 2000 Q3

336
Sep 2000 Q3

F
120 “grows” to 120 * 1.05(91/365)

120

Equivalently,
(just using a different picture)
F

-120 120 = Forward * 1.05-(91/365)

⇒ Forward = 120 * 1.05(91/365)

337
Sep 2000 Q3

338
Apr 2001 Q4

339
 Apr 2001 Q4(ii)

200 Roughly:
100 Ignore dividends and interest
0 About £30 of value is the special dividend
So expect £30 in April and £120 in May
-100 0 1 2 3
Making total value £150
-200
Ie guess forward = £120
Assuming dividends don’t increase:
150 = 3% * 150 ā3/12¬ + 30 v(2/12) + Forward v(3/12) @ δ = 5%
= 3% * 150 * 0.24844 + 30 * 0.99170 + Forward * 0.987578
=> Forward = £120.63
Assuming dividends increase continuously at 2% pa
150 = 3% * 150 ā3/12¬ @ δ = 3% + 30 v(2/12) @ δ 5% + Forward v(3/12) @ δ 5%
= 150 (1 – e-(3% * 3/12) ) + 30 e-(5% * 2/12) + Forward e-(5% * 3/12) 340
=> Forward = 150 e[ (5%- 3%) * 3/12] - 30 e(5% * 1/12) = £120.63 (again)
Apr 2001 Q4

341
Sep 2001 Q3

342
Apr 2002 Q1

343
Sep 2002 Q2

344
Sep 2003 Q4

345
 Key question
Get 100% on Apr 2000 Q9.

It doesn’t matter how many times you see the

answer.

Cover the answer up & do it again until

someone you explain it to goes “Aaah!”

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Next session: forward rates

END
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