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# Lecture 2 Futures Pricing and Trading (Chapters 3 and 5) Nicholas Chen

## Review of Last Lecture

Difference between futures and forward
Difference between futures and options Your own growth option a decision to increase your salary Real options pricing of a growth options for a firm

## Dr. Nicholas Chen, ICMA centre, 2011

Outline
Determination of Forward and Futures Prices
The value of Forward/Futures Contracts General Formula of the Forward and Futures Prices

## Forward vs. Futures Prices

What makes the difference between them?
___________in exchanges reduces the credit risk for the futures contract.

2.4

## Determination of Forward and Futures Price

Procedure a) Use no arbitrage rule b) Form riskless portfolio => it should earn risk free rate (compare alternative strategies) c) Solve for forward price

2.5

## Revisiting the Previous Arbitrage Example

Gold: An Arbitrage Opportunity? Suppose that:
The spot price of gold is US\$390 The quoted 1-year futures price of gold is US\$425 The 1-year US\$ interest rate is 5% per annum

1.6

## Generalizing the Previous Arbitrage Example

For any investment Suppose that:
The spot price of an investment is S0 The quoted 1-year futures price of this investment

1.7

## Price for a forwards/futures contract

0 Maturity = T |------------------------------------------------| Build a risk free portfolio: Short Forward contract and borrow to buy underlying asset Time 0 Forward: Cash 0 (no upfront cost) : +S0 (borrow) - S0 (to buy) => => Time T deliver (or sell ) asset at F0 Pay back the loan -S0erT

By no arbitrage, since the strategy requires no money down, this has to hold

___________ =0 ____________
Dr. Nicholas Chen, ICMA centre, 2011 2.8

## At the time 0, F0 is the delivery price K, which has to be S0erT.

Generalization (Cont)
For any investment asset that provides no income and has no

T: time until delivery date in a forward contract (in years) S0: price of asset underlying the forward contract today

## storage costs at time 0 when an contract is entered into, F0 = K = S0erT

(spot price) K: delivery price in forward contract F0: forward price today r: risk-free rate per annum (with continuous compounding) for an investment maturing at delivering date (in T years)

2.9

## Prices of Forwards/Futures Change over time

At a later date t, Ft = Ster(T t) Why does the futures prices change over time? Because St and time t change. When t -> T, at the maturity T FT = ST, because e-r(T t) = 1 (when t -> T)
Dr. Nicholas Chen, ICMA centre, 2011 2.10

## Convergence of forwards/futures to spot price (when t T)

Futures price Spot price Spot price Futures price

## Dr. Nicholas Chen, ICMA centre, 2011

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Outline
Determination of Forward and Futures Prices
The value of Forward/Futures Contracts General Formula of the Forward and Futures Prices

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## The value of a Forward/ Contract (Chap 5.7)

The price of a forward contract is not its value. The value of a long forward contract, , at time t is

= (Ft K )er(T-t) Similarly, the value of a short forward contract is f = (K Ft ) er(T-t) where K is delivery price in a forward contract & Ft is forward price that would apply to the contract at time t.

2.13

## Futures Value of Margin Account

Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600

Taking a Long position in a futures contract does not require the upfront investment, but needs to deposit an initial margin in a futures exchange. The changes in futures prices change cause the fluctuation of the margin account balance.

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## Practice Problem: Value of a Forward

A one-year long forward contract on a non-dividend-

paying stock is entered into when the stock price is \$40 and the risk-free rate of interest is 10% per annum with continuous compounding. 1. What are the forward price of today and the initial value of the forward contract? 2. Six months later, the price of the stock is \$45 and the risk-free interest rate is still 10%. What are the forward price and the value of the forward contract?

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## Practice Problem (cont)

a) The forward price at , F = ______________ The initial value of the forward contract, f = ___________.
b) The forward price is Ft = ___________________ The delivery price in the contract is k = ______________.
= ________________________
Dr. Nicholas Chen, ICMA centre, 2011 16

Outline
Determination of Forward and Futures Prices
The value of Forward/Futures Contracts General Formula of the Forward and Futures Prices

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## When underlying assets pay income

0 Maturity = T |------------------------------------------------| Build a risk free portfolio: Short Forward contract and borrow to buy underlying asset Time 0 Forward: Cash 0 (no upfront cost) : +S0 (borrow) - S0 (to buy) I Time T sell the asset at F0 Pay back the loan -S0erT IerT

Income (I) :

By no arbitrage, since the strategy requires no money down, this has to hold => ________________________ = 0 =>
F0= (S0-I )erT

2.18

## When underlying assets need storage fee

0 Maturity = T |------------------------------------------------| Build a risk free portfolio: Short Forward contract and borrow to buy underlying asset Time 0 Forward: Cash Income 0 (no upfront cost) : +S0 (borrow) - S0 (to buy) : I Time T sell the asset at F0 Pay back the loan -S0erT IerT

Storage

-U

-UerT

By no arbitrage, since the strategy requires no money down, this has to hold => _______________________ = 0 => F0= (S0- I +U)erT
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## General Pricing Formula for a Futures Contract of an Investment Asset

A discrete time version

## F0= (S0- I +U)erT

A continuous time version

F0 = S0 e (r q + u)T = S0 e cT
The cost of carry, c, is the interest costs, r, less the income

## rate, q, earned plus the proportional storage rate, u.

c= r q + u
Dr. Nicholas Chen, ICMA centre, 2011 2.20

## Cost of Carry in the General Pricing Formula

c= r q + u if the underlying is an investment asset

No income (non dividendpaying stock, discount bond) c=r A known cash income rate, q (stock paying known dividend, coupon bearing bond) c=r-q A known storage cost, u (commodity) c=rq+u
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## Futures and Forwards on Currencies

A foreign currency is analogous to a security providing an income The holder of the currency can earn interest at the risk free interest rate, rf, prevailing in the foreign

country.

F0 S0e

( r r f )T

2.22

## The Cost of Carry for Futures of A Consumption Asset

The cost of carry, c, is the storage cost plus the interest

## costs less the income earned

For an investment asset F0 = S0ecT
For a consumption asset F0 < S0ecT because you can

## consume such a physical asset.

Futures is less valuable than the physical asset particularly

when such an asset is short of stock so that we replace c with c y, where y is the convenience yield on the consumption asset.

F0 = S0 e(cy )T
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Practice Example 1
The risk-free rate of interest is 7% per annum with

continuous compounding, and the dividend yield on a stock index is 3.2% per annum. The current value of the index is 150. What is the six-month futures price?
r = 0.07 and q = 0.032 F = ___________________

## Dr. Nicholas Chen, ICMA centre, 2011

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Practice Example 2
The two-month interest rates in Switzerland and the

United States are 2% and 5% per annum, respectively, with continuous compounding. The spot price of the Swiss franc is \$0.8000. The futures price for a contract deliverable in two months is \$0.8100. What arbitrage opportunities does this create?
1) The theoretical futures price is F = _______________ 2) The actual futures price is too ________. This suggests that an arbitrageur should buy Swiss francs and short Swiss francs futures.
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Practice Example 3
The spot price of silver is \$15 per ounce. The storage

costs are \$0.24 per ounce per year payable quarterly in advance. Assuming that interest rates are 10% per annum for all maturities, calculate the futures price of silver for delivery in nine months.

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## Practice Example 3 (cont)

The present value of storage cost 0.24/4 x(1 + e-0.10x0.25 + e-0.10x0.5) = 0.176 The price of the futures is F0 = (15 + 0.176) e0.1x0.75 = 16.36

## Dr. Nicholas Chen, ICMA centre, 2011

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Outline
Determination of Forward and Futures Prices
The value of Forward/Futures Contracts General Formula of the Forward and Futures Prices

## Dr. Nicholas Chen, ICMA centre, 2011

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CAPM Intuition
Which investment will you pick according to our mean-

Investment A

Investment B

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## CAPM Intuition (Cont.)

You will take the investment B only if you are rewarded with

## E(R) of Investment B = Risk-free rate + Risk premium = 5% + 7%

Dr. Nicholas Chen, ICMA centre, 2011 30

Median Risk
r = 5% r = 5%

Investment B

Investment C

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## CAPM Intuition (cont.)

We know that investment C is riskier than investment B, so the

risk premium of C should be greater than the one of B by a factor of > 1, or x 7%.
E(R) of Investment B = Risk-free rate + Risk premium of B

12% = 5% + 7% => 7% = 12% - 5% E(R) of Investment C = Risk-free rate + Risk premium of C = 5% + x 7% = 5% + x (12% - 5%)

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## CAPM Intuition (cont.)

Let investment B be the investment in the market portfolio.
Investment C be any investment, i. We know 5% is the risk free rate r
Its expected return is k Its total return of 12% is the expected market return, E(Rm)

## Replacing the numbers with the symbols

K of Investment C = 5% + (12% - 5%)

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## Interpretation of the CAPM

The expected, or required, for any investment can be calculated

as

## measures the risk of any investment relative to an

k = r + (E(Rm) r)

## investment in the market portfolio.

= 1: Portfolio returns mirror returns on market. = 1.5: Excess returns on portfolio tend to be 1.5 times the

excess returns on market. = 0.5: Portfolios Excess return tend to be half of excess return on market
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