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

Dr. Nicholas Chen, ICMA centre, 2011 1

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

Review of Capital Asset Pricing Model (CAPM)

Dr. Nicholas Chen, ICMA centre, 2011

Forward vs. Futures Prices


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

We assume forward and futures contracts are the

same in this module by ignoring the settlement.

Dr. Nicholas Chen, ICMA centre, 2011

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

Dr. Nicholas Chen, ICMA centre, 2011

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

Is there an arbitrage opportunity?

Dr. Nicholas Chen, ICMA centre, 2011

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

is F0 The annual interest rate is r

What is the futures price?

Dr. Nicholas Chen, ICMA centre, 2011

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)

Dr. Nicholas Chen, ICMA centre, 2011

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

11

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

Review of Capital Asset Pricing Model (CAPM)

Dr. Nicholas Chen, ICMA centre, 2011

12

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.

Dr. Nicholas Chen, ICMA centre, 2011

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.

Dr. Nicholas Chen, ICMA centre, 2011

14

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?

Dr. Nicholas Chen, ICMA centre, 2011

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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

Review of Capital Asset Pricing Model (CAPM)

Dr. Nicholas Chen, ICMA centre, 2011

17

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

Dr. Nicholas Chen, ICMA centre, 2011

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
Dr. Nicholas Chen, ICMA centre, 2011 2.19

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
Dr. Nicholas Chen, ICMA centre, 2011 21

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

Dr. Nicholas Chen, ICMA centre, 2011

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
Dr. Nicholas Chen, ICMA centre, 2011 2.23

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.
Dr. Nicholas Chen, ICMA centre, 2011 25

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.

Dr. Nicholas Chen, ICMA centre, 2011

26

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

Review of Capital Asset Pricing Model (CAPM)

Dr. Nicholas Chen, ICMA centre, 2011

28

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

standard deviation rule?

Median Risk No Risk E(R) = 5% E(R) = 5%

Investment A

Investment B

Dr. Nicholas Chen, ICMA centre, 2011

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CAPM Intuition (Cont.)


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

the additional premium of 7% for extra risk you are bearing

Risk Premium 7% Median Risk No Risk r = 5% r = 5%

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


Dr. Nicholas Chen, ICMA centre, 2011 30

CAPM Intuition (Cont.)


Risk Premium 7% Risk Premium ? High Risk

Median Risk
r = 5% r = 5%

Investment B

Investment C

E(R) of Investment C = Risk-free rate + Risk premium = 5% + ?

Dr. Nicholas Chen, ICMA centre, 2011

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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%)

Dr. Nicholas Chen, ICMA centre, 2011

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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%)

k = r + (E(Rm) r) That is the CAPM that won the Nobel Prize!

Dr. Nicholas Chen, ICMA centre, 2011

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Your personal preference is not priced by the market

Dr. Nicholas Chen, ICMA centre, 2011

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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
Dr. Nicholas Chen, ICMA centre, 2011 35