Determination of Forward

and Futures Prices

Consumption vs Investment Assets

Investment Assets:
That is held for investment purposes by significant
numbers of investors.
(Examples: stocks, bonds, gold, silver)
Consumption Assets:
That is held by primarily for consumption.
(Examples: copper, oil, pork)

Short Selling

Short selling involves selling securities

you do not own
Your broker borrows the securities
from another client and sells them in
the market in the usual way
Required to maintain a margin account
with the broker
You must pay dividends and other
benefits the owner of the securities
receives

Cash flows form short sale and

purchase of shares
Purchase of shares
April : Purchase 500 shares for $120
-$60,000
May : Receive dividend
+$500
July : Sell 500 shares for $100 per share
+$50,000
Net profit= -$9,500
----------------------------------------------------------------------------Short sale of shares
April : Borrow 500 shares and sell them for $120
+$60,000
May : Pay dividend
- $500
July : Buy 500 shares for $100 per share
-$50,000
Replace borrowed shared to short position
Net profit= +$9,500

Assumption and Notation

Assumption:

1.No transaction costs when they trade.

2.The same tax rate on all net trading profits.
3.Borrow money at the same risk-free rate
of as they can lend money.
4.Take advantage of arbitrage opportunities
as they occur.

Assumption and Notation

NOTATION:
S0: Price of the asset underlying the
forward or futures contract today
F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for maturity T

Forward Price For an Investment Asset

Assume : S0 = $40,r = 5%,t = 3 months
(a)If F0 =$43 > S0ert
1.Borrow $40 at risk-free interest rate of 5% per annum.
2.Short a forward contract to sell one share in 3-months.
$40e0.05x3/12 = $40.5
$43 - $40.5 = $2.5

(b)If F0 =$39 < S0ert

1.Short one share, invest the proceeds of the short sale
at 5% per annum for 3 months.
2.Take a long position in a 3-months forward contract.
$40e0.05x3/12 = $40.5
$40.5 - $39 = $1.5
We deduce that for there to be no arbitrage the forward
price must be exactly $40.5.

F0 = S0erT
This equation relates the forward price and the
spot price for any investment asset that provides
no income

What If Short Sale Are Not Possible?

(a)If F0 > S0ert
1.Borrow S0 dollars at an interest rate r for T years.
2.Buy 1 ounce of gold.
3.Short a forward contract on 1 ounce of gold.
The investor make a profit of F0 - S0ert.

(b)If F0 < S0ert

1.Sell the gold for S0.
2.Invest the proceeds at interest rate r for time T.
3.Take a long position in a forward contract on
1 ounce of gold.
The investor make a profit of S0ert - F0.

When an Investment Asset Provides a

Known Dollar Income
F0 = (S0 I )erT
where I is the present value of the income
during life of forward contract

Known Income
Assume : S0 = $900 I = 40e-0.03x4/12 = $39.6
r =0.04 T = 0.75(9/12)
I:
?
0

$40
4

F0 = (900.00 39.6)e0.04x0.75 = $886.60

(a)If F0 = $910 > (S0 - I)ert = $886.60

1.Borrow $900 to buy the bond.
2.Short a forward contract.

900.00 - 39.6 = $860.40

860.40e0.04x0.75 = $886.60
910.00 -886.60 = $23.40

(b)If F0 = $870 < (S0 - I)ert = $886.60

1.Short the bond.
2.Enter into a long forward contract.

900 - 39.6 = $ 860.4

860.40e0.04x0.75 = $886.60

886.60 - 870 = $16.60

The forward price must be $886.60
5.15

Options, Futures, and Other Derivatives 6th Edition,

Copyright John C. Hull 2005

When an Investment Asset

Provides a Known Yield
F0 = S0 e(rq )T
where q is the average yield during the life of the
contract (expressed with continuous
compounding)

Known Yield

Assume : S0 = 25,r = 0.1,and T = 0.5,

the yield is 4% per annum with semiannual
compounding.
1+0.04 = (1+q/2)2

q = 3.96%

F0 = 25e(0.10 0.0396)x0.5 = $25.77

Valuing a Forward Contract

K is delivery price in a forward contract

F0 is forward price today
:Value of forward contract today

The value of a long forward contract, , is

= (F0 K )erT
Similarly, the value of a short forward contract is

(K F0 )erT

The value of a forward contract on an investment asset that

provides no income:
= (F0K)e-rt
Equation shows that F0 = S0ert
= (S0ertK)e-rt
= S0 Ke-rt

The value of a long forward contract on an investment asset that

provides a known income with present value I:
= S0 I Ke-rt

The value of a long forward contract on an investment asset that

provides a known yield at rate q:
= S0e-qt Ke-rt

Forward vs Futures Prices

A strong positive correlation between interest

rates and the asset price implies the futures price
is slightly higher than the forward price
A strong negative correlation implies the reverse
Last only a few months are in most circumstances
sufficiently small to be ignored
Forward and futures prices are usually assumed
to be the same. When interest rates are uncertain
they are, in theory, slightly different

Futures Prices Of Stock Index

Can be viewed as an investment asset paying a

dividend yield
The futures price and spot price relationship is
therefore

F0 = S0 e(rq )T
where q is the average dividend yield on the
portfolio represented by the index during life
of contract

Futures Prices Of Stock Index

F0 = S0e(r-q)T
q:The dividend yield
Example:
r = 0.05 S0 = 1,300 T = 3/12 (0.25)
F0 = 1,300e(0.05-0.01)x0.25 = $1,313.07

q = 0.01

Index Arbitrage

If F0 > S0e(r-q)T
1.Buying the stocks underlying the index at
the spot price
2.Shorting futures contracts
By a corporation holding short-term money
market investment.

Index Arbitrage

If F0 < S0e(r-q)T
1.Shorting or selling the stocks underlying
the index
2.Taking a long position in futures contracts
By a pension fund that owns an indexed
portfolio of stocks

Index Arbitrage

Program trading
Occasionally (e.g., on Black Monday)
simultaneous trades are not possible and
the theoretical no-arbitrage relationship
between F0 and S0 does not hold

Futures and Forwards on Currencies

Two ways of converting 1,000 units of a foreign
currency to dollars at time T. Here, S0 is spot exchange
rate, F0 is forward exchange rate, and r and rf are the
dollar and foreign risk-free rates.
1000 units of
foreign currency
at time zero

1000 e

rf T

units of foreign
currency at time T

1000 F0 e

rf T

dollars at time T

1000S0 dollars
at time zero

1000 S 0 e rT

dollars at time T

Futures and Forwards on Currencies

1,000 erfT F0 = 1,000 S0 erT
F0 = S0 erT / erfT

The relationship between F0 and S0

F0 S0e

( r rf ) T

Futures on Commodities

Income and Storage Costs

(a)In the absence of storage costs and income,

the forward price of a commodity that is an
investment asset is give by:

F0 = S0erT
(b)If U is the present value of all the storage costs,
net of income, during the life of a forward contract:

F0 = (S0 + U)erT

(c)If the storage costs net of income incurred at any

time are proportional to the price of the commodity,
they can be treated as negative:

F0=S0e(r+u)T
Where u denotes the storage costs per annum as
proportion of the spot price net of any yield earned on
the asset.

Futures on Consumption Assets

(a) F0 > (S0 + U)erT
1. Borrow an amount S0 + U at the risk-free rate and
use it to purchase one unit of the commodity and
to pay storage costs.
2. Short a forward contract on one unit of the
commodity.

(b) F0 < (S0 + U)erT

1. Sell the commodity, save the storage costs,
and invest the proceeds at the risk-free
interest rate.
2 . Take a long position in a forward contract.

Futures on Consumption Assets

F0 S0 e(r+u )T
where u is the storage cost per unit time as a
percent of the asset value.
Alternatively,

F0 (S0+U )erT
where U is the present value of the storage
costs.

Convenience Yield
* The benefits from holding the physical asset are
sometimes referred to as the convenience yield.
If the dollar amount of storage costs is known and has a
present value U, that the convenience yield y is defined
such that:

F0eyT = ( S0 + U )erT
If the storage costs per unit are a constant proportion, u, of the
spot price, then y is defined so that:

F0eyT = S0e(r+u)T

or

F0 = S0e(r+u-y)T

The Cost of Carry

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

the interest costs less the income earned

For a non-dividend-paying stock, it is r.

For a stock index, it is r - q.
For a currency, it is r - rf.

For a commodity that provide income at rate q and

require storage costs at rate u, it is r - q + u.

The Cost of Carry

Define the cost of carry as c.

For an investment asset , the futures price is

F0 = S0ecT

For a consumption asset, The convenience yield

on the consumption asset, y, is defined
so that

F0 = S0 e(cy )T

Delivery Options

Form equation (F0 = S0 e(cy )T ) that c > y, the benefits

from holding the asset (including convenience yield and
net of storage costs) are less than the risk-free rate .

If futures prices are decreasing as time to maturity

increase (c < y).It is then usually optimal for the party
with the short position to deliver as late as possible, and
futures prices should, as a rule, be calculated on this
assumption

The Risk in a Futures Position

The cash flow to the speculator are as follow :
Today : - F0e-rT
End of futures contract : +ST
The futures prices today : F0
The prices of the asset at time T : ST
The risk-free return on funds invested for time : T
The investor's required return : k
The expected value : E
The PV of this investment : - F0e-rT + E(ST)e-kT
Assume net present value = 0
- F0e-rT + E(ST)e-kT = 0
F0 = E(ST)e(r-k)T

The Risk in a Futures Position

If the asset has

no systematic risk, then k = r

F0 = E(ST)

and F0 is an unbiased estimate of ST

positive systematic risk, then k > r and

F0 < E (ST )

negative systematic risk, then k < r and

F0 > E (ST )

Normal Backwardation and Contango

Normal backwardation:
When the futures price is below the expected
future spot price.
Contango:
When the futures price is above the expected
future spot price.