Forward & Future Pricing

ABHIJEET DESHMUKH
Forward Pricing
Forward Price
 A forward price
 is the predetermined delivery price
 for an underlying commodity, currency or financial asset
 decided upon by the long (the buyer) and the short (the seller)
 to be paid at predetermined date in the future.
 At the inception of a forward contract, the forward price makes the value
of the contract at that time, zero.
Forward Rate - Example
 r is the annualized 3-month riskless interest rate is 6%.
 S is the spot price of the 6-month zero-coupon bond 970.87.
 A new 3-month forward contract on a 6-month zero-coupon bond should
command a delivery price of S*e^(r/4) ,
 then the delivery price is
F = 970.87 × e^(0.06*12/3)
F = 985.54.

Do Yourself
Calculate: Assume a security is currently trading at $100 per unit. An investor
wants to enter into a forward contract that expires in one year. The current annual
risk-free interest rate is 6%. Using the above formula, the forward price is? $106.18
Value of Forward Short & Long
Value of Forward – Short – Sell High
At Time Zero: -
 Borrow S dollars for τ years.
 Buy the underlying asset.
 Short the forward contract with delivery price F.

At Maturity: –
 Deliver the asset for F.
 repay the loan - use [S * e^(r*τ)]
 leaving an arbitrage profit of F − S * e^(r*τ) > 0.
Value of Forward Price (Short): Sell High
 The value of a long forward contract with no known income is given by the
following equation where F > Se^(rτ) (i.e. 28 < 32.83)
 Vf = F – S * erT
Here S is the spot price; T is the remaining time to maturity; r is the risk free
rate; F is the forward price which is set in the contract
 Consider at a Spot, a portfolio of one short forward contract, cash amount
S * erT, and one Long position in the underlying asset.

Example
 In short, Buy Spot @ 30 & Sell forward @ 34; @ 12% for 9 the value of the forward
contract will be:
 Vf (Short) = 34 – 28*e^(0.12×0.75)
= 34 – 30.64
= 3.36
Value of Forward – Long – Buy Low
At Time Zero: -
 Sell underlying asset get the cash
 Buy the Forward Contract F.
 Invest [F * e^( - r * τ)] for time T to get F at Maturity

At Maturity: –
 Pay F to buy the Forward Contract.
 leaving an arbitrage profit of S − [F * e^( - r * τ)] > 0.
Value of Forward Price (Long): Buy Low
 The value of a long forward contract with no known income is given by the
following equation where F < Se^(rτ) (i.e. 28 < 32.83)
Vf = S – F * e – r * T
Here S is the spot price; T is the remaining time to maturity; r is the risk free rate;
F is the forward price which is set in the contract
 The cash will grow to (F * e^-r*t) at maturity, which can be used to take delivery
of the Long Forward contract F
Example
 In short, Sell Spot @ 30 & buy forward @ 28, Risk free rate of 12% for 9 moths.
 Actually, We need to invest 25.59@ to get 12% for 9 month to get 28 to buy in
forward. Get the delivery and settle the open short position.
 the value of the forward contract will be:
Vf (Long) = 30 – 28*e^(-0.12×0.75)
= 30 – 25.59
= 4.41
Forward Short - Underlying Pays Predictable Income
 For a forward contract on an underlying asset providing a predictable income with
a PV of I,
Vf = (F − I) - S * e^(r*τ)

Example
 let us assume that the F =34; R = 12%; T = 9 months & S = 28 & Income received I = 2 .
 The rest of the details are the same as for a forward contract (continuous) with no
known income mentioned earlier.
 The value of the forward contract will be:
F = (34 -2) – 28*e^(0.12×0.75)
= 32 – 30.64
= 1.36
Forward Price (Long): Underlying Pays Predictable Income

Value of a long forward contract (continuous) which provides a known income or

Dividend. i.e.
F < (S − I)*e^(rτ) [Buy low]
then
F = S0 – I – Ke-rT
 where I is the present value at time 0 of the known income on the investment assets.

Example
 let us assume that the present value of the known income at time 0 is 2.
 The rest of the details are the same as for a forward contract (continuous) with no
known income mentioned earlier.
 The value of the forward contract will be:
F = 30 -2- 28e-0.12×0.75= 2.41
Forward Price for Intermittent Dividend Payment
Forward Price: Long with intermittent dividend
 Assume that the underlying asset pays dividends ’D’, over the life of the contract, the
formula for the forward price is:
Vf = (S - D) x F*e^(-r x t)

Example
 Here, Spot = 110; Forward = 100; r = 6%; t = 1year & D is 50-cent dividend every three
months.
 Now Dividend is equals the sum of each dividend's present value, given as:
 D = PV(d(1)) + PV(d(2)) + ... + PV(d(x))
 PV(d(1)) = $0.5 x e ^ -(0.06 x 3/12) = $0.493
 PV(d(2)) = $0.5 x e ^ -(0.06 x 6/12) = $0.485
 PV(d(3)) = $0.5 x e ^ -(0.06 x 9/12) = $0.478
 PV(d(4)) = $0.5 x e ^ -(0.06 x 12/12) = $0.471
 The sum of these is $1.927.
 VF = 110 – 1.927 - ($100 x e ^ (0.06 x 1) = 110 – 1.927 – 94.18 = 13.893
Forward Price: Short with intermittent Dividend
 Assume that the underlying asset pays dividends ’D’, over the life of the contract, the
formula for the forward price is:
VF = (F - D) x S*e^(r x t)

Example
 Here, Forward = 110; Spot = 100; r=6%; t=1year & D is 50-cent dividend every three
months.
 Now Dividend is equals the sum of each dividend's present value, given as:
 D = PV(d(1)) + PV(d(2)) + ... + PV(d(x))
 PV(d(1)) = $0.5 x e ^ -(0.06 x 3/12) = $0.523
 PV(d(2)) = $0.5 x e ^ -(0.06 x 6/12) = $0.515
 PV(d(3)) = $0.5 x e ^ -(0.06 x 9/12) = $0.508
 PV(d(4)) = $0.5 = $0.5
 The sum of these is $2.046.
 VF = 110 – 2.046 - ($100 x e ^ (0.06 x 1) = 110 – 2.046 – 106.18 = 1.774
Future Pricing
Future Pricing
 Pricing of a futures contract depends on the characteristics of underlying asset.
 There is no single way to price futures contracts because different assets have
different demand and supply patterns, different characteristics and cash flow
patterns. This makes it difficult to design a single methodology for calculation of
pricing of futures contracts.
 Futures are derivative products whose value depends largely on the price of the
underlying stocks or indices. However, the pricing is not that direct. There remains a
difference between the prices of the underlying asset in the cash segment and in
the derivatives segment. This difference can be understood through two simple
pricing models for futures contracts. These will allow you to estimate how the price
of a stock futures or index futures contract might behave. These theories gives you
a feel of what you can expect from the futures price of a stock or an index.
 These are:
 The Cost of Carry Model
 The Expectancy Model
Cost of Carry model
 Carry Cost refers to the cost of holding the asset till the futures contract matures.
 This could include
 storage cost or warehouse cost in case of commodities,
 insurance cost, commission paid, interest paid to acquire and hold the asset
 transaction cost, custodial charges, financing costs etc.
 Carry Return refers to any income derived from the asset while holding it like
dividends, bonuses etc.
 While calculating the futures price of an index, the Carry Return refers to the
average returns given by the index during the holding period in the cash market.
 A net of these two is called the net cost of carry.
 The price of a futures contract basically reflects these costs or benefits to charge
or reward you accordingly.
Cost of Carry model
Cost of Carry Model - Assumptions
 Markets tend to be perfectly efficient. This means there are no differences in the
cash and futures price. This, thereby, eliminates any opportunity for arbitrage.
 When there is no opportunity for arbitrage, investors are indifferent to the spot and
futures market prices
Assumptions
 the contract is held till maturity, so that a fair price can be arrived at.
 Underlying asset is available in abundance in cash market.
 Demand and supply in the underlying asset is not seasonal.
 Holding and maintaining of underlying asset is easy and feasible.
 Underlying asset can be sold short.
 No transaction costs.
 No taxes.
 No margin requirements.
Cost of Carry Model – Ex - 1
 This a financial model is used in the forwards market to determine the cost of
carry. This provides a good approximation for futures prices.
 The formula is expressed as follows:
F = S * e ^ ((r + s - c) x t)
Where: F = the forward price of the commodity; S = the spot price of the
commodity; e = the base of natural logs, approximated as 2.718; r = the risk-free
interest rate; s = the storage cost, expressed as a percentage of the spot price;
c = the convenience yield, which is an adjustment to the cost of carry; t = time
to delivery of the contract, expressed as a faction of one year
 For example, assume that a commodity's spot price is $1,000. There is a one-year
contract available, the risk-free rate is 2%, the storage cost is 0.5%, and the
convenience yield is 0.25%. The equation would be set up as follows:
 F = $1,000 x e ^ ((2% + 0.5% - 0.25%) x 1) = $1,000 x 1.0228 = $1,022.80.
 The forward price of $1,022.80 shows that the cost of carry in this situation is 2.28%,
($1,022.80 / $1,000) - 1.
Cash and Carry Model – Commodity Ex - 2
 Let us take an example from Bullion Market. The spot price of gold is Rs 15000 per 10
grams.
 The cost of financing, storage and insurance for carrying the gold for three months
is Rs. 100 per 10 gram.
 Now you purchase 10 gram of gold from the market at Rs 15000 and hold it for
three months. We may now say that the value of the gold after 3 months would be
Rs 15100 per 10 gram.
 Assume the 3-month futures contract on gold is trading at Rs 15150 per 10 gram.
 There is an arbitrage opportunity present in the gold market by buying gold in the
cash market and sell 3-month gold futures simultaneously.
 We borrow money to take delivery of gold in cash market today, hold it for 3
months and deliver it in the futures market on the expiry of our futures contract.
Amount received on honoring the futures contract would be used to repay the
financer of our gold purchase. The net result will be a profit of Rs 50 without taking
any risk.
Cost of Carry Model – Index Ex - 3
 Example, you buy index in cash market at 5000 level i.e. purchase of all the stocks
constituting the index in the same proportion as they are in the index, cost of
financing is 12% and the return on index is 4% per annum

 Given this statistics, fair price of index three months down the line should be:
 = Spot Price * e ^ (1+Cost of financing – holding period return)^(time to expiration
/ 365)
= 5000 * e((0.12-0.04)*90/365)
= Rs. 5099.61.

 If index futures is trading above 5100, we can buy index stocks in cash market and
simultaneously sell index futures to lock the gains.
Example
 Aug 1, 2015
 Stock Price: 1500
 December Future 1520
 Contact Size : 100
 Cost of Carry 8% i.e. 0.75% per month
 Calculate Fair Price: F = S * e ^ R T = 1504.69. The cost of carry/financing is 4.69 *100 =
469
 Based on Fair price and future price decide the Strategy Buy Spot and Sell Future

 Now: Gain/Loss if Stock Price rise to 1550

 Net Gain on Spot 5000 (50*100) and loss on future is 3000 (30*100) = 2000
 Net gain – 469 = 1531
 Now: Gain/Loss if Stock Price fall to 1480
 Loss on Spot 2000 (20*100); Gain on Future 4000 (40*100) = 2000
 Net gain 2000 – 469 = 1531
Thank You