Lecture 2 - Forwards and Futures

LECTURE 2 - Forwards & Futures 26/02/14
Lecture 2 - Forwards and Futures

FINM2002 Derivatives
FINM7041 Applied Derivatives
1
Review of Previous Lecture
In last weeks lecture we went through a
broad overview/revision of forward, futures
and options contracts.
In particular we focussed on the
mechanics of forward and futures markets.
2
Lecture Overview
In todays lecture we will discuss forwards and
futures contracts in greater detail, and how they are
related to the spot price of the underlying asset. We
will focus on the following topics:
Determination of interest rates;
What is short selling?;
Determination of forwards and futures prices; and,
Hedging strategies using forwards and futures contracts.

3
1. Consumption vs Investment Assets
When considering forward and futures contracts, it is important to
distinguish between investment assets and consumption
assets.
Investment assets are assets held by significant numbers of people
purely for investment purposes.
Examples of investment assets are stocks, bonds, gold and silver.
Consumption assets are assets held primarily for consumption and
NOT usually for investment purposes.
Examples of consumption assets are commodities such as copper,
oil and pork bellies.
We can use arbitrage arguments to determine the forward and futures
price of an investment asset from its spot price and other observable
market variables. We CANNOT do this for consumption assets.
4

2. Short Selling
Short selling (also called shorting), involves selling an asset that is NOT
owned.
It is NOT possible for all investment assets.
Your broker borrows the securities from another client and sells them
in the market in the usual way.
At some stage you must buy the securities back so they can be replaced
in the account of the client you originally borrowed them from.
You MUST pay dividends and other benefits that would have accrued to
the client you borrowed from, if they had still held the shares. In other
words, the client you borrowed from should be no worse off as a result of
lending you their shares.
Likewise, the client can be no better off. Therefore, if you borrow a
physical asset such as gold off a client, the client must pay you for the
storage costs of the gold.
The investor (the person who has shorted the asset) benefits if prices fall,
as they sell the asset for a higher price than what they buy it back for.

5

2. Short Selling
The investor is required to maintain a margin
account with the broker.
The initial margin is required so that possible
adverse movements (increases) in the price of
the asset that is being shorted are covered.
The margin account consists of cash or marketable
securities deposited by the investor with the broker
to guarantee that the investor will NOT walk away
from the short position if the share price
increases.
6
2. Short Selling
Regulators in the United States currently allow a stock to
be shorted ONLY on an uptick that is, when the most
recent movement in the price of the stock was an
increase.
In Australia, ONLY a limited number of stocks are
allowed to be short sold, called the ASX Approved
Securities List.
Further, in 2008, we saw a ban on various forms of short
selling in markets around the world.

7
3. Measuring Interest Rates
The compounding frequency used for an interest
rate is the unit of measurement.
From Foundations of Finance, you are familiar
with the need to calculate the effective rate of
interest.
The difference between quarterly and annual
compounding is analogous to the difference
between miles and kilometres.
8
In this course, we will mainly use continuous
compounding. As such you will need to ensure that your
interest rates are expressed as continually
compounded interest rates. We will detail any
exceptions to this rule as we progress through the course.
In the limit, as we compound more and more frequently,
we obtain continuously compounded interest rates.
$100 grows to $100e
RT
when invested at a continuously
compounded rate R for time T.
$100 received at time T discounts to $100e
-RT
at time
zero when the continuously compounded discount
rate is R.
9
If a nominal rate of 10% p.a. is
compounded continuously what is the
effective rate?
e
R
-1
e
0.10
-1

2.71828
0.10
-1= 10.51%

10
4. Assumptions
In this lecture we make the following
assumptions regarding market participants:
1. They are subject to no transaction costs when they
trade;
2. They are subject to the same tax rate on all net
trading profits;
3. They can borrow money at the same risk-free rate of
interest as they can lend money; and,
4. They take advantage of arbitrage opportunities as
they occur.
11
5. Forward and Futures Contract Prices
Remember from Foundations of Finance that:
It is well known in practice that if interest rates are
constant, a futures contract has the same value
as an otherwise identical forward contract. That is,
although a futures contract has a complicated cash
flow pattern (via the marking to market feature) it can
be valued as though it were a forward contract. Since
a forward contract has only a single cash flow, it is
easy to value. Consequently, it is industry practice to
value futures contracts as though they were forward
contracts.

12
Remember that:
Forward and futures contracts can be valued
by recognizing that, in many cases, forward
and futures markets are redundant. This
occurs when the payoff from a forward or
futures contract can be replicated by a
position in:
1. The underlying asset, and
2. Riskless bonds.
13
Before illustrating this concept, we define the
cost of carry (q) of the underlying commodity.
This is the cost of holding a physical quantity
of the commodity. For wheat the cost of carry
is the storage cost; for live hogs it consists of
storage and feed costs; and for gold it consists
of storage and security costs. Some
commodities have a negative cost of carry. For
example, holding a stock index provides the
benefit of receiving dividends.

14
Consider the strategy of:

Borrowing enough money to buy one unit of an
investment asset that provides the holder with no
income, and has no holding costs. Non-dividend paying
stocks and zero-coupon bonds are examples of such
investment assets. The borrower incurs the obligation to
pay for the associated interest through time T; and,
Entering into a forward or futures contract to sell the
commodity at time T.

The value of this position in terms of the initial (time 0)
and terminal (time T) cash flows is tabulated in the
following table.
15
Arbitrage Relationship Between Spot and
Forward Contracts
Position Initial Cash Flow Terminal Cash
Flow
Borrow and incur
cost of carry
S
0
-S
0
e
rT
Buy one unit of
commodity
-S
0
S
T
Enter 6-month
forward sale
0 F-S
T
Net portfolio
value
0 F- S
0
e
rT
16
Example:
Consider a four-month forward contract to
buy a zero-coupon bond that will mature one
year from today. (This means that the bond
will have eight months to go when the forward
contract matures.) The current price of the
bond is $930. We assume that the four-month
risk-free rate of interest (continuously
compounded) is 6% per annum. The forward
price, F
0
,

is given by:
4
0.06
12
0
930 $948.79 F e

17
6. Arbitrage
In general if:

Arbitrageurs can make a riskless profit from buying the asset and
entering into a short forward contract on the asset. This strategy
is financed by borrowing funds at the risk free-rate if interest.

Arbitrageurs can make a riskless profit by shorting the asset and
entering into a long forward contract. The excess funds are
invested at the risk-free rate of interest until they are needed to
buy back the asset.
0 0
rT
F S e
0 0
rT
F S e
18
on Assets with Known Income
We now consider a forward contract on an investment
asset that will provide a perfectly predictable cash
income to the holder.
Examples are stocks paying known dividend yields and
coupon-bearing bonds.

Where D is the present value of the income.
0 0
( )
rT
F S D e
19
7. Forward and Futures Contract Prices on
Assets with Known Income
Consider a long forward contract to purchase a
coupon-bearing bond whose current price is $900.
We will assume that the forward contract matures in 9
months. We also assume that a coupon payment of
$40 is expected after 4 months. The 4 - month and 9 -
month risk-free interest rates continuously
compounded are 3% and 4% per annum, respectively.

20
Assets with Known Income
4
0.03
12
0.04 0.75
0
40 39.60
(900 39.60) $886.60
I e
F e

21
Assets with Known Yield
How do we deal with a situation where the asset
underlying a forward contract provides a known yield
rather than known cash income?
A yield implies that the known income is expressed
as a percentage of the assets price at the time the
income is paid.
We defined as the average yield per annum on an
asset during the life of a forward contract with
continuous compounding.
The formula we use is:

( )
0 0
r d T
F S e

22
Assets with Known Yield
Consider a six-month forward contract on an asset that is
expected to provide an income equal to 2% of the asset price
once during a six-month period. The risk-free rate of interest with
continuous compounding is 10% per annum. The asset price is
$25.
The yield is 4% per annum with semi-annual compounding.
Converting this to continuous compounding we get:

This formula is one of the many located on page 84 to convert
nominal rates to continuously compounded rates.

So the forward price is given by:

0.04
ln(1 ) 2ln(1 ) 0.0396
2
m
c
R
R m
m

(0.10 0.0396) 0.5
0
25 $25.77 F e

23
Stock Indices
A stock index can be viewed as an investment
asset paying a dividend yield.
The futures price and spot price relationship is
therefore:

Where d is the dividend yield on the portfolio represented
by the index.
Remember, with indices, they are stated as points.
Therefore, the number of points must be multiplied by
a factor to end up with a dollar value for the contract.
In Australia, the convention is $25 per point.
( )
0 0
r d T
F S e

24
Stock Indices
Consider a 1-year futures contract on the ASX S&P200. Suppose
that the stocks underlying the index provide a dividend yield of 5%
per annum continuously compounded, that the current value of the
index is 3529, and that the continuously compounded risk-free
interest rate is 10% per annum.

If we multiply this value by $25 per point, each futures contract will
hedge a dollar value of $92,750.
( )
0 0
r d T
F S e

(0.10 0.05)
0
3529 3710 F e

25
on Stock Indices
In general if:

An arbitrageur can make a riskless profit by buying the stocks
underlying the index and shorting index futures contracts.
This strategy will be financed by borrowing funds at the risk-free
interest rate.

An arbitrageur can make a riskless profit by shorting the stocks
underlying the index and taking a long position in index
futures contracts. The excess funds will be invested at the risk-
free interest rate until needed to buy back the stocks.

( )
0 0
r d T
F S e

( )
0 0
r d T
F S e

26
Stock Indices
Index arbitrage involves simultaneous trades in
futures and many different stocks.
Very often a computer is used to generate the
trades.
Occasionally (e.g., on Black Monday) simultaneous
trades are NOT possible and the theoretical no-
arbitrage relationship between F
0
and S
0
does NOT
hold.

27
10. Futures and Forwards on Currencies
The underlying asset in a forward or futures currency contract is a
certain number of units of a foreign currency.
A foreign currency is analogous to a security providing a dividend
yield. A foreign currency has the property that the holder of the
currency can earn interest at the risk-free interest rate prevailing in
the foreign country. For example, the holder can invest the foreign
currency in a foreign-denominated bond.
Thus, the continuous dividend yield is the foreign risk-free
interest rate.
It follows that if r
f
is the foreign risk-free interest rate, S
0
as the
current spot price in dollars of one unit of the foreign currency and
F
0
as the forward or futures price in dollars of one unit of the
foreign currency,

28
F S e
r r T
f
0 0
( )
11. Forwards and Futures on Commodities
First, let us consider the futures prices of
commodities that are investment assets such as gold
and silver.
In the absence of storage costs and income the
forward price of a commodity that is an investment
asset is given by:

If there are storage costs, Q is the present value of
all of the storage costs less all income during the
life of the forward contract, and the forward price is
given by:

0 0
rT
F S e
0 0
( )
rT
F S Q e
29
If storage costs and income are given as a
percentage, then q is the percentage storage
costs less the percentage income during the
life of the forward contract, and the forward price
is given by:
( )
0 0
r q T
F S e

30
Now let us consider consumption commodities.
Commodities that are consumption assets rather than
investment assets usually provide no income, but
can be subject to significant storage costs.
Individuals and companies who keep such a commodity
in inventory do so because of its consumption value,
not because of its value as an investment. They are
reluctant to sell the commodity and buy forward
contracts because forward contracts cannot be
consumed. There is therefore nothing to keep the
previous equations holding (ie arbitrage).
31
As a result:

Due to the high storage costs of consumption
commodities, Q is the present value of all of the
storage costs, and the forward price is given by:

If storage costs are expressed as a proportion q of
the spot price, the equivalent formula is:

0 0
( )
rT
F S Q e
32
( )
0 0
r q T
F S e


The reason we do not have equality in the formulas on the previous slide is because
users of a consumption commodity may feel that ownership of the physical
commodity provides benefits that are not obtained by holders of futures
contracts.
For example, an oil refiner is unlikely to regard a futures contract on crude oil in the
same way as crude oil held in inventory.
The crude oil in inventory can be used in the refining process whereas a futures
contract cannot.
The benefits from holding the physical asset is referred to as the convenience
yield.
As such we can re-write the equations on the previous slide, where y, the
convenience yield simply measures the extent to which the left hand side is less than
the right hand side in those previous equations:

0 0
( ) ( )
0 0 0 0
( )
and if the storage costs are a percentage then,

yT rT
yT r q T r q y T
F e S Q e
F e S e or F S e

33
12. Valuing Forward Contracts
The value of a forward contract at the time it is first entered into is
zero. At a later stage it may prove to have a positive or negative
value.
Suppose that
K is delivery price in a forward contract (the initial forward price when the
contract was negotiated some time ago);
F is the current forward price for the contract that was negotiated some
time ago;
The delivery date is T years from today;
r is the T-year risk-free interest rate; and,
f is the value of the forward contract today.
The value of a long forward contract (on both investment and
consumption assets, , is:

Similarly, the value of a short forward contract is

( )
rT
f F K e

( )
rT
f K F e

34
A long forward contract on a non-
dividend paying stock was entered into
some time ago. It currently has six
months to maturity. The risk-free rate of
interest (with continuous compounding) is
10% per annum, the stock price is $25,
and the delivery price is $24. What is the
value of the forward contract?
35
0.1 0.5
0
0.1 0.5
25 $26.28
(26.28 24) $2.17
F e
f e

36
The value of the forward contract is:
13. Forward vs Futures Prices
Forward and futures prices are usually assumed to be
the same. When interest rates are uncertain they are,
in theory, slightly different:
A strong positive correlation between interest rates and the
asset price implies the futures price is slightly higher than the
forward price. This is due to the person in the long position in
a futures contract receiving an immediate gain because of
daily settlement. The positive correlation indicates that interest
rates are also likely to have risen, therefore the gain will be
invested at a higher than average interest rate.
A strong negative correlation implies the reverse.
37
14. Delivery
In a futures contract, the party in the
short position has the right to choose to
deliver the asset at any time during a
certain period (called the delivery
period).
The person in the short position has to
give at least a few days notice of their
intention to deliver.
38
Hedging Strategies
Using Futures
39
15. Hedging
Hedgers aim to use futures markets or forward
contracts to reduce a particular risk they may
face. This risk may relate to the price of an
asset such as gold, a move in the foreign
exchange rate, or the level of the stock market.
A perfect hedge is one that completely
eliminates the risk. However, a perfect hedge
is very rare.

40
15. Hedging
A short hedge is a hedge which involves a short
position in futures contracts. It is appropriate
when the hedger already owns an asset (or will
own it at some definite date) and expects to sell
it at some time in the future. This allows them
to lock in the price they will receive.
A long hedge involves taking a long position in
futures contracts. It is appropriate when a
company knows it will have to purchase a
certain asset in the future and wants to lock in
the price now.
41
15. Hedging

Arguments in FAVOUR of hedging include:
Companies should focus on the main business
they are in and take steps to minimize risks
arising from interest rates, exchange rates, and
other market variables; and,
By hedging, they avoid adverse movements such
as sharp rises in the price of a commodity.

42
15. Hedging
o Arguments AGAINST hedging include:
Shareholders are usually well diversified
and can make their own hedging
decisions;
It may increase risk to hedge when
competitors do not; and,
Explaining a situation where there is a loss
on the hedge and a gain on the underlying
can be difficult
43
16. Basis Risk
Hedges are NOT always perfect and
straightforward. Some of the reasons for
this are:
The asset whose price is to be hedged may
NOT be exactly the same as the asset underlying
the futures contract;
The hedger may NOT be certain of the exact
date the asset will be bought or sold; and,
The hedge may require the futures contract to
be closed out before its delivery month.
44
16. Basis Risk
What is basis risk:
If the asset to be hedged and the asset underlying the futures
contract are the same, the basis risk should be zero at the
expiration of the futures contract.
Prior to expiration, the basis may be positive or negative.
When the spot price increases by more than the futures price,
the basis increases. We call this strengthening of the basis.
When the futures price increases by more than the spot price,
the basis declines. We call this weakening of the basis.
The formula for working out the basis in a hedging situation is:
Basis = Spot price of asset to be hedged - Futures price of contract used
45
Convergence of Futures to Spot

46
Time Time
(a) (b)
Futures
Price
Futures
Price
Spot Price
Spot Price
16. Basis Risk
Basis risk with a long hedge:
Suppose that
F
1
: Initial Futures Price
F
2
: Final Futures Price
S
2
: Final Asset Price
You hedge the future purchase of an
asset by entering into a long futures
contract
Cost of Asset = S
2
(F
2
F
1
) = F
1
+Basis
47
16. Basis Risk
Basis risk with a short hedge:
Suppose that
F
1
: Initial Futures Price
F
2
: Final Futures Price
S
2
: Final Asset Price
You hedge the future sale of an asset by
entering into a short futures contract
Price Realized = S
2
+(F
1
F
2
) = F
1
+Basis
48
16. Basis Risk
One key factor affecting basis risk is the choice of
the futures contract to be used for hedging. This
choice has two components:
Choose a delivery month that is as close as possible
to, but later than, the end of the life of the hedge; and,
When there is no futures contract on the asset being
hedged, choose the contract whose futures price is
most highly correlated with the asset price.
49
17. Cross Hedging
Cross hedging occurs when the asset
underlying the futures contract is different to
the asset whose price is being hedged.
For example an airline company may be concerned
about the future price of aviation fuel. However, as
there are no futures contracts on aviation fuel, the
company choose to use heating oil futures contracts
to hedge its exposure.
50
18. Optimal Hedge Ratio
The hedge ratio is the ratio of the size of the
position taken in futures contracts to the size of
the exposure.
The optimal hedge ration is calculated by:

where
s
S
is the standard deviation of dS, the change in the
spot price during the hedging period;
s
F
is the standard deviation of dF, the change in the
futures price during the hedging period; and,
r is the coefficient of correlation between dS and dF.

51
h
S
F
r
s
s
19. Hedging Using Index Futures
Stock index futures can be used to hedge an
equity portfolio.
To hedge the risk in a portfolio the number of
contracts that should be shorted is:

where
P is the value of the portfolio,
b is its beta, and
A is the value of the assets underlying one futures
contract.
52
b
P
A
Reasons for using index futures to
hedge an equity portfolio include:
Desire to be out of the market for a short
period of time. (Hedging may be cheaper
than selling the portfolio and buying it back.)
Desire to hedge systematic risk
(Appropriate when you feel that you have
picked stocks that will outperform the market.)
53
Imagine that the value of SPI200 is 3500
The value of the portfolio to be hedged is
$5 million
The beta of the portfolio is 1.5

What position in SPI200 futures contracts
is necessary to hedge the portfolio?
54
b
P
A
55
= 1.5 x 5m/3500x25=86 contracts (SHORT)
What position is necessary to reduce
the beta of the portfolio to 0.75?
What position is necessary to reduce the beta of the
portfolio to 0.75 (b*)?
Given we were hedging 100% with 86 contracts to reduce
our risk to zero, we can take 43 to hedge 50% to give us
half of our previous risk of 1.5.
Generally:
5
( *) (1.5 .75) 43
87500
P m
A
b b
56
What position is necessary to increase the beta of the portfolio to 2.00?
What position is necessary to increase the
beta of the portfolio to 2.00?

( *)
P
A
b b
5
(1.5 2.0) 29
3500 25
M
x

57
Since this is negative we must go LONG

We can use a series of futures contracts
to increase the life of a hedge.
Each time we switch from 1 futures
contract to another we incur a type of
basis risk.
58
20. Conclusion
In todays lecture we have discussed futures
and forward contracts in detail.
In particular we focussed on determining
forward/futures prices, valuing forward/futures
contracts, basis risk and hedging.
In next weeks lecture we will discuss interest
rate contracts and swaps.
59

Lecture 2 - Forwards and Futures

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LECTURE 2 - Forwards & Futures 26/02/14

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