FORWARD AND FUTURES PRICING

Week 2
MSc in Finance and Investment
Semester 2: 2009-10
Peter Moles

Todays key ideas

Mechanics of forwards and futures
Cost of carry
Pricing via replication
Arbitraging & other issues with forward and futures prices

Remember, the price that people agree to in the pit is not the price
that people think is going to exist in the future. It's the price that
both sides vehemently agree won't be there.
- Jeffrey Silverman
Week 2: Derivatives Forward & Futures Pricing

1. Forwards & Futures Mechanics

Forwards vs. futures

Forwards

Futures

Any amount

Specific contract amount

Any maturity date

Specific dates

Terms and conditions as

negotiated
Any counterparty
Cancellation by mutual
consent
No mark-to-market
No margin

Traded OTC

Week 2: Derivatives Forward & Futures Pricing

(normally 4 times a

year)

Standard terms and conditions

Clearing house
Has to be sold (repurchased)
Daily mark-to-market
Initial and variation margin
required
Traded on an organized
exchange

Futures contracts
Available on a wide range of underliers
Exchange traded
Margin (performance bond)
Clearing house
Standardization
Means contracts are fungible, hence liquid

Specifications need to be defined:

What can be delivered,
Where it can be delivered, &
When it can be delivered

Settled daily
Gains and losses paid in/out of margin account

Week 2: Derivatives Forward & Futures Pricing

Financial futures
Fixes the price, exchange rate, interest rate or
stock index level at which a financial transaction
will occur at a future date
currency futures
short-term interest rate futures (money markets)
medium and long-term interest rate futures (bond
markets; swaps)
stock index futures
miscellaneous

Week 2: Derivatives Forward & Futures Pricing

Exchange pricing mechanisms

Currency futures
Exchange rate pair ($ per unit of foreign currency)
125 000 per contract

Short-term interest rate futures

Interest rate index = (100 interest rate)
Notional deposit = $1mm (e.g. eurodollar futures)
Cash settled

Government bond futures

notional bond with x% coupon
Actual bonds used for delivery

Conversion factor
Cheapest to deliver
Stock index futures
$ value per index point
S&P futures $250 index
Cash settled
Week 2: Derivatives Forward & Futures Pricing

2. Pricing Forwards & Futures

Cost of carry model [I]

Buyer
Defers purchase
Gains interest advantage
Loses any income from underlier

Seller
Defers sale
Gains any income from underlier
Loses interest advantage
Pays storage, wastage, etc.

Cost
Costofofcarry
carry(CC)
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modelwhich:
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(b)
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Week 2: Derivatives Forward & Futures Pricing

Interest rate calculations

Simple interest
(money markets)

PV (1 + rsT ) = FV T
PV (1 + r ) = FV T
T

Compound interest
(standard textbook)

Continuous interest*

PV e rcT = FVT

(Derivatives pricing)

*Note that rc = [ln(1 + r )]

Week 2: Derivatives Forward & Futures Pricing

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Cost of carry model [II]

Model at its simplest
No income lost (value leakage)
No wastage
No storage costs

S0
r
T
FT

= spot price of underlier

= risk-free interest rate to time T
= time to maturity (expiration) of contract
= forward price with maturity at time T

S 0 e r (T ) = FT
With simplest CC model, only the time value of money
(cost of borrowing) matters
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Week 2: Derivatives Forward & Futures Pricing

Cost of carry model [III]

What of value leakage?

S 0 e (r q )(T ) = FT

1. Continuous dividends
q = continuous dividend yield
2. Known dividend(s)
D = dividend paid at time t
(T > t)

Dividends are either present valued and subtracted

[S De ( ) ]e ( ) = F
r t

r T

Or future valued and subtracted

Storage costs?
u = storage costs as a yield

Convenience yield?
y = unobservable convenience yield
Week 2: Derivatives Forward & Futures Pricing

S0e r (T ) De r (t ) = FT

S0e (r +u )(T ) = FT
S0e (r +u y )(T ) = FT
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The Cost of carry [IV]

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
The convenience yield on the consumption asset, y, is defined so that :

F0 = S0 e(cy )T

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Week 2: Derivatives Forward & Futures Pricing

Valuing a forward contract

Suppose that
K is delivery (contracted) price in a forward contract &
F0 is forward price that would apply to the
contract today
The value of a long forward contract, , is

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

fS = (K F0 )erT

Week 2: Derivatives Forward & Futures Pricing

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3. Arbitrage & Other Issues

Principles of arbitrage
Classical arbitrage involves simultaneous purchase and sale of asset in two
markets (see Week 1 class)
Rule is:
Buy the underpriced asset
Sell overpriced one

Cash-futures arbitrage operates on same principle

Cash and carry = sell futures, buy cash instrument
Reverse cash and carry = buy futures, sell cash instrument

Profit is made when prices come into line or contract expires

Scalping involves arbitraging (exploiting) very short-term price differences

Week 2: Derivatives Forward & Futures Pricing

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Index arbitrage
When F0>S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells
futures
When F0<S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks
underlying the index
Index arbitrage involves simultaneous trades in futures & many different stocks
Very often a computer is used to generate the trades (program trading)
Occasionally (e.g., on Black Monday) simultaneous trades are not possible and
the theoretical no-arbitrage relationship between F0 and S0 may not hold

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Week 2: Derivatives Forward & Futures Pricing

Factors affecting arbitrage

profits
Transaction costs
Short selling restrictions
Limits on borrowing funds
Unequal borrowing and lending rates
Interest received or paid in marking-to-market futures contracts
Note: these are either imperfections in the standard model or real-world
frictions which the model does not take into account

Week 2: Derivatives Forward & Futures Pricing

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Basis risk
Basis is the difference between spot & futures
S F = Basis
Simple basis =
Carry (theoretical) basis =
Value basis =

SF
S F*
F F*

[ F* = S0erT ]

Basis risk arises because of the uncertainty about the basis when the futures
contract is closed out
NB mostly affects hedging transactions

Note there is no basis risk if futures contract held to expiration

(as futures contract price converges to cash market price)
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Week 2: Derivatives Forward & Futures Pricing

Effect of basis change on hedge

performance
Hedge Position and Return
Type of Hedge

Basis Weakens

Basis Strengthens

Short

Returns < 0

Returns > 0

Long

Returns > 0

Returns < 0

Weaker basis:

cash price increases less or falls more than

futures price

Stronger basis:

cash price increases more or falls less than

futures price

Value of
hedge
position

Positive basis = S F > 0

Negative basis = S F < 0

T futures expiration
Week 2: Derivatives Forward & Futures Pricing

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Variation in basis
T
Actual basis

Basis

Variation in actual basis

to the (theoretical) carry basis
Carry basis

If the spot price = 100, cost of carry value is 105, and actual value of
the futures contract is 105.5 then:
Simple basis (S F) = 100 105.5 = 5.5
Carry basis (S F*) = 100 105 = 5.0
Value basis (F F*) = 105.5 105 = 0.5

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Week 2: Derivatives Forward & Futures Pricing

Risks from hedging with futures

Cross-asset positions

Underlying position and futures contract

are not the same leading to potential
differences in performance

Rounding error

Requirement to transact in whole

contract amounts leads to slight over
(under) hedging

Variation margin

Margin flows on futures position can

cause uncertainty in hedging

Timing mismatches

Gains and losses on the two sides may

not match

Basis risk

Problem of variable convergence

Week 2: Derivatives Forward & Futures Pricing

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Case 3: The basis in futures contracts

Briefly explain using an appropriate example what is meant by a crossasset or cross-market spread in the futures market and why market
participants would want to establish such a position.

2. The cash market price of an index is 4625 and the 3-month futures price
is 4595. The index has a dividend yield of 4.20 per cent. The risk-free
interest rate is 3.95 per cent. What is the raw basis, the carry basis, and
the value basis? Is it possible to undertake an arbitrage transaction if
transaction costs are one per cent of the cash market value of the index?

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Week 2: Derivatives Forward & Futures Pricing

Case 4: Arbitrage in futures markets

1 Using an appropriate example, explain the steps required by a

market arbitrageur to exploit mispricing between the cash
market and the futures market. What are the difficulties
involved?
2 The party with a short position in a futures contract sometimes
has options as to the precise asset or underlier that can be
delivered, where the delivery will take place, when the delivery
will take place, and so on. How do these delivery options, as
they are known, affect the futures price? Explain your
reasoning.

Week 2: Derivatives Forward & Futures Pricing

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Lets design a new futures

contract on the weather
Lets see if we can put together a contract that allows us to hedge or speculate
on the weather!
(Talking about the weather is a very common topic of conversation in the UK.)

Week 2: Derivatives Forward & Futures Pricing

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