Q&A on Forward/Futures

FNCE 305 Analysis of Derivative Securities

Professor Dashan Huang

The Value of a Forward Contract as Time Passes

Recall that the forward price of asset, that does not pay any dividends during the life of the contract,
is specified at time 0 and for maturity T is
F0 = S0 erT ,

(1)

where S0 is the time 0 price of the asset and r is the risk-free interest rate with continuous compounding. If we want to compute the forward price at any time t after time 0 and before maturity
T , 0 < t T , the same argument as before gives us the more general formula for the forward price
based on the current price St ,
Ft = St er(T t) .

(2)

Question: What is FT at time T ?

Solution: Using the formula, FT = ST er(T T ) = ST . So a forward contract with maturity 0
reduces to a spot contract.
Example: 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 interest rate is 10% per annum with continuous compounding.
What are the forward price and the initial value of the forward contract?
Solution: The forward price is given by
F0 = 40 e0.11 = 44.21.
But the initial value of the forward contract is 0 because it costs nothing to enter a forward.
Question: Assume that six months later, the price of the stock is $45 and the risk-free rate is
still 10%. What are the current forward price for the same maturity and the value of the forward
contract?
Answer: at t = 6/12 = 0.5, St = 45, r = 0.1, so
Ft = 45 e0.10.5 = 47.31.
Regarding the value of the contract at t = 0.5, lets compare our position in a long forward with
a newly initiated long forward at time t = 0.5 years. Using the numbers from our example, we
get that the original long forward obligates us to buy the asset at maturity for F0 = $44.21 but
someone who enters a long forward at time t for the same maturity T is obligated to buy the asset
at time T for more, say Ft = $47.31, so the holder of the original long forward would buy the asset
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cheaper by 47.31 44.21 = 3.10 compared to the current (time t) forward deal for the same delivery
date T .
The difference Ft F0 represents the value of the original forward at time T because this is exactly
how much a time t-buyer would have to pay for the existing long forward so as to be equivalent
to entering a new long forward with a higher forward price. The value of the forward contract at
time t we get by discounting its T -value:
ft = (Ft F0 )er(T t) = (47.31 44.21)e0.10.5 = 2.95.
Question: What happens if we also enter a short position at time t with maturity T ?
Answer: Adding a short forward position at time t, with the same maturity as the original long
position from time 0, is equivalent to closing our original long forward position.
Question: What is the total payoff at maturity T of this portfolio of long and short forwards?
Answer: We know the payoff at maturity T of a long forward with delivery price F0 and a short
forward with delivery price Ft ,
Total payoff at time T = (ST F0 ) + (Ft ST ) = Ft F0 .
The total payoff that we end up with if we close our original long forward position is again the
value of the forward at maturity T , i.e., the time t-value we get by discounting.
To summarize: The t-value of a long forward with maturity T is given by


ft = (Ft F0 )er(T t) = St er(T t) S0 erT er(T t) = St S0 ert .
Check the above example, 45 40e0.10.5 = 2.95.
So the time 0-value is f0 = S0 S0 er0 = 0, and the time T -value is FT = ST S0 erT .

Forwards on Assets with Continuously Paid Dividends

Let St , r and q be the asset price at time t, the risk-free interest rate (assumed constant), and the
continuous dividend yield, respectively.
Dividend yield q refers to the fact that over the time interval [t, t + t], the dividend paid by
the asset at time t is
St qt.
Question: What happens if we reinvest the dividends immediately back into the asset?
Answer: If we have 1 share of the asset at time t, we can buy qt more shares of the asset at
time t using the dividend. So at t + t, we have (1 + qt) shares of the asset.
Now suppose the forward has a maturity T . Lets equally split the maturity into N subintervals,
i.e., t = T /N .
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Suppose at time 0, we have 1 share of the asset. Then with yield q, at time t, we have 1 + qt
shares, at time 2t, we have (1 + qt)(1 + qt) = (1 + qt)2 , and at time T , we have
(1 + qt)(1 + qt) (1 + qt) = (1 + qt)N = (1 + qt)T /t eqT ,
as t 0.
To generalize, if at time 0, we have eqT shares of the asset. With reinvesting all the yields back
in the asset, we have eqT eqT = 1 share at time T .

The Forward Price for Continuous Dividends

Lets find the forward price in the case of continuous dividends. The strategy is to buy 1 share of
asset at time 0 for S0 and enter into a short forward to sell this asset at time T for the forward
price F0 , which is specified at time 0, so it is a known cash received at time T . In sum, at time 0
we have a cost of S0 (for obtaining 1 share of the asset) because it costs nothing to enter a forward
contract and at time T we receive certain cash F0 . This strategy does not lead to any arbitrage
only if the cost today is equal to the present value (PV) of the known cash F0 received at time T :
S0 = PV(F0 ) = F0 erT F0 = S0 erT .
Question: How can we use the same strategy to find the forward price when the asset pays
dividends continuously?
Answer: If we start with eqT shares of the asset, which will grow to 1 share after time T . Again,
buy now eqT units of the asset for a total cost of S0 eqT and enter a short forward to sell 1 share
of the asset at time T for a price of F0 . To avoid arbitrage, the cost today must be equal to the
present value of the known cash F0 received at time T :
S0 eqT = PV(F0 ) = F0 erT F0 = S0 e(rq)T .

Homeworks for Weeks 12

1. A trader enters into a one-year short forward contract to sell an asset for $100 when the spot
price is $90. The spot price in one-year proves to be $95.
(a) What is the traders gain or loss from the forward on the maturity date? Draw the
gain/loss diagram for the trader.
(b) What is the gain or loss of the buyer of this forward on the maturity date? Draw the
gain/loss diagram for the buyer.
Solutions:
(a) The underlying price increases but is still less than the forward price 100, so the seller
benefits. She can buy at $95 from the spot market and sells to the buyer of the forward
contract at $100. The trader gains 100 95 = $5.
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(b) The buyer loses, because he has to buy the asset at $100 but can only sell it at $95. He
loses $5.

2. (a) What the are the main shortcomings of the forward contracts? (b) How are futures
contracts designed to overcome these shortcomings?
Solutions:
(a) Liquidity and credit risk. Because of the non-standardized terms of forward contracts
and no fixed spaces to trade, it is difficult to reverse a forward position in most forward markets. Because no one guarantees the performance of the counterparty, forward
traders face significant counterparty default risk.
(b) To deal with liquidity, futures are traded with standardized specifications and in fixed
exchanges. To deal with the credit risk, clearinghouse is introduced to guarantee the
performance of every futures contract. To protect the clearinghouse, marking to market
margin account is established.
3. Consider a coffee futures contract (37,500 lbs per contract). The December contract was
settled at $1.1675 per lb on 2nd September. Suppose we bought 1 December futures on 2nd
September (day 0). On the 4 succeeding trading days, the December contract settled at the
following prices:$1.1043, $1.1523, $1.2004, and $1.1650. Compute:
(a) The gains and losses in these 4 days:

Day

Gains/Losses

(1.1043 1.1675) 37, 500 = $2, 370

(1.1523 1.1043) 37, 500 = +$1, 800

(1.1204 1.1523) 37, 500 = +$1, 803.75

(1.1650 1.2004) 37, 500 = $1, 327.50

(b) If the initial margin was $5,000 and the maintenance margin was $4,000 for each contract,
compute the dollar value of the margin account after 4 days, assuming you earn no
interest in the account.
Assuming no withdrawal of the amount above the initial margin (you can assume otherwise)
Day

Gains/Losses

Margin Account

Remark

$2, 370

$5,000

Margin call of $2,370

+$1, 800

$6,800

Gain

+$1, 803.75

$8,603.75

Gain

$1, 327.50

$7,276.25

Loss

4. Mark-to-Market Reduces Credit Risk: Edwin buys 10 gold futures at $1,400/oz with maturity
in 250 days (contract size 100 oz). Suppose the gold futures price goes down $0.2 every day
for 250 days. (a) How much will Edwin pay at maturity without marking-to-market? (b)
How much will Edwin pay daily with marking-to-market?
Solutions:
(a) (a) Without mark-to-market (MTM), the gold (futures) price will be $1,350/oz at time
T . Edwin will lose (14001350)10010 = $50, 000. Without mark-to-market (MTM),
he has to pay $50,000 at T . This makes the default rate high.
(b) With MTM, he pays 0.2 100 10 = $200 daily. This significantly decreases the default rate (because the broker will close out the contract if Edwin does not top up when
getting a margin call).
5. Calculate the fair forward price on a non-dividend paying stock whose current price is $50,
assuming 5% interest rate and one year to maturity. How can you make an arbitrage profit
(i.e., 0 net investment and positive, risk-free return) if
(a) The actual forward price is $53.50?
The fair forward price is
F0 = S0 erT = 50 e0.051 = $52.56.
Since FA = 53.60 > F0 buy low sell high suggests that the forward is too high relative
to stock. Consider the following cash and carry strategy:
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(1) Borrow $50 to buy one share of the security in spot market and keep it to T .
(2) Sell (or short) one forward contract.
(3) At T = 1, deliver the security to close out the forward to get $53.50 and repay the
loan.
The cash flow of Cash and Carry is
Strategy

t=0

t=T

Borrow

+50

50e0.051 = 52.56

Buy the spot

50

ST

Sell the forward

53.50 ST

Total

53.50 52.56 = 0.94

You have zero investment now and risk-free positive profit at time T , an arbitrage!
(b) The actual forward price is $51.61?
Since FA = 51.61 < 52.56, the forward is too low relative to the stock. Considering the
following reverse cash and carry strategy:
(1) Short sell the stock and lend the proceeds;
(2) Buy one forward contract;
(3) Close out the forward using your loan and cover the short in stock.
The cash flow is as:
Strategy

t=0

t=T

Short sale

+50

ST

Lend

50

50e0.011 = 52.56

Buy the forward

51.61 + ST

Total

52.56 51.61 = 0.95

6. Compute the fair forward price under the same assumptions as in the previous question except
that the stock will pay a dividend of $2 five months from the date the forward contract is
negotiated. How can you make an arbitrage profit if
(a) The actual forward price FA is $51.41?
I = 2e0.055/12 = $1.96. So the fair forward price is F0 = (50 1.96)e0.051 = $50.50.
If FA = 51.41, the forward price is too high relative to the stock. Consider the following
strategy:
(1) Borrow $50 to buy one share of the security in the spot market and keep it to T ;
(2) Lend the dividend when it is received;
(3) Sell one forward contract;
(4) At T = 1, deliver the security to close out the forward to gets $51.41 and repay the
loan.
The cash flow is as follows:

Strategy

t=0

t = 5/12

t=T

Borrow

+50

Buy the spot

50

+2

ST

Lend dividend

2e0.05(15/12) = 2.06

Sell the forward

51.41 ST

Total

52.56 + 2.06 + 51.41 = 0.91

50e0.051 = 52.56

(b) The actual forward price is $49.53?

If FA = 49.53 < 50.50, the forward is too low relative to stock. Consider the following
reverse cash and carry strategy:
(1) Short sell the stock and lend the proceeds;
(2) Borrow $2 to pay the dividend in 5 months;
(3) Buy one forward contracts;
(4) Close out the forward using your loan and cover the short in stock.
Strategy

t=0

t = 5/12

t=T

Short sell

+50

ST

Lend

50

Borrow

+2

Buy the forward

49.53 + ST

Total

52.56 2.06 49.53 = 0.97

50e0.051 = 52.56
2e0.05(15/12) = 2.06

7. Compute the fair forward price for a one year forward contract under the same assumptions
as in Question 5 except that the stock is expected to provide a continuous dividend yield of
2% per year. How can you make an arbitrage profit if
(a) (a) The actual forward price is $52.60?
The fair forward price is
F0 = S0 e(rq)T = 50e(0.050.02)1 = 51.52.
If FA = 52.60 > 51.52, consider the following strategy:
(1) Borrow 50e0.021 = 49.01;
(2) Buy e0.021 shares of stock;
(3) Sell one forward contract;
(4) Close out the forward using the stock and cover the loan.
Strategy

t=0

Borrow

50e0.021 = 49.01

Buy stock

50e0.021 = 49.01

t=T
49e0.051 = 51.52
ST

Sell the forward

52.60 ST

Total

52.60 51.52 = 1.08

(b) The actual forward price is $50.05?

Since FA = 50.05 < 51.52, consider the following strategy:
(1) Short sell shares of stock and lend the proceeds;
(2) Buy one forward contract;
(3) Close out the forward using your loan and cover the short in stock.
Strategy

t=0

t=T

Short sell

50e0.021 = 49.01

ST

50e0.021 = 49.01

Lend

49.01e0.051 = 51.52

Buy the forward

ST 50.05

Total

51.52 50.05 = 1.47

8. Take the formulas for a forward (or futures, for our purposes) contract. What will happen
to the forward price around the ex-dividend day, if the underlying asset (say, a stock) was
to pay a dividend? Will the share price change, if the dividend was announced well before?
Why or why not?
Answer: On the ex-dividend day, the share price will drop by the amount of the dividend
if arbitrage is to be ruled out in the stock market. Simultaneously, the present value of the
dividend I (on the ex-date) will also drop by the amount of the dividend. As a result, the
futures or forward price will remain unchanged.
Of course, if someone argues that the futures price must drop (or rise) on any given day due
to a well-known, pre-announced dividend on the underlying (0 or any perfectly predictable
event), he should recognize that thats inconsistent with a temporal strategy of selling the
futures just before and buying it just after, leading to predictable profits with no investment.
9. Suppose the annual interest rate is 5%, compounded once a year. The IBM stock is trading
at $185. What is the fair forward price of a forward contract which calls for delivery of 1
share of IBM stock at the end of one year? Construct arbitrage portfolios and analyze cash
flows to show that this is indeed the fair forward price.
Answer: The fair forward price is
F0 = S0 erT = 185e0.051 = 194.49.
Suppose the forward price FA is greater than $194.49. Consider the following strategy:
(1) Borrow 185 to buy one share of IBM in spot market and keep it to the end of one year;
(2) Sell (short) the forward;
(3) At the end of one year, deliver the security to close out the forward and get FA .
Lets look at the cash flow:

Strategy

t=0

Borrow

185
185

Buy stock

t=T
194.49
ST

Sell the forward

FA ST

Total

FA 194.49

So we see that the above portfolio has zero net investment, risk-free, and positive return,
which means that it is an arbitrage strategy. Therefore the forward price cannot be greater
than 194.49. Similarly, we can show that it is cannot be less than 194.49. Therefore, 194.49
must be the fair forward price.
10. Consider a forward on a non-dividend paying stock whose current price is: Bid $29.875 ,
Ask $30.125, assuming 5% interest rate and one year to maturity. Is there any arbitrage
opportunity (i.e., 0 net investment and positive, risk-free return) if
(a) The actual forward price FA is 32.05?
If the actual forward price FA is 32.05, first try to sell the forward. Then since the
liability is to deliver the stock at T , we need to buy the stock at time 0. To finance this
we need to borrow. Since we have to buy at the ask, so we need to borrow 30.125. The
principal plus interest at time T would be 30.125e0.051 = 31.67. Since we are going to
get 32.05, we will be making 32.05-31.67=0.38 risk free arbitrage profit. So in this case
there is an arbitrage opportunity.
(b) The actual forward price FA is 31.50?
From (a) we know that we cannot do cash and carry to make an arbitrage profit since
the forward price 31.50 is not enough to pay back the loan of 31.67. So lets try the
reverse cash and carry strategy. Suppose we buy the forward. Then our liability would
be to pay the forward price at time T . Thus we need to short sell the stock at time 0
(at the bid). So we will have 29.875 at time 0 and will grow to 29.875e0.051 = 31.41.
But this is not sufficient to pay the forward price. So in this case there is no arbitrage
opportunity.

Homeworks for Weeks 34

1. Suppose you bought a six-month forward contract on a non-dividend paying stock on June
1. The interest rate is 5%, the stock price on June 1 was $25. Suppose today is September 1
and the stock price is $35 now. What is the value of his position?
Answer: In this case, S0 = 25, r = 0.05, T = 0.5, and t = 0.25.
On June 1, F0 = 25e0.050.5 = $25.63. The fair forward price today is
F (0.25) = 35e0.05(0.50.25) = $35.44.

So the value of his position is

f (0.25) = (35.44 25.63)e0.05(0.50.25) = $9.69.
2. As a copper tube manufacture in Singapore, you will need 50,000 lbs copper in December.
The current futures price is $0.7090 per lb. The copper futures contract size is 25,000 lbs.
(a) How would you hedge?
Buy 50, 000/25, 000 = 2 December copper futures.
(b) If the December spot price is $0.7100, what is the net cost of the hedged copper? What
if the December spot price is $0.6900?
If the December spot price is $0.7100, then you will pay $0.7100 per lb to buy copper
from the spot market, but you will gain 0.7100 0.7090 = 0.0010 from the futures
position. So the net cost is $0.7090 per lb.
If the December spot price is $0.6900, then you will pay $0.6900 per lb to buy copper
from the spot market, but you will lose 0.7090 0.6900 = $0.0190 from the futures
position. So the net cost is again $0.7090 per lb.
(c) Is the net cost with hedge always less than that without hedge?
No. In the second case, it is more than without hedge. Hedging does not always improve
outcome, but it reduces the fluctuation of outcome.
3. A wholesaler will purchase 1.5 million gallons of gasoline on November 1 in the spot market
and would like to hedge on September 1. He hedges with crude oil futures (the contract size
is 1,000 bbl). He uses historical data to compute S = $0.0505 per gallon, F = $1.6/bbl,
and = 0.95. How many contracts should he buy or sell?
Answer The optimal hedge ratio:
h = 0.95

0.0505/gallon
= 0.03bbl/gallon
1.6/bbl

He then calculates the number of futures contract as follows:

N =

0.03bbl/gallon 1, 500, 000gallan

= 45.
1, 000bbl

Therefore the optimal number of crude oil futures contract is 45.

4. Suppose that S&P 500 index value is currently at 1,605.00. The continuously compounded
rate of interest rate is 5% per year. The dividend yield is estimated at 2.25% per year. Whats
the futures price for a futures contract that matures in three months?
Answer: In this example, we have S0 = 1, 605.00, r = 0.05, q = 0.0225, and T = 0.25. So
F0 = 1, 605.00 e(0.050.0225) 1, 616.07.

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5. Consider the October futures contract on S&P 500. The multiplier for this contract is 250.
Suppose the futures price is quoted at 1,553.00. How much will a buyer of one contract lose
or gain if on the maturity day the S&P index is at (a) 1,402.00 and (2) 1,603.70?
Answer: If on the maturity day the S&P index is at 1,402.00, then the buyer in this contract
will lose
(1, 553.00 1, 402.00) 250 = 37, 750
per contract. If on the maturity day the S&P index is at 1,603.70, then the buyer in this
contract will make
(1, 603.70 1, 553.00) 250 = 12, 675
per contract.
6. Suppose on July 23, the DJIA index was at 14,650, the September futures was at 14,700, the
December one was at 14,800, and the maturity dates were 56 and 154 days away, respectively.
The risk-free rate is 5.10% (Assume there are 360 days per year).
(a) What would be the fair futures price if we assumed the dividend on the DJIA was zero
between July 23 and the time the December futures matures?
For the September futures, F0 = 14, 650e0.05156/360 = 14, 766.69. For the December
futures,
F0 = 14, 650e0.051154/360 = 14, 973.13.
(b) What is the present value of the future dividends that is embedded in the market price
of each futures contract? Ignore transaction costs in your calculations.
For the September futures, we have 14, 700 = (14, 650 I)e0.05156/360 . So the present
value of the future dividends that is embedded in the market price of this futures contract
is I = 66.16. For the December futures, we have 14, 800 = (14, 650 I)e0.051154/360 . So
I = 169.39.
7. As a portfolio manager, you have a portfolio worth $2,000,000 and decide to hedge a possible
market downturn risk with the S&P futures for 4 months. Suppose S&P 500 index is 1,500.00,
the interest rate is 6%, the dividend yield on index is 4% and the portfolio = 1.5. How
many futures contracts should the manager trade? Buy or Sell?
Answer: The current futures price is
1, 500e(0.060.04)4/12 = 1, 510.03.
The contract price is Y = 250 1, 530.30 = 377, 508.4.
So the optimal number of S&P futures contract is
1.5

2, 000, 000
= 8.
377, 508.4

You need sell 8 contracts.

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8. Suppose that on September 1, a UK firm agreed to buy 2 Boeing 747 from Boeing on December
1 at a price of $90m each. The September 1 spot exchange rate was $1.6730/. The December
futures was quoted at $1.6612/.
(a) What was the exchange rate risk that this UK firm faced?
This risk is that pound may depreciate against USD so that the firm has to pay more
in terms of pound.
(b) Should it long or short the futures in to hedge this risk? How many futures contracts
(the size of contract is 62,500)? Explain why this position serves as a hedge.
It should short the futures in pound. Since the firm needs $180m, the number of contracts
that should be sold is
180, 000, 000
1

= 1734.
62, 500
1.6612
The reason that this position is a hedge is that when pound depreciates, even though
the firm has to use more pounds to buy dollars, it is going to gain from the drop in the
pound price in its short futures position.
(c) Compute the total costs to the firm when the Dec. 1 spot exchange rate is $1.6550/ and
when the Dec. 1 spot exchange rate is $1.6705/. In which case, the total costs are
lower without hedging?
If the Dec. 1 spot exchange rate is $1.6550/, then it needs
180, 000
= 108, 761, 329.3
1.6550
to buy the airplanes, but it would gain
1734 62, 500 (1.6612 1.6550)/1.6550 = 405, 996.98.
So the total cost is 108, 355, 332.3.
If the Dec. 1 spot exchange rate is $1.6705/, then it needs
180, 000, 000
= 107, 752, 170
1.6705
to buy the airplanes, but it would be
1734 62, 500 (1.6705 .16612)
= 603, 344.81.
1.6705
So the total cost is 108, 355, 514.8. The difference
108, 355, 514.8 108, 355, 332.3 = 182.5
is due to rounding.

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