Forward Anf Futures Prices PDF

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Oct. 3, 2008
FORWARDS AND FUTURES
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Initially, we will assume that a forward and futures contract is the same thing. Both are
contracts where a buyer agrees to buy and a seller agrees to sell at a set price on a future date.
The key is that the price for exchange is set today and represents a fair price for both the seller
and the buyer. An example of such a contract would be a situation where a farmer (sell) and a
cereal producer (buy) agree to exchange 1,000 bushels of corn at $2.54/bushel six months from
today. The farmer and the producer both lock in a fixed price for exchange in six months.
Without this type of contract, neither the farmer nor the producer could lock in prices today for
future delivery.
The result is that there is a set of prices in the market for commodities with different
delivery dates. There is the cash (spot) price, which is the price for delivery today; on December
23, 2006, the cash price for a bushel of oats was $2.22. In addition, there is the price for delivery
in 30 days or 90 days. All those prices would be different. For example, on December 23, 2006,
the futures prices per bushel for oats on the Chicago Board of Trade were as shown in Figure 1:
Figure 1. Futures prices per bushel for oats.
Price
$2.0425
1.9500
1.7600
1.5500
1.5600
1.5800
No
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Delivery Date
March 2007
May 2007
July 2007
September 2007
December 2007
March 2008
Do
Each of those prices represents the market-clearing price today for payment and delivery of oats
at some future date.
This technical note was prepared by Professor Robert M. Conroy. Copyright 2007 by the University of Virginia
Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.
This document is authorized for use only by Nalini Tripathy until July 2010. Copying or posting is an infringement of
copyright. Permissions@hbsp.harvard.edu or 617.783.7860.
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Relationship between Spot Prices and Future/Forward Prices

Financial assets: no income
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Cash prices and futures/forward prices are different; however, an important question is
how are those prices related? The simplest example is to consider a share of firm XYZs stock,
which currently sells for $75 per share. Assume there is an investor who wishes to own a share
of stock three months from now. This investor can enter into a futures contract to buy the stock
at the futures/forward price in three months. The result would be that the investor would pay the
fixed price in three months and receive one share of the stock. Today alternatively, the investor
could borrow $75 for three months,1 buy one share, hold it for three months, and then repay the
r T
loan of $75 plus accrued interest in three months, $75 e f . We will refer to this as the borrow
buyholdrepay alternative. In either case, the investor would pay and own the stock in three
months. Assuming that the risk-free rate is 6%, the relationship between the current stock price
and the futures/forward price would be as shown in Equation 1:
FT S 0 e
or
r f T
$75 e.06.25
(1)
FT $76.133 5
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Since buying a share of stock at S0 and simultaneously entering into a futures contract to
sell a share of stock at the futures/forward price, FT, results in a risk-less profit, FT S0. Since the
payoff is risk-less, an investor should earn the risk-free rate of return, rf, on this investment. This
r T
is exactly what the relationship, FT S 0 e f is meant to capture.
No
What if this relationship did not hold? For example, what is the effect if the
futures/forward price is not $76.1335? If the quoted three-month futures/forward price were not
$76.1335 but rather $77.0000, it would be possible to buy the stock for $75 and simultaneously
agree to sell the stock in three months at the futures/forward price of $77. The trader would earn
approximately 10.53% on this set of transactions,2 which is more than the risk-free rate of return.
This would represent an arbitrage opportunity.
Do
For simplicity, let us assume that the investor can borrow at the risk-free rate, rf. Assuming continuous
compounding, the principal and interest due at the end of three months would be:
2
$75 e
r f T
$75 e
r f .25
The investor buys the stock at $75 and with certainty receives $77 for it in three months. The return is:
$75 e R.25 $77

77
R ln 4 10.53%
75
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Alternatively, if the futures/forward price was $76, an investor could sell the stock short,
collect $75, and agree to buy the stock at $76. If investors invested the $75 at the risk-free rate
for three months, they would have $76.1335. If they bought the stock back at $76, they would be
able to realize an arbitrage profit of $0.1335. Hence, if the futures/forward price were either $77
or $76, traders would very quickly trade until the futures/forward price was once again $76.1335.
Financial assets with income (dividends)
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Consider the same example discussed above, but now the stock pays a dividend of $1.00
in two months. Again, we wish to own and pay for the stock in three months. One alternative is
to enter into a futures/forward contract with a price of FT. Alternatively, we could borrow $75 for
three months today, buy the stock, and hold it for three months. If we own the stock, we get the
$1.00 dividend in two months. In order to keep everything on the same timing, we assume that
we invest the $1.00 dividend at the risk-free rate, rf, for one month. We can use the proceeds
from the invested dividend to offset what we owe on the loan. The relationship between the
borrowbuyholdrepay strategies and taking the buy side of a futures/forward contract must
satisfy the following shown in Equation 2:
FT S 0 e
rf 3
12
FT $75.00 e
Dividend e
.06 3
12
rf 1
12
$1.00 e
.06 1
12
(2)
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FT $75.1285
It is common to express the relationship between the futures/forward price and the spot price as:
FT S 0 I 0 e
r f T
r t
No
Where I0 is the present value of the dividend, I 0 Dividend e f D and tD is the time to the
dividend ex-date. This is equivalent to the expression in this note.3 I personally prefer the basic
approach used in this note, because it more clearly reflects the physical actions that define the
arbitrage relationship between futures/forward prices and spot prices.
The relationship is as follows:
Do
FT S 0 e
rf 3
12
Dividend e
rf 1
12
FT S 0 e
rf 3
12
Dividend e
rf 1
12
r f 3
12
FT ( S 0 Dividend e
rf 1
12
FT ( S 0 Dividend e
r f ( 1 3 )
12 12
)e
FT ( S 0 Dividend e
r f 2
rf 3
12
12
)e
rf 3
12
)e
rf 3
12
rf 3
12
rf 3
12
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Above we assumed a single dividend. If the underlying asset was not a stock, but rather a
stock index, it is easier to think in terms of a dividend yield, q, than to deal with individual
dividends. In this case, we can think of the dividend yield as a reverse interest rate. In the
borrowbuyholdrepay strategy, the interest rate continuously accrues over time. If we assume
a continuous dividend, it offsets the interest costs. As such, for stock indexes with a dividend
yield, q, the relationship between the spot value of the index and the futures/forward prices is as
follows in Equation 3:
FT S 0 e
( r f q )T
(3)
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Foreign currency futures/forward prices
The relationship between currency spot rates and futures/forward rates is based on
interest rate parity. It should not be possible to earn more than the domestic risk-free rate of
return by doing the following:
Exchanging into a foreign currency at todays current spot rate;
Entering into an agreement to exchange at todays futures/forward rate;
Investing foreign currency at todays foreign interest rate;
Exchanging back to the domestic currency at maturity at the futures/forward rate.
No
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As an example, consider an investor in British pounds. Her investment horizon is five

months and risk-free pound-denominated investments are yielding 6%. Alternatively, she could
exchange one pound () for Japanese yen () at the current exchange rate of 177/1, invest at
the yen risk-free rate of 1%, and agree to exchange in five months at the current futures/forward
rate, F. At maturity, she would exchange the yen back into pounds at the futures/forward rate.
In order for no-arbitrage opportunities, the relationship between the current spot rate, S, and the
futures/forward, F, rate must satisfy (Equation 4):
1
1 e rf T S e rf T
F
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Expressing everything in terms of F yields:
F S e rf T e -rf T
F S e ( rf
rf )T
(4)
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For the values in the example, the futures/forward rate should be (Equation 5):
F S e rf T e -rf T
F S e ( rf
rf )T
F 177 e
(.01.06 ) 5
12
F 173.35
(5)
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From this, we can see the usual result that if the Japanese risk-free rate is less than the British
pound rate, the futures/forward exchange rate will be less than the current spot exchange rate. A
yen investor, who invests in British pounds to get the higher rate, has the higher interest rate
offset by getting fewer yen back at maturity.
Commodities futures/forward prices
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Commodity futures/forward prices are quite different from those for the financial assets
that we have examined so far. Commodities are physical assets that have to be stored, can be
consumed, and deteriorate over time. In addition, unlike financial assets, commodity prices are
affected by changes in supply. For agricultural commodities, the supply changes with the harvest
cycle. Exhibit 1 shows the average monthly prices by month for corn. In addition, it also shows
the ratio of the monthly price to Januarys price for each month.4 It is apparent that there is a
cycle for corn prices. The prices are the lowest during the month of October immediately
following the harvest. This cycle does affect futures/forward prices for commodities in a way
that we do not see in financial assets. In the sections that follow, we will ignore this price cycle.
However, it does cause problems with establishing the no-arbitrage pricing relationships that we
used with financial assets.
No
Once again, we will compare the borrowbuyholdrepay alternative to entering into a

futures/forward contract. Lets consider you wish to own 1,000 bushels of corn in five months.
You can enter into a futures/forward contract to exchange (buy) at a fixed price FT in five
months. Alternatively, you can adopt a borrowbuyholdrepay strategy. In the case of
commodities, it is a bit more complicated to implement this strategy than it is for financial assets.
The reason is that buying and holding a physical commodity entails storing it. Storing 1,000
shares of stock is not a big problem, but storing 1,000 bushels of corn is. Hence, we have to
consider the cost of storage in the borrowbuyholdrepay strategy.
Do
Assume that the current spot price for corn is $1.96/bushel, the risk-free rate is 5%, and
the cost of storage is $0.05 per bushel per month, which must be paid up front. The borrowbuy
4
The average price relative for each month is calculated as I t
Pt
t 1,..,12 . These are then averaged
Pt 1
for each month over the full 22-year period.
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holdrepay strategy would entail the purchase of 1,000 bushels for $1,960, and a storage cost of
$250 ($0.05 1,000 5 months) for a total investment of $2,210. Hence, we would borrow
$2,210, purchase the corn, and pay for storage. In five months with the futures contract, we
would have to pay FT. In the borrowbuyholdrepay strategy, we would
repay $2,210 e 12 $2,256.53 . For no arbitrage, the relationship between the spot and
futures/forward price must be (Equation 6):
.05 5
FT S 0 storage e
r f T
$2,210 e
.05 5
12
$2,256.53
(6)
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FT $2.25653 per bushel.
In the analysis above, we incorporated storage costs. Another issue for commodities that
is not relevant for financial assets is spoilage. For most agriculture commodities, what you put
into storage is not what you take out. In this case, in order to borrowbuyholdrepay you have
to put more into storage than you plan to take out. In the corn example, if the spoilage rate over
five months is 3%, i.e., 100 bushels placed into storage results in 97 bushels in five months, we
need to start with more than 1,000 bushels. With a spoilage rate of 3%, we need to put
1,000.00
1,030.93 bushels into storage in order to get 1,000.00 bushels out in five months. If
.97
we consider storage costs and spoilage, the futures/forward price should satisfy:
1,000
.05 5
(1.96 .05 5) e 12 $2,326.32
.97
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FT
$2.32631 per bushel.
Convenience yield
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No
We have assumed that using futures/forward contracts is a perfect substitute for the
borrowbuyholdrepay strategy. In the case of commodities, this is not necessarily true. Actual
ownership of the commodity may be more attractive than using futures/forward contracts. As
such, there could be reluctance on the part of holders of the commodity to sell and replace the
holdings with futures/forward contracts. Consider a situation where a refinery holds an inventory
of oil for future use, and assume that there is no loss in storage. If FT is less than the no-arbitrage
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price, FT S 0 storage e f , the holder of the inventory could sell at spot, and save storage
costs and contract to buy back at FT. This should result in an arbitrage profit. Often however,
holders of inventory may be unwilling to sell and replace the inventory with futures/forward
contracts. Holding the inventory has value. Consequently, it is often the case for commodities
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that FT is less than the no-arbitrage price. This apparent violation of the no-arbitrage rule is
referred to as a convenience yield,5 y (Equation 7).
S 0 storage e r T
f
FT y
Cost of carry
(7)
For commodities, the storage costs and spoilage is sometimes expressed as a continuous
yield. Lets use for the storage costs and use as the spoilage rate. This yields a relationship
between the spot price and the futures/forward price as shown in Equation 8:
r f T
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FT S 0 e
(8)
The exponent r f is sometimes referred to as the cost of carry, c, and the relationship
between the futures/forward price and the spot price is expressed as Equation 9.
FT S 0 e cT
(9)
For commodities, the convenience yield is incorporated as follows (Equation 10):
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FT S 0 e c y T
(10)
It is common for the convenience yield to exceed the cost of carry. A good example of this is
found in the futures prices for oats at the beginning of this note.
Futures/forward prices and the expected spot rate
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No
One interpretation of the futures/forward price is to say that it is the expected future spot
price, FT E ( ST ). For example, if the current three-month futures/forward price for oil is $26
per barrel, it is tempting to say that this must be the expected spot price three months from now.
In general, this is not true. First, it cannot be true for financial assets. Assume that we have a
stock price of $75, a risk-free rate of 6%, and a maturity of three months, the no-arbitrage
futures/forward price would be:
FT S 0 e
r f T
$75 e.06.25 $76.133
Convenience yield is sometimes also expressed as the rate, y, that satisfies:
FT e yT S 0 storage e
r f T
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If FT E ( ST ) $76.133, then an investor who purchased the stock today would have an
expected return:
S 0 e E RT T E ( ST )
e E RT T
E ( ST )
S0
S 0 e rf T
ln
S
0
rf T
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E ( ST )
F
ln T
E ( RT ) T ln
S0
S0
E ( RT ) r f
Since buying the stock is risky,6 it cannot be the case that E ( RT ) r f and as such for financial
assets FT E ( ST ).
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For commodities, it is possible that the Beta of the commodity, i.e., its market risk, is
zero. Hence for commodities,7 it is possible for FT E ( ST ) . However, even if commodities have
zero market risk, it does not have to be an equality. If, for example, farmers were taking the sell
side of futures/forwards contracts as insurance, then they may be willing to accept FT E ( ST ) .
This condition is refereed to as backwardation.
No
Alternatively, if users of the commodity, such as the General Mills of the world, were the
primary users of futures/forwards, they might be willing to accept FT E ( ST ) . This, in turn, is
referred to as contango. The result is that the question of the relationship between
futures/forward prices and the expected spot rate is an empirical question. Basically, the
empirical results are mixed. There is some evidence to support FT E ( ST ) for commodities, but
it is not conclusive.
Futures verses forward prices
Futures and forward prices refer to different types of contracts. A forward contract is
usually a specific agreement between two parties. The terms are specific to the needs of each
party and any cash settlement of the contract takes place on the maturity date. Futures contracts
6
Do
Risky, in this case, refers to market risk. From the capital asset pricing model (CAPM), the expected return on
an asset must satisfy:
E ( RT ) r f Beta E RM r f .
As such, for assets with a Beta > 0, E ( RT ) r f .

7
If Beta = 0, then E ( RT ) r f 0 E RM r f
. , and E ( R ) r .
T
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on the other hand are traded on formal exchanges, such as the Chicago Board of Trade, the
Chicago Mercantile Exchange, or the London Metals Exchange. These contracts are
standardized. (See Exhibit 2 for an example of the futures contract for corn.) All the terms of the
contracts that mature in December, or any other month, are the same. An important difference
between a futures contract and a forward contract is that a futures contract is marked to market
on a daily basis. What this means is that unlike a forward contract, which is settled at maturity, a
futures contract is settled on a daily basis.
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An example is the easiest way to see how this works. Assume that a person on the buy
side and a person on the sell side agree today to exchange corn in July at a price of $2.41 per
bushel. The next day the futures price for July delivery drops to $2.32/bushel. The daily
settlement involves the buy side paying the sell side $0.09/bushel and the contract for July
delivery is rewritten with a price of $2.32/bushel. The next day, the price jumps back up to
$2.40/bushel for July delivery. Now the sell side pays the buy side $0.08/bushel, and the contract
is rewritten once again at a price of $2.40/bushel. This daily cash settlement goes on over the life
of the contract.
Exhibit 3 shows the different pattern of cash flows for a futures contract and a forward
contract. While the total cash flow payments are the same, the marking to market feature of the
futures contract results in interim cash payments between the buy side and the sell side.
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Given that the terms of the forward contract and the futures contract are different, it is
reasonable to ask if the quoted prices for each contract would be the same. The answer to this
question is not clear. Each of the contracts has advantages and disadvantages. The net result is
that it comes down to a simple empirical question of whether we observe systematic differences
between the prices offered under each contract. The evidence is that there is not a systematic
difference in forward and futures prices. As such for the remainder of the course, we will refer to
futures and forward prices interchangeably. However, it is important to remember that they do
refer to different types of contracts.
No
Value of futures and forward contracts
Do
The value of a futures or forward contract at the time it is accepted by the buy side and
the sell side is zero. No money changes hands at the point in time when the contract is written.8
Immediately after that point, however, the futures or forward contract can have value. If the
original contract was for July delivery and the agreed-upon price was $2.42, immediately after
this time if the price for delivery in December changes, the right to buy or sell at $2.42 will have
value. Suppose at the end of the day the price increases to $2.50. The value of the original
futures contract is easy. For the buyer it is $0.08 ($2.50$2.42). Since it is marked to market, the
buy side collects the difference, and the contract is rewritten at $2.50.
In this case, written refers to the point in time that the buy side and sell side agree on a price for exchange.
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A forward contract, on the other hand, is not cash settled at the end of the day. Hence, the
value of the forward contract is different. In order to realize the value, the buy side would have to
take the sell side of a July contract with a price of $2.50. Here the individual would have the
right in July to buy at $2.42 and to sell at $2.50. The difference is $0.08/bushel, but this would
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only be realized in July. Hence the value of the forward contract would be $2.50 $2.42 e f
or just the present value of the $0.08.
Summary
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The basic relationship between the futures/forward prices, which mature at time T, and
spot prices is:
FT S 0 e
r f T
This is derived from the no-arbitrage condition that using a futures contract is the same as
a strategy that involves borrowing, buying, holding, and repaying. We can use this condition to
derive a no-arbitrage relationship between futures/forward prices and spot price for any financial
asset.
Do
No
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For commodities, we can do the same thing, but we need to include the effects of actually
holding the physical asset. This means that we must include the storage costs and potential
spoilage. By incorporating these additional factors, we can derive a no-arbitrage pricing
relationship for commodities. However, for commodities, the price cycle and the value of
actually holding the underlying asset are also important factors, which cause the no-arbitrage
condition to be consistently violated when we examine actual futures/forward prices in the
market.
Exhibit 1
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Do
No
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Average Corn Cash Prices by Month

(monthly averages for 1980 through 2006)
Exhibit 2
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Futures Contract Specifications

Corn Futures
Contract size
5,000 bu.
Tick size
1/4 cent/bu. ($12.50/contract).
Price quote
Cents and 1/4 cents/bu.
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Deliverable grades
No. 2 yellow at par, no. 1 yellow at 1-1/2 cents per bushel over contract price, no. 3 yellow at 1-1/2 cents per bushel
under contract price.
Contract months
December, March, May, July, September.
Last trading day

The business day prior to the 15th calendar day of the contract month.
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Last delivery day

Second business day following the last trading day of the delivery month.
Trading hours
Open outcry: 9:30 a.m.1:15 p.m. Chicago time, Mon.Fri.
Electronic (a/c/eSM): 8:30 p.m.6:00 a.m. Chicago time, Sun.Fri.
Trading in expiring contracts closes at noon on the last trading day.
No
Ticker symbols
Open Outcry: C
Electronic (a/c/e): ZC
Do
Daily price limit

20 cents/bu. ($1,000/contract) above or below the previous days settlement price. No limit in the spot month (limits
are lifted two business days before the spot month begins).
Exhibit 3
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Cash flow for futures and forwards.
Futures Price
$2.32
$2.40
$2.45
$2.49
$2.55
$2.62
$2.57
$2.53
$2.50
$2.55
Total
Cash Flow
Futures Forward
$(0.09)
$ 0.08
$ 0.05
$ 0.04
$ 0.06
$ 0.07
$(0.05)
$(0.04)
$(0.03)
$ 0.05 $0.14
$0.14
$0.14
Do
No
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Days
1
2
3
4
5
6
7
8
9
10
Beginning price
Buy-Side
Futures Forward
$2.41
$2.41

Forward Anf Futures Prices PDF

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FORWARDS AND FUTURES

Relationship between Spot Prices and Future/Forward Prices

$75 e R.25 $77

Foreign currency futures/forward prices

Exchanging into a foreign currency at todays current spot rate;

Entering into an agreement to exchange at todays futures/forward rate;

Investing foreign currency at todays foreign interest rate;

Exchanging back to the domestic currency at maturity at the futures/forward rate.

As an example, consider an investor in British pounds. Her investment horizon is five

Expressing everything in terms of F yields:

Once again, we will compare the borrowbuyholdrepay alternative to entering into a

The average price relative for each month is calculated as I t

for each month over the full 22-year period.

FT $2.25653 per bushel.

$2.32631 per bushel.

For commodities, the convenience yield is incorporated as follows (Equation 10):

$75 e.06.25 $76.133

Convenience yield is sometimes also expressed as the rate, y, that satisfies:

As such, for assets with a Beta > 0, E ( RT ) r f .

Value of futures and forward contracts

FORWARDS AND FUTURES

Average Corn Cash Prices by Month

FORWARDS AND FUTURES

Futures Contract Specifications

Last trading day

Last delivery day

Daily price limit

FORWARDS AND FUTURES

Cash flow for futures and forwards.

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