P1.T3.

Financial Markets & Products

Hull, Options, Futures & Other Derivatives

Determination of Forward and Futures Prices

Bionic Turtle FRM Video Tutorials

By David Harper, CFA FRM

1
Determination of Forward and Futures Prices

• Differentiate between investment and consumption assets.

• Define short-selling and calculate the net profit of a short sale of a dividend-paying stock.
• Describe the differences between forward and futures contracts and explain the relationship
between forward and spot prices.
• Calculate the forward price given the underlying asset’s spot price, and describe an arbitrage
argument between spot and forward prices.
• Explain the relationship between forward and futures prices.
• Calculate a forward foreign exchange rate using the interest rate parity relationship.
• Define income, storage costs, and convenience yield.
• Calculate the futures price on commodities incorporating income/storage costs and/or
convenience yields.
• Calculate, using the cost-of-carry model, forward prices where the underlying asset either does
or does not have interim cash flows.
• Describe the various delivery options available in the Futures markets and how they can
influence futures prices.
• Explain the relationship between current futures prices and expected future spot prices,
including the impact of systematic and nonsystematic risk.
• Define and interpret contango and backwardation, and explain how they relate to the cost-of-
carry model.

2
Differentiate between investment and consumption assets.

• An investment asset is held for investment purposes

by a significant number of investors; e.g., stocks, bonds
 Convenience yield must be zero.
• A consumption asset is held primarily for consumption
and confers a convenience yield; e.g., copper,
oil, pork bellies, gold, silver.
 Gold and silver (stores of value and used for
industrial applications) are examples of commodities
that are both investment and consumption assets.

Investment Assets Consumption Assets

[Theory] No-arbitrage implies Because of convenience yield,
that the forward price is a storage cost and the lease
function of the spot price and rate, the forward price is not
any dividends paid. a simple function of spot.

3
Define short-selling and calculate the net profit of a short sale
of a dividend-paying stock.

In a short sale, the investor wants to profit from a

decline in the price of the security.

• Shorting involves selling an asset that is not owned. The short-seller

borrows shares of stock from the broker to sell the shares. An investor
with a short position must pay to the broker any income, such as
dividends or interest, that would normally be received on the
securities that have been shorted.
• The short-seller purchases the shares to replace the borrowed shares,
which is known as covering the short position, and it cancels out the
short position with the stocks bought. The short-seller can experience
what is known as a short squeeze. In a short-squeeze, the contract is
open, the broker runs out of shares to borrow, and the investor is forced
to cover, i.e., close out the position.

4
Define short-selling and calculate the net profit of a short sale
of a dividend-paying stock.
In a short sale, the investor wants to profit from a decline in the price of the
security.
Example: Consider an investor who shorts 500 shares when the price per share is
$120. Suppose that a dividend of $1 per share is paid in a month’s time after the
short sale. The position is closed by buying back the shares in 2 months when the
price per share is $100. The net profit calculation is shown in the table below.

Time Short sale Calculation Cash Flow

0 Borrow shares, Sell shares + (500 * 120) + 60,000

1 Pay dividend - (500 * 1) - 500

2 Buy shares to close short - (500 * 100) - 50,000

position
Net Profit + 9,500

5
Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices.
Differences between forward and futures contracts
While both forwards and futures are agreements to buy or sell an asset in the
future (at a pre-determined price), a forward contract is traded over-the-
counter (OTC) and is not standardized.
The futures contract is traded on an exchange, and has standardized contract
specifications. The futures position is also often closed out before maturity,
rather than physically delivered.

Forward Futures
Trades over-the-counter (OTC) Trades on an exchange
Not standardized Standardized contracts
One specified delivery date Range of delivery dates
Settled at the end of a contract Settled daily
Delivery or final cash settlement usually Contract usually closed prior to
occurs maturity

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)

Notation: The following notations apply to

forward/futures contract pricing:

Time until delivery date in a forward/futures contract (in years)

Price of the underlying asset (spot price)
Today’s forward or futures price
Forward value of a contract
Delivery price
Risk-free rate—per annum with continuous compounding
Foreign risk-free interest rate
Present value of income received from asset (in dollar terms)
Dividend yield rate (in percentage terms; e.g., 2% dividend yield)
, Storage cost. = dollar cost and = cost in % terms
Convenience yield

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)
Forward price given by the Cost of Carry Model

The cost-of-carry model sets the futures price as a function of the spot
price. The futures price ( ) equals the spot price ( ) compounded at the
cost of carry ( ).
c = cost of carry

=
The cost of carry is the interest rate ( , required to finance the asset) plus
the storage cost ( / ) of the asset less any income ( / ) earned on the
asset, less any convenience yield ( ) gained by the asset.

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)
Forward price given by the Cost of Carry Model

For a non-dividend-paying investment asset (when asset has no storage

cost) the futures price is similar to forward prices. The generalized forward
price ( ) is either case (futures or forwards) is given as:

=
If the investment asset provides income (e.g., a stock that pays
dividends) in the form of interim cash flows, where which equals the
present value of the cash flows received, or in the form of dividend yields
expressed as a constant percentage of the spot price ( ), then

= − =

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)

• A foreign currency can be regarded as

an investment asset paying a known yield,
which is the foreign risk-free interest rate of and
is priced as follow.

This is known as interest rate parity (IRP) such that IRP is a version of the
cost of carry model:

( )
=

10
Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)
• For consumption assets, which have a storage
cost and produces a convenience yield:

if is the convenience yield shown as a constant percentage of the spot

price, and is the storage cost given as a constant percentage or is the
lump-sum dollar storage cost, then:

= + − or =

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)

COC contains two increasing factors (financing and storage) and two
decreasing factors (income and convenience)
• “Storage costs can be treated as negative income” – Hull

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)

In summary, the cost of carry links the spot price to the forward price:

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)

Value of a forward contract

When a forward contract is first initiated,
it has no value because immediately the
delivery price, , equals the forward price .
Only as time passes and when the forward price change does the forward
contract gain or lose value.
• A long forward contract provides a payoff at time of − with PV:

= −
• As = , the value of a long forward contract:

= −

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)

Value of a forward contract

F = −
F
F
F(t) K = −
F
F

 This equation is extended to give the value of long forward contract

with income as:

= − − = −

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)
Example:
A stock’s price today is $50.00. The stock will pay a $1.00
dividend (2%) in six months. The risk-free rate is 5.0% for all
maturities. What is the price of a (long) forward contract, , to
purchase the stock in one year?

Answer:
Forward price
= −
=[ −( ) ( . )( / )] ( . )( ) = $ .

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Describe the differences between forward and futures
contracts and explain the relationship between forward and
spot prices (continued)
Example:
A long forward contract on a non-dividend-paying stock has
three months left to maturity. The delivery price is $8 and the
stock price is $10. Also, the risk-free rate is 5%. Find the price of
the forward contract and its value at maturity.

Answer:
The forward price (because t = 0.25 or one-fourth of a year) is given by:
( %)( . ) Forward price
= = = .
And the value of the forward contract is given by:
( %)( . )
= . − = .

Forward value

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Calculate the forward price given the underlying asset’s spot
price, and describe an arbitrage argument between spot and
forward prices.

Hull's COC Examples Stock Bond Stock Asset Stock

(Sec 5.4) (Ex 5.1) (Ex 5.2) (Ex 5.3) (Ex 5.4)

Spot, S(0) $40.00 $930.00 $50.00 $25.00 $25.00

Maturity (yrs) 0.25 0.33 0.83 0.50 0.50
Interest rate 5.00% 6.00% 8.00% 10.00% 10.00%
Per annum
Storage costs, u 0.00% 0.00% 0.00% 0.00% 0.00%
Yield/Dividend, q 0.00% 0.00% 0.00% 3.96% 0.00%
Convenience, y 0.00% 0.00% 0.00% 0.00% 0.00%
Lump inc/exp $2.16
Per month
Storage costs, u 0.000% 0.000% 0.000% 0.000% 0.000%
Yield/Dividend, q 0.000% 0.000% 0.000% 0.330% 0.000%
Convenience, y 0.000% 0.000% 0.000% 0.000% 0.000%
Theoretical price, F(0) $40.50 $948.79 $51.14 $25.77 $26.28

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Calculate the forward price given the underlying asset’s spot
price, and describe an arbitrage argument between spot and
forward prices.
Hull's COC Examples Index AUD Asset Asset Asset
(Ex 5.5) (Ex 5.6) (Ex 5.8) (Ex 5.8) (Ex 5.8)

Spot, S(0) $1,300.00 $0.9800 $100.00 $100.00 $450.00

Maturity (yrs) 0.25 2.00 0.50 0.50 1.00
Interest rate 5.00% 1.00% 2.00% 2.00% 7.00%
Per annum
Storage costs, u 0.00% 0.00% 9.00% 17.00% 0.00%
Yield/Dividend, q 1.00% 3.00% 0.00% 0.00% 0.00%
Convenience, y 0.00% 0.00% 0.00% 0.00% 0.00%
Lump inc/exp ($1.86)
Per month
Storage costs, u 0.000% 0.000% 0.750% 1.417% 0.000%
Yield/Dividend, q 0.083% 0.250% 0.000% 0.000% 0.000%
Convenience, y 0.000% 0.000% 0.000% 0.000% 0.000%
Theoretical price, F(0) $1,313.07 $0.94 $105.654 $109.966 $484.63

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Calculate the forward price given the underlying asset’s spot
price, and describe an arbitrage argument between spot and
forward prices (continued)

From the spot forward relationship

equations discussed in the previous
section, the forward prices as shown in
the above table are calculated as:

20
Calculate the forward price given the underlying asset’s spot
price, and describe an arbitrage argument between spot and
forward prices (continued)
Arbitrage argument between spot and forward prices
Consider a long forward contract to purchase a non-dividend-paying stock in 3
months. If the stock price is $40 and risk-free interest rate is 5% per annum, then its
(theoretical) forward price should be 40 ( % ∗ / ) = $40.50.
If the forward prices vary from this value, then arbitrage opportunities arise, which
can be exploited to earn a riskless profit as shown in the two scenarios below.

Forward Price = $43 Forward Price = $39

Action now: Action now:
 Borrow $40 at 5% for 3 months to  Short 1 unit of asset to realize $40
buy one unit of asset and invest it at 5% for 3 months

 Enter into forward contract to sell
asset in 3 months for $43
Action in 3 months:
 Sell asset for $43
 Use $40.50 to repay loan with
interest
Profit realized = $1.50
 Enter into a forward contract to buy
asset in 3 months for $39
Action in 3 months:
 Buy asset for $39 to cover short
position
 Receive $40.50 from investment
Profit realized = $1.50

Cash and carry Reverse C&C 21

Explain the relationship between forward and futures
prices.

If the risk-free rate, , is constant across all

maturities, then the forward price should equal
the futures price (forward = futures price).
When asset price increases, an investor who holds a long futures
position makes an immediate gain because of the daily settlement
procedure. Also, if the interest rates are higher, the gain will tend to be
invested at a higher than average rate of interest. Therefore, when there is
a correlation between the underlying asset (S) and interest rates,
 If the correlation is strongly positive: futures > forward:
 If the correlation is strongly negative: futures < forward

22
Calculate a forward foreign exchange rate using the
interest rate parity relationship.

Consider a forward foreign currency contract from the perspective of a US

investor. The underlying asset is one unit of the foreign currency. Let be
the current spot price in dollars of one unit of the foreign currency and the
forward or futures price in dollars of one unit of the foreign currency. 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,
while the dollar risk-free rate is . If an individual starts with 1,000 units of
foreign currency, there are two ways it can be converted to dollars at future
time :
• One is by investing it for years at and
entering into a forward contract to sell the
proceeds for dollars at time . This
generates 1,000 dollars.
• The other is by exchanging the foreign
currency for dollars in the spot market
and investing the proceeds for years at
rate . This generates 1,000 dollars.

23
Calculate a forward foreign exchange rate using the
interest rate parity relationship (continued)

In the absence of arbitrage, the two strategies must give the same result.
, = ,

Such that the interest rate parity relationship is implied: =

1000 Units of
foreign currency
at time zero

Units of foreign
dollars at time
currency at time
zero
zero

dollars at time T dollars at time T

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Calculate a forward foreign exchange rate using the
interest rate parity relationship (continued)
This XLS on next page
Hull Example 5.6:
Suppose that the 2-year interest rates in
Australia and the US are 3.0% and 1.0%,
respectively, and the spot exchange rate
between the Australian dollar (AUD) and
the US dollar (USD) is 0.980 USD per AUD.
According to the interest rate parity(IRP)
relationship, the forward exchange rate
should be:
( . . )×
= = .
= .

In the absence of arbitrage opportunities,

the two strategies must be equal

1,000 = 1,000 

1000 × 0.9416 . × = 1000 ×

0.98 . ×  $999.80 = $999.80

25
Calculate a forward foreign exchange rate using the
interest rate parity relationship (continued)
Quote Currency USD
Hull Example 5.6: Base Currency AUD
Spot FX AUD/USD 0.98000 ie, 0.98000 USD per AUD
= Start with 1,000 units of AUD
( . . )× Period (maturity) of 2.0 years
= .
= . Invest at r(AUD) for period, Exchange now to USD
convert to USD w/ forward then invest at r(USD)
Time Zero, T + 0 AUD 1,000.00 USD 980.00
↓ ↓ ↓
AUD rate: USD rate:
Interest rates 3.00% 1.00%
↓ AUD 1,061.84

→
Time + 2.0 years 0.94157 F0 = S0 *exp[(rUSD-rAUD)*T] ↓
USD 999.80 ← F 0 solves to equate → USD 999.80

Mis-priced F(0)? 0.9300 0.9600

Borrow AUD 1,000.00 USD 1,000.00
Convert USD 980.00 AUD 1,020.41
Invest USD 1.00% AUD 3.00%
Grows to USD 999.80 AUD 1,083.51
Payoff Loan AUD 1,061.84 USD 1,020.20
Forward contract USD 987.51 USD 1,040.17
Riskless profit USD 12.29 USD 19.97
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Calculate a forward foreign exchange rate using the
interest rate parity relationship (continued)
Skipped in video (accompanies next slide)
In case forward exchange rate rates vary from 0.9416, arbitrage
opportunities arise. If the 2-year forward exchange rate is less than
this, say 0.9300 to illustrate, an arbitrageur can
• Borrow 1,000 AUD at 3% per annum for 2 years, convert it to
$980(1000 × 0.98) and invest it at 1%. It grows to $999.80 (=
980 . × ) in 2 years.
• Out of this amount, to repay principal and interest on the 1,000 AUD
that is borrowed (1,061.84 = 1000 . × ), $987.51 is used to enter in
to a forward contract to buy 1,061.84 AUD ($987.51 = 1,061.84 ×
0.93). The strategy generates a riskless profit of $12.29 (=999.80 −
987.51).
Instead, if the 2-year forward exchange rate is greater than this, say 0.9600, she can:
• Borrow $1,000 at 1% per annum for 2 years, convert it to 1020.41 AUD (1000/ 0.98) and
. ×
invest it at 3%. It grows to 1083.51 AUD (= 1020.41 ) in 2 years.
. ×
• To repay principal and interest on the borrowed $1,000 (1,020.20 = 1000 ), enter
into forward contract to sell 1083.51 AUD for $1040.17 (1,083.51 × 0.96). The strategy
gives rise to a riskless profit of $19.97 (=1040.17 − 1,020.20).

27
Define income, storage costs, and convenience yield.

• Income refers to the cash that a commodity pays to the owner

(holder) of the asset; the party who is long the futures or forward
contract forgoes the income. Examples include stocks paying known
dividends, coupon-bearing bonds, gold providing interest income.

• Storage costs are the costs incurred to store or carry

the asset; storage costs are typically associated with
physical commodities.
• Convenience yield reflects the “excess benefits” conferred by taking physical
ownership of the asset
• The convenience yield is generally not relevant for financial assets. But for
commodities (physical assets), ownership may confer positive benefits or
may decrease perceived risk.
• The convenience yield is the “plug variable” that validates the cost of carry
model. The convenience yield impounds benefits of holding/owning the
physical asset. This includes any real optimality benefits of commodity
ownership

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Calculate the futures price on commodities incorporating
income/storage costs and/or convenience yields.

The futures price for a commodity with income/storage costs can be

given as:
or
= +U− =

The futures price of commodity with convenience yield can be given

as:
=

The futures price of a commodity with income, storage costs and

convenience yields can be given as:
( ) or
= +U− =

Storage costs is economically like negative (-) income while convenience

yield is treated as income/dividend.

29
Calculate the futures price on commodities incorporating
income/storage costs and/or convenience yields (cont.)

Example: For calculation of futures price on commodity with storage cost

refer to Ex 5.8 in the prior exhibit which displays all the cost-of-carry
examples together. In this example, it costs $2 per unit to store the asset,
with the payment being made at the end of the year.
• Investment requires lump sum storage outlay of $2 in 12 months (at the
rate of 7%). PV of storage cost is:
%∗ ⁄
($2) ∗ = $1.865.
• Using = +U ,
%∗
$484.63 = 450 + 1.865

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Calculate, using the cost-of-carry model, forward prices where
the underlying asset either does or does not have interim
cash flows.

For calculation of forward prices for an

underlying asset with or without interim cash
flows refer to the prior exhibit which displays
all the cost-of-carry examples together.

In particular, for an asset with interim cash flow, refer to Hull’s Ex 5.2. Here
dividends of $0.75 per share are expected after 3 months, 6 months, and 9
months. The present value of the dividends, is therefore:

= 0.75 %∗ / + 0.75 %∗ / + 0.75 %∗ / = 2.162

Then as shown in the table, the forward price is calculated as:

%∗ .
= − → (50 − 2.162) = $51.14

31
Describe the various delivery options available in the Futures
markets and how they can influence futures prices.

Although a forward contract typically specifies the day of delivery,

futures contract often allows the short to choose to deliver at any time
during a certain period.
 If the futures price is an increasing
function of time to maturity, the short
should deliver as early as possible.
This is because the interest earned
on the cash received outweighs the
benefits of holding the asset. (And
for modeling purposes, here we
assume delivery at beginning of
period.)
 If the futures price is a decreasing
function of time to maturity, the short
should deliver as late as possible as
the reverse is true. (And for modeling
purposes, here we assume delivery
at end of period.)
32
Explain the relationship between current futures prices and
expected future spot prices, including the impact of systematic
and nonsystematic risk.

“Normal backwardation” and “normal contango” refer to an unobserved

relationship between the spot price and the expected future spot price.

Normal contango

The forward/futures price is greater than the expected future spot price:
> (note the curve may or may not be inverted!).

Normal backwardation

The forward/futures price is less than the expected future spot price: <
. (again, the curve may or may not be inverted!).
A classic model predicts normal backwardation (i.e., compensation to the
long forward position) during contango (i.e., positive cost of carry).

33
Explain the relationship between current futures prices and
expected future spot prices, including the impact of systematic
and nonsystematic risk (continued)

The theory of normal backwardation assumes that hedgers tend to be

net short and speculators tend to be net long.
The futures price will fall below the expected future spot price. Normal backwardation
is expected under this theory because the long forward position (the speculator)
expects more than a zero profit, so the long must expect > , . The expected
positive non-zero profit, − , , is the compensation for bearing systemic risk.

If, instead, hedgers are net long and speculators are net short, futures prices will be
greater than expected future spot prices and this is known as normal contango.

34
Explain the relationship between current futures prices and
expected future spot prices, including the impact of systematic
and nonsystematic risk (continued)
The impact of systemic and non-systemic risk
The futures price today is a function of the expected spot price at the end of the
contract:

= ( )
where k is the expected or required return: = + ∗

Relationship of
Relationship of expected futures price to
Underlying asset return to risk-free rate expected future spot price
No systematic risk k=r = ( )
Positive systematic risk k>r < ( )
Negative systematic risk k<r > ( )

If the investment has positive systematic risk, the future price should be less
than the expected future spot price: the long position expects compensation for
the assumption of systemic risk!

35
Define and interpret contango and backwardation, and
explain how they relate to the cost-of-carry model.

Contango refers to an upward-sloping (“normal”) forward curve: long-term forward

prices are greater than near-term forward prices (and the spot price).

Backwardation refers to an inverted forward curve: long-term forward prices are less
than near-term forward prices (and the spot price).
• Contango and backwardation describe the shape of an observed forward curve.
• Backwardation (inverted forward curve) may occur when convenience yield is
greater than the interest rate (or greater than interest rate plus the storage costs):

36
The End

P1.T3. Financial Markets & Products

Hull, Options, Futures & Other Derivatives, 9th Edition

Determination of Forward and Futures Prices

37