Financial Derivatives

Prof. Scott Joslin

USC Marshall

FBE 459
Spring 2020
Outline of the Lecture

Determining Futures and Forwards Prices

Readings:
Hull Chapter 3 and 5

c USC 1/1
Example (Review)

Consider a 3-month forward contract for 10,000 bushels of soybean

at a forward price of $3.5/bushel. The long side is committed to
buy 10,000 bushels of soybean from the short side three months
from now at the price of $3.50/bushel.

c USC 2/1
Payoff from Forward Contract

$10000

$5000
Payoff of Forward

−$5000

−$10000
$2.50 $3.00 $3.50 $4.00 $4.50
Soybean Price at Expiration

c USC 3/1
Determining Futures/Forward Prices

We know the payoff, which is risky. How to determine the price?

In our first finance class, we used the equation

E [payoff]
price =
1+r

r is the cost of capital

the discount rate for equivalently risky cash flows in the market

But how to figure out what r is right?

And how to figure out E [payoff]?
Our Method
We will compute prices by no arbitrage. Only one price will
guarantee absence of arbitrage.

c USC 4/1
General Question
What determines forward and futures prices?

Answer: Forward/futures prices are linked to spot prices.

Contract Spot at t Forward Futures

Price St F H

Ignoring differences between forwards and futures, we have

F ' H.

Two ways to buy the underlying for date T :

1 Buy forward or futures contract of maturity T .
2 Buy the underlying now and store it until T .

c USC 5/1
Difference between buy-and-store from forward/futures:
a. Cost of storing (for commodities).
b. Benefits from storing:
Convenience yield (for commodities).
Dividends/interests (for financials).

c USC 6/1
Example 1 (No benefit/cost to store)

Gold.
Easy to store—negligible cost of storage.
No dividends or benefits.

Two ways to buy gold for T :

Buy now for S0 and hold until T .
Pay for this by taking a loan of S0
Requires paying back S0 (1 + rF )T at time T .
Buy forward, pay F and take delivery at T .

No-arbitrage requires that

F = S0 (1 + rF )T ' H.

c USC 7/1
Example 2 (cost to storing, but no benefit)

Consider a forward contract on a commodity that has costly

storage but offers no benefits for owning. Suppose that:
the spot price is $100/unit
To store the commodity for one year costs $2/unit with $1
due after 6 months and $1 due at end of year
The term structure is flat at 4% APR, compounded
semi-annually

What should the forward price of the commodity be?

c USC 8/1
Example 2 (continued)

The price to pay now in order to own the commodity in 1 year is

$1 $1
$100 + + = $101.94.
1.02 1.022
The future value (FV) is

$100 × 1.022 + $1 × (1.02) + $1 = $106.06.

So the forward price should be $106.06.

c USC 9/1
Example 3 (benefit to owning)

For financial futures, the underlying are financial assets. Financials

have the following features:
No cost to store (the underlying asset).
Dividend or interest on the underlying.

c USC 10/1
Example 3 (benefit to owning)

Stock index futures.

Underlying are bundles of stocks — S&P, Nikkei, etc.
Futures settled in cash (no delivery).

Let the dividend yield be d, then there is the following

relation between the forward/futures price and spot price:

F ≈ S0 (1 + r − d)T ' H.

or sometimes we may use

F = S0 (1 + r )T − FV (benefits to holding asset)

We will see this through an example.

Deviations from this relation triggers index arbitrage.

c USC 11/1
Example 3 (continued)

Prices on January 23, 2013:

S&P 500 closed at 1,495.
Suppose that the 1-year period rate is 1%
Suppose that the dividend yield is 2%.

What is the futures price for settlement on January 23, 2014?

c USC 12/1
First Solution to Example 3

First, let’s assume that the dividend is paid out as a lump sum at
the end of one year.
That is, the dividend is $1495 × 0.02 = $29.90/share

In this case we can

1 Buy 1 share for $1495.
2 Borrow $1495 for one year and repay

1495(1 + 0.01) = $1509.95

3 Receive the dividend of $29.90
Net cash flow of -$1509.95 + $29.90 = $1480.05 in one year.

So the futures price should be $1480.05.

c USC 13/1
Second Solution to Example 3

Now, let’s assume that the dividend is paid out continuously:

We get dividends throughout the year.
0.02
For example, over one day we get dividends of St × 365
(approx) when the index level is St .

In this case, the amount of dividends we collect is random

We get more dividends if the index goes up

Question
How to incorporate the unknown dividends into an arbitrage
strategy?

c USC 14/1
Second Solution (continued)

Trick: if we take the dividends and always re-invest them, the

number of shares that we have will go up at a constant rate
After t year we will have e .02t shares
Compare to continuously compounding interest

So if I buy 100e −0.02 ≈ 98 shares now and reinvest the dividends, I

will have 100 shares in one year.

c USC 15/1
Second Solution (continued)

So with the assumption of continuous dividend payments, I can:

1 Buy e −0.02 = 0.98 shares now for

e −0.02 × $1495 = $1465.40

2 Reinvest the dividends as I receive them.

3 Borrow $1465.40 for one year and repay

1465.40(1 + 0.01) = $1480.051

So the futures price should be $1480.051.

c USC 16/1
Comparison of Solutions to Example 3

Both solutions give almost the same future price.

The exact formula in the first case is

F = S0 (1 + r − y )

where r is the period rate and y is the ”period dividend yield”.

In general this formula will be approximately correct even if r and

y are given according to different conventions.

c USC 17/1
Example 4 (cost and benefit to storing)

3 Oil.
Costly to store.
Additional benefits, convenience yield, for holding physical
commodity (over holding futures).
Not held for long-term investment (unlike gold), but mostly
held for future use.
Let the percentage holding cost be c and convenience yield be
y . We have

F ≈ S0 [1 + r − (y − c)]T
= S0 (1 + r − yb)T
' H

where
yb = y − c
is the net convenience yield.

c USC 18/1
Example 4 (continued)
Prices on August 30, 2007 were
Spot oil price 73.50/barrel (light sweet).
Nov 07 oil futures price 72.61/barrel.
the (annualized) 3-month period interest rate is 5.51%.

Solving:
F = S0 [1 + rF − (y − c)]T
= S0 (1 + rF − yb)T
' H
where
yb = y − c
Annualized net convenience yield satisfies:
 
0.0551 yb
72.61 = 73.50 1 + −
4 4
or yb = 10.35%.
c USC 19/1
Main Idea

There are two ways to own the asset in the future:

1 Buy and store
2 Enter forward
Main Idea
When we incorporate the full cost/benefit of owning the asset
(versus the promise of owning the asset), the price of the two ways
to own the asset in the future should be the same.

c USC 20/1
Futures Terms

For commodity futures:

1 Contango means:
1 spot prices are lower than futures prices, and/or
2 prices for near maturities are lower than for distant.
2 Backwardation means:
1 spot prices are higher than futures prices, and/or
2 prices for near maturities are higher than for distant.

Another definition is one that adjusts for the time-value of money:

1 Contango: H > S0 (1 + rF )T
2 Backwardation: H < S0 (1 + rF )T .
Backwardation occurs if net convenience yield exceeds interest rate:

yb − rF = y − c − rF > 0.

c USC 21/1
Crude oil forward price curves for selected dates

c USC 22/1
con-
o
ace, West Texas Intermediate Spot Price with Futures
g Dollars per Barrel
l in 58.00
March 2005
vely June 2005*
53.00 October 2004
pot
ush 48.00
August 2004 December 2004
43.00
g May 2004
ces. 38.00
February 2003 February
ty, 2004
33.00
hase
g to 28.00
st
t of 23.00 December 2001 *Average of daily data
through June 21, 2005
e to 18.00
– 2001 2002 2003 2004 2005 2006

c USC 23/1
Expectations Hypothesis

The expectations hypothesis asserts that the the futures price is

simply the expected future spot price: F0 = E [PT ]
This neglects the riskiness of the future price and the premium
market participants may require for bearing this risk.

c USC 24/1
Expecations Hypothesis and Risk Premia
Keynes and Hicks argued that normal backwardation should be the
norm.
If farmers want to hedge their risk in wheat prices, they must
offer a premium to speculators to induce them to bear risk of
changes in wheat prices.
F0 < E [PT ]

Others argue that intermediaries may be the ones who want to

hedge.
If the bread company wants to hedge the risk in how much
they pay for wheat, they must offer a premium to speculators
to induce them to bear risk of a short position in wheat
futures.
F0 > E [PT ]

We may also have a combination of the above depend on if the

long side or the short side is hedging or speculating.
c USC 25/1
Expectations Hypothesis and Portfolio Theory

Portfolio theory says

E [PT ]
P0 =
(1 + r )T
where r is the required rate of return in the market.
No-arbitrage requires:
F0
P0 =
(1 + rf )T

Thus:  1 + r T
f
F0 = E [PT ]
1+r
So the relationship between the futures prices and the expected
future price is determined by the required rate of return. This is β
in the CAPM.

c USC 26/1
Currency Futures and Forwards

There are also futures and forwards which represent agreements to

exchange currency in the future at a fixed exchange rate.

Example
Agree to exchange $1.5 million for £1 million in March 2021.

c USC 27/1
Interest Rate Parity

Forward exchange rates must link interest rates in different

currencies.

This is because we can save money in pounds by:

borrowing in dollars
exchanging the initial borrowed funds to pounds
entering into a forward exchange agreement to turn future
pounds into future dollars to pay back the loan.

We see this through an example.

c USC 28/1
Example

Let

St = exchange rate at time t

= price of the foreign currency in USD

And suppose that

rUS = 5%
rUK = 6%
The current exchange rate is S0 = $1.60/£
S1 , the future exchange rate, is not known yet.

c USC 29/1
There are two ways to exchange USD for GBP in the future:
1 Borrow $160 in Los Angeles

Need to repay $160 × 1.05 = $168 in one year

2 Convert $160 into £100.
3 Save £100 in London
Will have £100 × 1.06 =£106 in one year

So this is a commitment to turn $168 into £106 in one year.

168
Equivalently, we can turn £1 into 106 = $1.585
Notice this is a commitment to buy the asset GBP in the
future
The forward exchange rate must be $1.585 for £1.

c USC 30/1
Interest Rate Parity

So interest rates in different countries must be related by:

1 + rUS
F0 = S0
1 + rUK

c USC 31/1
Carry Trades

Forward exchange rates are similar to carry trades.

A carry trade is an investment strategy where one borrows in a

currency with a low interest rates and saves in a currency with a
high interest rate.

Example
Borrow in low rate currency (e.g. Japan U) and save in high
yielding currency. (e.g. Brazil)

c USC 32/1
Carry Trade

The carry trade is risky.

Currency risk – if exchange rates change, the value of the trade

changes.

Carry trade can also cause contagion in financial markets. When a

country’s sovereign debt is downgraded, it can ripples to other high
yield debts. (unwinding trades, margin calls)

c USC 33/1
Carry Trade is Currency Speculation

When you enter into a long position on a stock, you bet that
E0 [ST ] > F0 .

Currency forwards are similar but now the underlying asset is the
other currency instead of a stock.

Borrow in one currency to lend in another is equivalent to entering

into a forward so it is also a bet on future currency prices (=
exchange rates)

c USC 34/1
Hedging with Forwards

Hedging with forward contracts is simple, because one can tailor

the contract to match maturity and size of position to be hedged.

Example
Suppose that you, the manager of an oil exploration firm, have just
struck oil. You expect that in 5 months time you will have 1
million barrels of oil. You are unsure of the future price of oil and
would like to hedge your position.

c USC 35/1
Using a forward contract, you could hedge your position by selling
forward 1 million barrels of oil. Let St be the spot oil price at t (in
months). Then,

Position Value in 5 months (per barrel)

Long position in oil S5
Short forward position F − S5
Net payoff F

Thus, in this case you know today exactly what you will receive 5
months from now. That is, the hedge is perfect.

c USC 36/1
One problem with using forwards to hedge is that they are illiquid.
Thus, if after 1 month you discover that there is no oil, then you no
longer need the forward contract. In fact, holding just the forward
contract you are now exposed to the risk of oil-price changes.
In this case, you would want to unwind your position by buying
back the contract. Given the illiquidity of forward contracts, this
may be difficult and expensive.
To avoid problems with illiquid forward markets, one may prefer to
use futures contracts.

c USC 37/1
Example

In the above example, you can sell 1 million barrels worth of

futures. Suppose that the size of each futures contract is 1,000
barrels. The number of contract you want to short is

1, 000, 000
= 1, 000.
1, 000

c USC 38/1
Partial Hedging with Futures

Suppose that you feel that AAPL stock is likely to do well relative
to the market. To make this bet, you decide to buy $100,000
worth of AAPL stock. How can you hedge the market risk?

According to yahoo finance, AAPL has a β of 1.32.

rAPPL − rf = β(rM − rf ) + 
So if the market goes up 1%, AAPL will go up 1.32% (on
average,i.e. if the idiosyncratic risk  = 0)

c USC 39/1
We can hedge if we short $100, 000 × β = $132, 000 of the
market.
If the market went up 1%, we would lose $1,320 on market
position
We would make 1.32% or $1,320 on our AAPL position,
ignoring the idiosyncratic return 
Effectively isolated the idiosyncratic risk

c USC 40/1
Say the SP is at 3000.
An e-mini would be 50 × $3000 = $150, 000.
Short two e-minis
Ideally, we would like to short $132, 000/3, 000 = 44 shares of
the SP500.

c USC 41/1
Partial Hedging with Futures

The same argument works for hedging other risks. We just need to
match the value sensitivity by considering the relative sensitivity to
the risk.
cov (rM , r ) σr
β= =ρ×
var rM σrM
β gives the slope of the ”best fit” line relating the two returns. In
general, we can replace rM with other underlying returns risk to
hedge.

c USC 42/1