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Forwards and Futures pricing

- Amit Yagnik

Future/Spot convergence
The basis is the different between the spot price and the futures price Basis = spot price future price At expiry futures price equals or is very close to the spot price of the underlying

Basis Risk
Interruption in the convergence of the futures and spot prices Changes in the cost of carry Imperfect matching between the cash asset and the hedge asset 1. Maturity or duration mismatch

2. Liquidity mismatch

Hedging with Futures

Short Hedge Sell (short) futures to hedge against a price decrease in the existing long position Long Hedge Buy (long) futures to hedge against a price increase

Arguments for and against hedging Hedging and Shareholders Hedging and competitors

Impact on profitability

The optimal hedge ratio

Minimum variance hedge ratio A hedge ratio is size of the futures position relative to the spot position This is also the beta of spot prices with respect to futures contract prices HR = S,F = p * (S/F)

P - coefficient of correlation between S and F S standard deviation of S F standard deviation of F

Hedging with stock Index futures

Optimal number of contracts Hedging of equity portfolio using index futures contracts Hedge portfolios beta serve as a hedge ratio in determining the correct no. of contracts to sell or buy N = * P/A Where, N optimal no. of contracts for hedging P current value of the portfolio A current value of the futures contract This provides complete hedge i.e. reduces beta to zero

Adjusting the portfolio beta

Number of future contracts required to sell or buy to adjust beta of the portfolio Hedging boils down to a reduction of the portfolio beta (systematic risk) N = (n ) * P/A Where,

N no. of contracts to buy or sell to achieve target beta () n target beta P current value of the portfolio A current value of the futures contract

Forward and Future pricing

The pricing model makes following assumptions: 1. No transaction costs or short sale restrictions 2. Same tax rates on all net profits 3. Borrowing and lending at risk-free rate 4. Arbitrage opportunity are exploited as they arise Notations to be used: 1. T = time to maturity (in years) 2. S0 = underlying asset price today (t = 0) 3. F0 = Forward/Future price today 4. r = continuously compounded risk-free annual rate 5. q = dividend yield