Determination of Forward

and Futures Prices

1
Consumption vs Investment Assets

• Investment assets are assets held by significant numbers of

people purely for investment purposes (Examples: gold,
silver)
• Consumption assets are assets held primarily for
consumption (Examples: copper, oil)

2
Short Selling

• Short selling involves selling securities you do not

own
• Your broker borrows the securities from another
client and sells them in the market in the usual way

3
Short Selling (continued)

• At some stage you must buy the securities so they can

be replaced in the account of the client
• You must pay dividends and other benefits the owner of
the securities receives
• There may be a small fee for borrowing the securities

4
Example

• You short 100 shares when the price is $100 and close out the
short position three months later when the price is $90
• During the three months a dividend of $3 per share is paid
• What is your profit?
• What would be your loss if you had bought 100 shares?

5
Notation for Valuing Futures and
Forward Contracts

S0: Spot price today

F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T

6
An Arbitrage Opportunity?
• Suppose that:
• The spot price of a non-dividend-paying stock is $40
• The 3-month forward price is $43
• The 3-month US$ interest rate is 5% per annum
• Is there an arbitrage opportunity?

7
Another Arbitrage Opportunity?
• Suppose that:
• The spot price of non-dividend-paying stock is $40
• The 3-month forward price is US$39
• The 1-year US$ interest rate is 5% per annum (continuously
compounded)
• Is there an arbitrage opportunity?

8
 The Forward Price (equation 5.1)

If the spot price of an investment asset that provides no income is

S0 and the futures price for a contract deliverable in T years is F0,
then
F0 = S0erT
where r is the T-year risk-free rate of interest.
In our examples, S0 =40, T=0.25, and r=0.05 so that
F0 = 40e0.05×0.25 = 40.50

9
If Short Sales Are Not Possible..

Formula still works for an investment asset because investors

who hold the asset will sell it and buy forward contracts when
the forward price is too low

10
When an Investment Asset Provides a Known Income
(equation 5.2)

F0 = (S0 – I )erT
where I is the present value of the income during life of
forward contract

11
When an Investment Asset Provides
a Known Yield (equation 5.3)

F0 = S0 e(r–q )T
where q is the average yield during the life of the contract
(expressed with continuous compounding)

12
Valuing a Forward Contract

• A forward contract is worth zero (except for bid-offer spread effects)

when it is first negotiated
• Later it may have a positive or negative value
• Suppose that K is the delivery price and F0 is the forward price for a
contract that would be negotiated today

13
 Valuing a Forward Contract
(equation 5.4)

• By considering the difference between a contract with delivery

price K and a contract with delivery price F0 we can deduce
that:
• the value of a long forward contract is
(F0 – K )e–rT
• the value of a short forward contract is
(K – F0 )e–rT

14
Forward vs Futures Prices

• When the maturity and asset price are the same, forward
and futures prices are usually assumed to be equal.
(Eurodollar futures are an exception)
• In theory, when interest rates are uncertain, they are
slightly different:
• A strong positive correlation between interest rates and the asset
price implies the futures price is slightly higher than the forward
price
• A strong negative correlation implies the reverse

15
 Stock Index (equation 5.8)

• Can be viewed as an investment asset paying a dividend yield

• The futures price and spot price relationship is therefore

F0 = S0 e(r–q )T
where q is the average dividend yield on the portfolio
represented by the index during life of contract

16
 Stock Index (continued)

• For the formula to be true it is important that the index represent

an investment asset
• In other words, changes in the index must correspond to
changes in the value of a tradable portfolio
• The Nikkei index viewed as a dollar number does not represent
an investment asset (See Business Snapshot 5.3)

17
Index Arbitrage

• When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the

index and sells futures
• When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells
the stocks underlying the index

18
Index Arbitrage
(continued)

• Index arbitrage involves simultaneous trades in

futures and many different stocks
• Very often a computer is used to generate the
trades
• Occasionally simultaneous trades are not
possible and the theoretical no-arbitrage
relationship between F0 and S0 does not hold
(see Business Snapshot 5.4)

19
Futures and Forwards on Currencies
(equation 5.9)

• A foreign currency is analogous to a security providing a

yield
• The yield is the foreign risk-free interest rate
• It follows that if rf is the foreign risk-free interest rate

( r  rf ) T
F0 S0e

20
Explanation of the
Relationship Between Spot
and Forward (Figure 5.1)

1000 units of
foreign currency
(time zero)

r T
1000 e f units of
foreign currency
1000S0 dollars
at time zero
at time T

r T
1000 F0 e f 1000S0erT
dollars at time T dollars at time T

21
 Consumption Assets: Storage is Negative
Income (equations 5.11 and 5.12)

F0  S0 e(r+u )T
where u is the storage cost per unit time as a percent of the
asset value.
Alternatively,

F0  (S0+U )erT
where U is the present value of the storage costs.

22
The Cost of Carry (equation 5.19)

• The cost of carry, c, is the storage cost plus the interest costs
less the income earned
• For an investment asset F0 = S0ecT
• For a consumption asset F0  S0ecT
• The convenience yield on the consumption asset, y, is defined
so that F0 = S0 e(c–y )T

23
Futures Prices & Expected Future
Spot Prices (equation 5.20)
• Suppose k is the expected return required by investors
in an asset
• We can invest F0e–r T at the risk-free rate and enter into a
long futures contract to create a cash inflow of ST at
maturity
• This shows that

 rT kT
F0 e e  E ( ST )
or
F0 E ( ST )e ( r  k )T
24
Futures Prices & Future Spot Prices
(continued)

No Systematic Risk k=r F0 = E(ST)

Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic Risk k<r F0 > E(ST)

Positive systematic risk: stock indices

Negative systematic risk: gold (at least for some periods)

25