Review of Previous Lecture

FINM7041 Applied Derivatives

Lecture 2 Forwards and Futures

In last weeks lecture we went through a

broad overview/revision of forward, futures
and options contracts.
In particular we focussed on the
mechanics of forward and futures markets.

Hull et al: Chapters 3 & 5

Lecture Overview

1. Consumption Vs. Investment Assets

In todays lecture we will discuss Forwards and

Futures contracts in greater detail, and how they
are related to the spot price of the underlying
asset. We will focus on the following topics:

Determination of interest rates;

What is short selling?;
Determination of Forwards and Futures prices; and,
Hedging strategies using Forwards and Futures
contracts.

When considering forward and futures contracts, it is

important to distinguish between investment assets and
consumption assets.
Investment assets are assets held by significant numbers of
people purely for investment purposes.
Examples of investment assets are stocks, bonds, gold and
silver.
Consumption assets are assets held primarily for consumption
and not usually for investment purposes.
Examples of consumption assets are commodities such as
copper, oil and pork bellies.
We can use arbitrage arguments to determine the forward and
futures price of an investment asset from its spot price and other
observable market variables. We cannot do this for consumption
assets.

2. Short Selling

2. Short Selling

Short selling (also called shorting), involves selling an

asset that is not owned.
It is not possible for all investment assets.
Your broker borrows the securities from another client and sells them in
the market in the usual way.
At some stage you must buy the securities back so they can be
replaced in the account of the client you originally borrowed them from.
You must pay dividends and other benefits that would have accrued to
the client you borrowed from, if they had still held the shares. In other
words, the client you borrowed from should be no worse off as a result
of lending you their shares.
Likewise, the client can be no better off.
Therefore, if you borrow a physical asset such as gold off a client, the client
must pay you for the storage costs of the gold.

The investor (the person who has shorted the asset) benefits if prices
fall, as they sell the asset for a higher price than what they buy it back
for.

The investor is required to maintain a margin account

with the broker.
The initial margin is required so that possible adverse
movements (increases) in the price of the asset that is
being shorted are covered.
The margin account consists of cash or marketable
securities deposited by the investor with the broker to
guarantee that the investor will not walk away from the
short position if the share price increases.

2. Short Selling

3. Measuring Interest Rates

Regulators in the United States currently allow a stock to

be shorted only on an uptick that is, when the most
recent movement in the price of the stock was an increase.
In Australia, only a limited number of stocks are allowed to
be short sold, called the ASX Approved Securities List.
Further, in 2008, we saw a ban on various forms of short
selling in markets around the world.

The compounding frequency used for an interest rate is

the unit of measurement.
From FINM7006, you are familiar with the need to
calculate the effective rate of interest.
The difference between quarterly and annual
compounding is analogous to the difference between
miles and kilometres.

3. Measuring Interest Rates

3. Measuring Interest Rates

In this course, we will mainly use continuous

compounding.
As such you will need to ensure that your interest rates are
expressed as continually compounded interest rates.
We will detail any exceptions to this rule as we progress through
the course.

In the limit, as we compound more and more

frequently, we obtain continuously compounded
interest rates.
For Example:
$100 grows to $100eRT when invested at a
continuously compounded rate R for time T.
$100 received at time T discounts to $100e-RT at time
zero when the continuously compounded discount
rate is R.

Example: If a nominal rate of 10% p.a. is

compounded continuously what is the
effective rate?
eR-1
e0.10-1
2.718280.10-1= 10.51%

4. Assumptions

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5. Forward and Futures Contract Prices

In this lecture we make the following assumptions

regarding market participants:
1. They are subject to no transaction costs when they trade;
2. They are subject to the same tax rate on all net trading
profits;
3. They can borrow money at the same risk-free rate of
interest as they can lend money; and,
4. They take advantage of arbitrage opportunities as they
occur.

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Remember from FINM7006:

It is well known in practice that if interest rates are constant, a
futures contract has the same value as an otherwise identical
forward contract.
That is, although a futures contract has a complicated cash
flow pattern (via the marking to market feature) it can be
valued as though it were a forward contract.
Since a forward contract has only a single cash flow, it is easy
to value.
Consequently, it is industry practice to value futures contracts
as though they were forward contracts.

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5. Forward and Futures Contract Prices

5. Forward and Futures Contract Prices

Remember that:

Before illustrating this concept, we define the

cost of carry (q) of the underlying commodity.

Forward and futures contracts can be valued by

recognizing that, in many cases, forward and futures
markets are redundant. This occurs when the payoff
from a forward or futures contract can be replicated
by a position in:
1. The underlying asset; and,
2. Riskless bonds.

This is the cost of holding a physical quantity of the

commodity. For wheat the cost of carry is the storage
cost; for live hogs it consists of storage and feed
costs; and for gold it consists of storage and security
costs.
Some commodities have a negative cost of carry. For
example, holding a stock index provides the benefit of
receiving dividends.

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5. Forward and Futures Contract Prices

5. Forward and Futures Contract Prices

Consider the strategy of:

Arbitrage Relationship Between Spot and Forward

Contracts

Borrowing enough money to buy one unit of an investment

asset that provides the holder with no income, and has no
holding costs. Non-dividend paying stocks and zero-coupon
bonds are examples of such investment assets.
The
borrower incurs the obligation to pay for the associated
interest through time T; and,
Entering into a forward or futures contract to sell the
commodity at time T.

The value of this position in terms of the initial (time 0)

and terminal (time T) cash flows is tabulated in the
following table.

Position

Initial Cash Flow

Terminal Cash
Flow

Borrow and incur

cost of carry

S0

-S0erT

Buy one unit of

commodity

-S0

ST

Enter 6-month
forward sale

F-ST

Net portfolio
value

F- S0erT

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5. Forward and Futures Contract Prices

6. Arbitrage

Example:

In general if:

Consider a four-month forward contract to buy a zero-coupon

bond that will mature one year from today.
Note: this means that the bond will have eight months to go
when the forward contract matures.

The current price of the bond is $930. We assume that the

four-month risk-free rate of interest (continuously
compounded) is 6% per annum. The forward price, F0, is
given by:

F0 = 930e

4
0.06
12

= $948.79

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F0 > S0 e rT

Arbitrageurs can make a riskless profit from buying the asset

and entering into a short forward contract on the asset. This
strategy is financed by borrowing funds at the risk free-rate if
interest.

F0 < S0 e rT
Arbitrageurs can make a riskless profit by shorting the asset and
entering into a long forward contract. The excess funds are
invested at the risk-free rate of interest until they are needed to
buy back the asset.

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7. Forward and Futures Contract Prices on

Assets with Known Income

7. Forward and Futures Contract Prices on

Assets with Known Income

We now consider a forward contract on an investment

asset that will provide a perfectly predictable cash
income to the holder.

Example:
Consider a long forward contract to purchase a
coupon-bearing bond whose current price is $900.
We will assume that the forward contract matures in
nine months.
We also assume that a coupon
payment of $40 is expected after 4 months. The fourmonth and nine-month risk-free interest rates
continuously compounded are 3% and 4% per
annum, respectively.

Examples: Stocks paying known dividend yields and couponbearing bonds.

F0 = ( S0 D)e rT
Where D is the present value of the income.

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7. Forward and Futures Contract Prices on

Assets with Known Income

I = 40e

0.03

4
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8. Forward and Futures Contract Prices on

Assets with Known Yield
How do we deal with a situation where the asset
underlying a forward contract provides a known
yield rather than known cash income?

= 39.60

A yield implies that the known income is expressed as a

percentage of the assets price at the time the income is paid.
We define d as the average yield per annum on an asset during
the life of a forward contract with continuous compounding.
The formula we use is:

F0 = (900 39.60)e0.040.75 = $886.60

F0 = S0 e( r d )T
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8. Forward and Futures Contract Prices on

Assets with Known Yield

9. Forward and Futures Contract Prices on

Stock Indices

Example: Consider a six-month forward contract on an asset that is expected

to provide an income equal to 2% of the asset price once during a six-month
period. The risk-free rate of interest with continuous compounding is 10% per
annum. The asset price is $25.
The yield is 4% per annum with semi-annual compounding. Converting this to
continuous compounding we get:

R
0.04
Rc = m ln(1 + m ) = 2 ln(1 +
) = 0.0396
m
2

This formula is one of the many located on page 84 to convert nominal rates
to continuously compounded rates.

So the forward price is given by:

F0 = 25e (0.10 0.0396)0.5 = $25.77

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A stock index can be viewed as an investment asset

paying a dividend yield.
The futures price and spot price relationship is
therefore:

F0 = S 0e( r d )T

Where d is the dividend yield on the portfolio represented by the

index.
Remember, with indices, they are stated as points. Therefore,
the number of points must be multiplied by a factor to end up
with a dollar value for the contract. In Australia, the convention
is $25 per point.

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9. Forward and Futures Contract Prices on

Stock Indices

9. Forward and Futures Contract Prices on

Stock Indices
In general if:

Consider a 1-year futures contract on the ASX S&P200.

Suppose that the stocks underlying the index provide a
dividend yield of 5% per annum continuously
compounded, that the current value of the index is
3529, and that the continuously compounded risk-free
interest rate is 10% per annum.

F0 > S0 e( r d )T
An arbitrageur can make a riskless profit by buying the
stocks underlying the index and shorting index futures
contracts. This strategy will be financed by borrowing
funds at the risk-free interest rate.

F0 = S0 e( r d )T
F0 = 3529e

(0.10 0.05)

F0 < S0e ( r d )T

= 3710

An arbitrageur can make a riskless profit by shorting the

stocks underlying the index and taking a long position in
index futures contracts. The excess funds will be
invested at the risk-free interest rate until needed to buy
back the stocks.

If we multiply this value by $25 per point, each futures

contract will hedge a dollar value of $92,750.
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9. Forward and Futures Contract Prices on

Stock Indices
Index arbitrage involves simultaneous trades in
futures and many different stocks.
Very often a computer is used to generate the
trades.
Occasionally (e.g., on Black Monday) simultaneous
trades are not possible and the theoretical noarbitrage relationship between F0 and S0 does not
hold.

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10. Futures and Forwards on Currencies

The underlying asset in a forward or futures currency contract is a

certain number of units of a foreign currency.
A foreign currency is analogous to a security providing a dividend
yield. 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. For example, the holder can invest the foreign
currency in a foreign-denominated bond.
Thus, the continuous dividend yield is the foreign risk-free interest
rate.
It follows that if rf is the foreign risk-free interest rate, S0 as the
current spot price in dollars of one unit of the foreign currency and
F0 as the forward or futures price in dollars of one unit of the foreign
currency.

F0 = S0e

( r rf ) T

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11. Forwards and Futures on Commodities

11. Forwards and Futures on Commodities

First, let us consider the futures prices of commodities
that are investment assets such as gold and silver.
In the absence of storage costs and income the forward
price of a commodity that is an investment asset is
given by:

F0 = S0 e rT
If there are storage costs, Q is the present value of all of
the storage costs less all income during the life of the
forward contract, and the forward price is given by:

If storage costs and income are given as a

percentage, then q is the percentage storage
costs less the percentage income during the
life of the forward contract, and the forward
price is given by:

F0 = S0e( r + q )T

F0 = ( S0 + Q )e rT
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11. Forwards and Futures on Commodities

11. Forwards and Futures on Commodities

Now let us consider Consumption Commodities:

As a result:
Due to the high storage costs of consumption
commodities, Q is the present value of all of the
storage costs, and the forward price is given by:

Commodities that are consumption assets rather than

investment assets usually provide no income, but can
be subject to significant storage costs.
Individuals and companies who keep such a
commodity in inventory do so because of its
consumption value, not because of its value as an
investment.

F0 ( S0 + Q)e rT
If storage costs are expressed as a proportion q of
the spot price, the equivalent formula is:

They are reluctant to sell the commodity and buy forward

contracts because forward contracts cannot be consumed.
There is therefore nothing to keep the previous equations
holding (i.e. arbitrage).

F0 S0 e( r + q )T

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12. Valuing Forward Contracts

11. Forwards and Futures on Commodities

32

The reason we do not have equality in the formulas on the previous

slide is because users of a consumption commodity may feel that
ownership of the physical commodity provides benefits that are not
obtained by holders of futures contracts.

For example, an oil refiner is unlikely to regard a futures contract on crude oil in
the same way as crude oil held in inventory.
The crude oil in inventory can be used in the refining process whereas a futures
contract cannot.

The benefits from holding the physical asset is referred to as the

convenience yield.
As such we can re-write the equations on the previous slide, where y,
the convenience yield simply measures the extent to which the left
hand side is less than the right hand side in those previous
equations:

F0 e

yT

= ( S 0 + Q )e

contract was negotiated some time ago);

F is the current forward price for the contract that was negotiated some time
ago;
The delivery date is T years from today;
r is the T-year risk-free interest rate; and,
f is the value of the forward contract today.

The value of a long forward contract (on both investment and consumption
assets, , is:
rT

Similarly, the value of a short forward contract is

f = ( F K )e

rT

And if the storage costs are a percentage, then:

The value of a forward contract at the time it is first entered into is zero. At
a later stage it may prove to have a positive or negative value.
Suppose that
K is delivery price in a forward contract (the initial forward price when the

f = ( K F )e rT

F0 e yT = S 0 e( r + q )T or F0 = S 0 e( r + q y )T
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34

12. Valuing Forward Contracts

12. Valuing Forward Contracts

Example:

The value of the forward contract is:

A long forward contract on a non-dividend

paying stock was entered into some time ago.
It currently has six months to maturity.
The risk-free rate of interest (with continuous
compounding) is 10% per annum.
The stock price is $25, and the delivery price
is $24.
What is the value of the forward contract?
35

F0 = 25e0.10.5 = $26.28
f = (26.28 24)e 0.10.5 = $2.17

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13. Forward vs Futures Prices

14. Delivery

Forward and futures prices are usually assumed

to be the same. When interest rates are
uncertain, they are, in theory, slightly different:

In a futures contract, the party in the short

position has the right to choose to deliver
the asset at any time during a certain
period (called the delivery period).
The person in the short position has to
give at least a few days notice of their
intention to deliver.

A strong positive correlation between interest rates

and the asset price implies the futures price is
slightly higher than the forward price.
This is due to the person in the long position in a
futures contract receiving an immediate gain
because of daily settlement.
The positive correlation indicates that interest rates
are also likely to have risen, therefore the gain will
be invested at a higher than average interest rate.

A strong negative correlation implies the reverse.

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15. Hedging
Hedgers aim to use futures markets or forward
contracts to reduce a particular risk they may
face.

Hedging Strategies
Using Futures

This risk may relate to the price of an asset such as

gold, a move in the foreign exchange rate, or the level
of the stock market.

A perfect hedge is one that completely

eliminates the risk. However, a perfect hedge is
very rare.
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40

15. Hedging

15. Hedging

A short hedge is a hedge which involves a

short position in futures contracts.

Arguments in favour of hedging include:

It is appropriate when the hedger already owns an

asset (or will own it at some definite date) and
expects to sell it at some time in the future.
This allows them to lock in the price they will
receive.

Companies should focus on the main business they

are in and take steps to minimize risks arising from
interest rates, exchange rates, and other market
variables; and,
By hedging, they avoid adverse movements such
as sharp rises in the price of a commodity.

A long hedge involves taking a long position in

futures contracts.
It is appropriate when a company knows it will have
to purchase a certain asset in the future and wants
to lock in the price now.
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42

15. Hedging

16. Basis Risk

Arguments against hedging include:

Shareholders are usually well diversified and
can make their own hedging decisions;
It may increase risk to hedge when
competitors do not; and,
Explaining a situation where there is a loss on
the hedge and a gain on the underlying can
be difficult.

Hedges are not always perfect and

straightforward. Some of the reasons for this
are:
The asset whose price is to be hedged may not be
exactly the same as the asset underlying the futures
contract;
The hedger may not be certain of the exact date the
asset will be bought or sold; and,
The hedge may require the futures contract to be
closed out before its delivery month.

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16. Basis Risk

44

Convergence of Futures to Spot

What is basis risk:

If the asset to be hedged and the asset underlying the futures
contract are the same, the basis risk should be zero at the
expiration of the futures contract.
Prior to expiration, the basis may be positive or negative.
When the spot price increases by more than the futures price,
the basis increases. We call this strengthening of the basis.
When the futures price increases by more than the spot price,
the basis declines. We call this weakening of the basis.
The formula for working out the basis in a hedging situation
is:

Futures
Price

Spot Price
Futures
Price

Spot Price

Time

Basis = Spot price of asset to be hedged - Futures price of contract used

(a)

Time

(b)

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16. Basis Risk

46

16. Basis Risk

Basis risk with a long hedge:

Basis risk with a short hedge:

Suppose that:

Suppose that:

F1: Initial Futures Price

F2: Final Futures Price
S2: Final Asset Price

You hedge the future purchase of an asset

by entering into a long futures contract.
Cost of Asset= S2 (F2 F1) = F1 + Basis

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F1: Initial Futures Price

F2: Final Futures Price
S2: Final Asset Price

You hedge the future sale of an asset by

entering into a short futures contract.
Price Realised= S2+ (F1 F2) = F1 + Basis
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16. Basis Risk

17. Cross Hedging

One key factor affecting basis risk is the choice

of the futures contract to be used for hedging.
This choice has two components:

Cross hedging occurs when the asset underlying

the futures contract is different to the asset
whose price is being hedged.

Choose a delivery month that is as close as possible

to, but later than, the end of the life of the hedge; and,
When there is no futures contract on the asset being
hedged, choose the contract whose futures price is
most highly correlated with the asset price.

For Example: an airline company may be concerned

about the future price of aviation fuel. However, as
there are no futures contracts on aviation fuel, the
company choose to use heating oil futures contracts
to hedge its exposure.

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50

18. Optimal Hedge Ratio

19. Hedging Using Index Futures

The hedge ratio is the ratio of the size of the position

taken in futures contracts to the size of the exposure.
The optimal hedge ration is calculated by:

h= S
F
Where:
S : is the standard deviation of S, the change in the
spot price during the hedging period;
F : is the standard deviation of F, the change in the
futures price during the hedging period; and,
: is the coefficient of correlation between S and F.

Stock index futures can be used to hedge an equity

portfolio.
To hedge the risk in a portfolio the number of contracts
that should be shorted is:

P
A

Where P is the value of the portfolio, is its beta, and

A is the value of the assets underlying one futures
contract.

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52

19. Hedging Using Index Futures

19. Hedging Using Index Futures

Reasons for using index futures to hedge

an equity portfolio include:

Example:

Desire to be out of the market for a short period of

time (Hedging may be cheaper than selling the
portfolio and buying it back).
Desire to hedge systematic risk (Appropriate when
you feel that you have picked stocks that will
outperform the market).

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Imagine that the value of SPI200 is 3500.

The value of the portfolio to be hedged is $5
million.
The beta of the portfolio is 1.5.

What position in SPI200 futures contracts

is necessary to hedge the portfolio?
54

19. Hedging Using Index Futures

19. Hedging Using Index Futures

P

What position is necessary to reduce the beta of the

portfolio to 0.75 (*)?
Given we were hedging 100% with 86 contracts to
reduce our risk to zero, we can take 43 to hedge 50% to
give us half of our previous risk of 1.5.

= 1.5 x 5m/3500x25=86 contracts (SHORT)

What position is necessary to reduce

the beta of the portfolio to 0.75?

Generally:
( *)

P
5m
= (1.5 .75)
= 43
A
87500

What position is necessary to increase the beta of the

portfolio to 2.00?
55

19. Hedging Using Index Futures

19. Hedging Using Index Futures

What position is necessary to increase the beta of the

portfolio to 2.00?

( *)
(1.5 2.0)

56

P
A

5M
= 29
3500 x 25

We can use a series of futures contracts

to increase the life of a hedge.
Each time we switch from 1 futures
contract to another we incur a type of
basis risk.

Since this is negative we must go LONG!!!

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20. Conclusion
In todays lecture we have discussed futures
and forward contracts in detail.
In particular we focused on determining
forward/futures prices, valuing forward/futures
contracts, basis risk and hedging.
In next weeks lecture we will discuss interest
rate contracts and swaps.

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