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Financial Engineering and Risk Management: Forwards Contracts

1) A forward contract allows the buyer to purchase an asset at a specified future time (maturity) for a price (forward price) set today. The forward price is always higher than the current spot price to account for the cost of carry. 2) The forward price is set using no-arbitrage arguments by creating a riskless portfolio of buying the forward contract and short selling the underlying asset. Setting the forward price so the portfolio has zero value today ensures there are no arbitrage opportunities. 3) The value of the forward contract today (t=0) is zero, and at maturity (t=T) is the spot price minus the forward price. The forward price today (t=

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18 views

Financial Engineering and Risk Management: Forwards Contracts

1) A forward contract allows the buyer to purchase an asset at a specified future time (maturity) for a price (forward price) set today. The forward price is always higher than the current spot price to account for the cost of carry. 2) The forward price is set using no-arbitrage arguments by creating a riskless portfolio of buying the forward contract and short selling the underlying asset. Setting the forward price so the portfolio has zero value today ensures there are no arbitrage opportunities. 3) The value of the forward contract today (t=0) is zero, and at maturity (t=T) is the spot price minus the forward price. The forward price today (t=

Uploaded by

Mobin Kurian
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial Engineering and Risk Management

Forwards contracts

Martin Haugh Garud Iyengar


Columbia University
Industrial Engineering and Operations Research
Forward contract
Definition. A forward contract gives the buyer the right, and also the obligation,
to purchase
a specified amount of an asset
at a specified time T
at a specified price F (called the forward price) set at time t = 0

Example.
Forward contract for delivery of a stock with maturity 6 months
Forward contract for sale of gold with maturity 1 year
Forward contract to buy 10m $ worth of Euros with maturity 3 months
Forward contract for delivery of 9-month T-Bill with maturity 3 months.

2
Setting the forward price F
Goal: Set the forward price F for a forward contract at time t = 0 for 1 unit of
an asset with
asset price St at time t
and maturity T

ft = value/price at time t of a long position in the forward contract

Value at time T : fT = (ST F )


long position in forward: must purchase the asset at price F
spot price of asset: ST

Forward price F is set so that time t = 0 value/price f0 is 0

Use no-arbitrage principle to set F

3
Short selling an asset
Short selling is the selling of shares in a stock that the seller doesnt own
The seller borrows the shares from the broker
The shares comes from the brokerages own inventory
The shares are sold and the proceeds are credited to the sellers account

However ... sooner or later


the seller must close the short by buying back the shares (called covering)

Profit/loss associated with a short sale


Results in a profit when the price drops
Results in a loss when the price increases

Short positions can be very risky


Price can only drop to zero ... potential profit is bounded
Price can increase to arbitrarily large values ... potential loss is unbounded

4
No-arbitrage argument to set F
Assume asset has no intermediate cash flows, e.g. dividends, or storage costs.

Portfolio: Buy contract, short sell the underlying and lend S0 up to time T

Cash flow t=0 t=T


Buy contract f0 = 0 fT = ST F
Short sell asset
and buy back at time T +S0 ST
Lend S0 up to T S0 S0 /d(0, T )
Net cash flow 0 S0 /d(0, T ) F

The portfolio has a deterministic cash flow at time T and the cost = 0.
Therefore,  S
0
 S0
0= F d(0, T ) F =
d(0, T ) d(0, T )

Why is F strictly greater than the spot price S0 ?


Cost of carry
5
Examples of forward contracts
Example. Forward contract on a non-dividend paying stock that matures in 6
months. The current stock price is $50 and the 6-month interest rate is 4% per
annum.

Solution. Assuming semi-annual compounding, the discount factor


1
d(0, .5) = = 0.9804.
1 + 0.04
2

Therefore,
F = 50/0.9804 = 51.0

6
Forward value ft for t > 0
Recall the value of a long forward position
at time 0: f0 = 0
at time T : fT = ST F

F0 : Forward price at time 0 for delivery at time T


Ft : Forward price at time t for delivery at time T

Pricing via the no-arbitrage arguments

Cash flow t=t t=T


Short Ft contract 0 Ft ST
Long F0 contract ft ST F0
Net cash flow ft Ft F0

The portfolio has a deterministic cash flow. Therefore,

ft = (Ft F0 )d(t, T )

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