Chapter 5

Determination of Forward and

Futures Prices

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 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)

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 2
Short Selling
Short selling involves selling securities
you do not own
You (through your broker) borrows the
securities from another client and sells
them in the market in the usual way

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 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? 100*100-90*100-3*100
What would be your loss if you had bought
100 shares? -100*100+90*100+3*100
Options, Futures, and Other Derivatives, 9th Edition,
Copyright © John C. Hull 2014 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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 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?

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 7
Another Arbitrage Opportunity?
Suppose that:
The spot price of nondividend-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?

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 8
 The Forward Price
If the spot price of an investment asset 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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 10
When an Investment Asset
Provides a Known Income

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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 11
When an Investment Asset
Provides a Known Yield
F0 = S0 e(r–q )T
where q is the average yield during the life
of the contract (expressed with continuous
compounding)

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 12
Stock Index
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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 13
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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 14
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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 15
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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 16
Futures and Forwards on
Currencies
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
Options, Futures, and Other Derivatives, 9th Edition,
Copyright © John C. Hull 2014 17
Explanation of the Relationship
Between Spot and Forward
1000 units of
foreign currency
(time zero)

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

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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 18
Consumption Assets: Storage is
Negative Income
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.

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 19
The Cost of Carry
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

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 20