Chapter 6

Forward and Future contract. Option.

Introduction

The valuation of financial derivatives will be based on the principle of no arbitrage.

Definition 6.1
Arbitrage means making of a guaranteed risk free profit with a trade or a series of
trades in the market.

Definition 6.2
An arbitrage free market is a market which has no opportunities for risk free profit.

Definition 6.3
An arbitrage free price for a security is a price that ensure that no arbitrage op-
portunity can be designed with that security.

The principle of no arbitrage states that the markets must be arbitrage free. Some
financial jargon will be used in what follows.
One says that has/takes a long position on an asset if one owns/is going to own a
positive amount of that asset. One says that has/takes a short position on an asset if
one has/is going to have a negative amount of that asset. Being short on money means
borrowing. You can take a short position on many financial assets by short selling .

Example 6.1
Short selling.
To implement some trading strategy you need to sell some amount of shares (to get
money and invest in other assets).
The problem is that you do not have any shares right now.
You can borrow the shares from another investor for a time period (paying interest)
and sell the borrowed shares in the market.
At the end of the borrowing period you must buy again the shares in the market and
give them back to the lender.

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CHAPTER 6. FORWARD AND FUTURE CONTRACT. OPTION. 2

Forward Contracts

Definition 6.4
A forward contract is an agreement to buy or sell an asset on a fixed date in the
future, called the delivery time, for a price specified in advance, called the forward
price.

The party selling the asset is said to be taking a short forward position and the party
buying the asset is said to be taking a long forward position. Both parties are obliged to
fulfill the terms of the contract.
The main reason to enter into a forward contract agreement is to become independent
of the unknown future price of a risky asset. Assume that the contract is entered at time
t = 0, the delivery time is t = T and denote by F (0, T ) the forward price. The time t price
of the underlying asset is denoted S (t) . Due to the symmetry of the contract, no payment
is made by either party at the beginning of the contract, t = 0.
At delivery, the party with the long position makes a profit if

F (0, T ) < S (T ) ,

while the party with the short position will make a loss (exactly of the same magnitude as
the profit of the other party). If
F (0, T ) > S (T )
the situation is reversed.
The payoff at delivery for a long forward position is:

The payoff at delivery for a short forward position is:

CHAPTER 6. FORWARD AND FUTURE CONTRACT. OPTION. 3

Forward Price

If the contract is initiated at t < T , we will write F (t, T ) for the forward price and the
payoffs will be S (T ) − F (t, T ) (long position) and F (t, T ) − S (T ) (short position). As no
payment is made at the beginning of the forward contract, the main problem is to find the
forward price F (0, T ) such that both parties are willing to enter into such agreement. One
possible approach would be to compute the present value, which we know that is zero, by
discounting the expected payoff of the contract. That is,

0 = V (0) = e−rT E [S (T ) − F (0, T )] ,

which yields F (0, T ) = E [S (T )]. Note that F (0, T ) would depend on the distribution of
S (T ), hence, we would only have translated the problem to agree on which distribution use.

• The solution comes from the fact that we can also invest in the money market and
there exists only one value for F (0, T ) such avoid arbitrages.

• The price obtained does not depend on the distribution of S(T ).

Rules 1. Buy and hold strategy

• Borrow S (0) NOK, to buy the asset at time zero

• Hold it until time T .

• At time T , the amount S(0) erT to be paid to settle the loan is a natural candidate for
F (0, T ).

Theorem 6.1
The forward price F (0, T ) is given by

F (0, T ) = S (0) erT , (6.1)

where r is the constant risk free interest rate under continuous compounding. If the
contract is initiated at time t ≤ T, then

F (t, T ) = S (t) er(T −t) . (6.2)

Remark 1. The formula in the previous theorem applies as long as the underlying asset does
not generate an income (dividends) or a cost (storage and insurance costs for commodities).
In this lecture we will, many times, be implicitly assuming that the underlying is a stock
which does not pay dividends.
Remark 2. In the case considered here we always have

F (t, T ) = S (t) er(T −t) > S (t) .

Moreover, the difference

F (t, T ) − S (t) ,
called the basis, converges to 0 as t converges to T .

Value of a Forward Contract

CHAPTER 6. FORWARD AND FUTURE CONTRACT. OPTION. 4

Every forward contract has value zero when initiated. As time goes by, the price of the
underlying asset may change and, along with it, the value of the forward contract.

Theorem 6.2
The time t value of a long forward position with forward price F (0, T ) is given by

V (t) = (F (t, T ) − F (0, T )) e−r(T −t) , 0 ≤ t ≤ T, (6.3)

where F (t, T ) is the forward price of a contract starting at t and with delivery date
T.

Remark 3. Consider a forward contract with forward price K instead of F (0, T ). The value
of this contract at time t will be given by equation
with F (0, T ) replaced by K,

VK (t) = (F (t, T ) − K) e−r(T −t) . (6.4)

Such contract may have non-zero initial value

VK (0) = (F (0, T ) − K) e−rT = S (0) − Ke−rT . (6.5)

Futures

One of the two parties in a forward contract will lose money. There is a risk of default
(not being able to fulfill the contract) by the party losing money. Futures contracts are
designed to eliminate such risk.

Definition 6.5
A futures contract is an exchange-traded standardized agreement between two par-
ties to buy or sell an asset at an specified future time and at a price agreed today. The
contract is marked to market daily and guaranteed by a clearing house.

Assume that time is discrete with steps of length τ , typically one day. The market dictates
the so called futures prices f (nτ, T ) for each time step {nτ }n≥0 such that nτ ≤ T . These
prices are random (and not known at time 0) except for f (0, T ).
As in the case of forward contracts, it costs nothing to take a futures position. However,
a futures contract involves a random cash flow, known as marking to market. Namely, at
each time step nτ ≤ T , n ≥ 1, the holder of a long futures position will receive the amount

f (nτ, T ) − f ((n − 1)τ, T )

if positive, or he/she will have to pay it if negative. The opposite payments apply for a short
futures position.
The futures price at delivery is

f (T, T ) = S (T ) .

At each nτ ≤ T ,n ≥ 1, the value of a futures position is reset to zero, after marking to

market.
Remark 4. Futures markets are very liquid (high number of transactions) due to standardiza-
tion and the presence of a clearing house. There is no risk of default, in contrast to forward
CHAPTER 6. FORWARD AND FUTURE CONTRACT. OPTION. 5

contracts negotiated directly between two parties. A negative aspect of of the highly stan-
dardized contracts is that you may not find a contract that actually covers the risk you want
to hedge. For example, you want protection against adverse movements of the share prices
of a company, but in the market there are no futures on the share price of that company. In
this case, you may use futures on a stock index containing the company, but the hedge is
less perfect and more risky.

Theorem 6.3
If the interest rate r is constant, then f (0, T ) = F (0, T ).

In an economy with constant interest rate r we obtain a simple structure of futures prices

f (t, T ) = S (t) er(T −t) . (6.6)

Note that the futures are random but only due to S (t).

Options

Definition 6.6
A European call/put option is a contract giving the holder the right (but not the
obligation) to buy/sell an asset for a price K fixed in advance, known as the exercise
price or strike price, at a specified future date T , called the exercise time or
expiry date.

Definition 6.7
An American call/put option is a contract giving the holder the right (but not the
obligation) to buy/sell an asset for a strike price K, also fixed in advance, at any time
between now and the expiry date T .

• Some underlying assets may be impossible to buy or sell (e.g., stock indices).

• The option then is cleared in cash.

An option is determined by its payoff , which for a European call is


+ S(T ) − K if S(T ) > K
(S (T ) − K) = max (0, S (T ) − K) = ,
0 if S(T ) ≤ K

and for a put option is (K − S (T ))+ . Since the payoffs are non negative, a premium must
be paid to buy an option, otherwise there is an arbitrage opportunity. The premium is the
market price of the option at time 0.
The prices of European calls and puts will be denoted by C E and P E . We will use the
notation C A and P A for the American ones. The same constant interest rate r will apply for
borrowing and lending money and we will use continuous compounding. The gain/profit
of an option buyer (seller, also known as writer) is the payoff minus (plus) the premium
C E or P E paid (received) for the option.
CHAPTER 6. FORWARD AND FUTURE CONTRACT. OPTION. 6

Put-Call Parity

In what follows we will find bounds and some general properties for option prices. We
will use the principle of no arbitrage alone, without any assumption on the evolution of the
underlying asset prices. Take a long position with a European call and a short position with
a European put, both with the same strike K and expiry time T. We obtain a portfolio
having the same payoff as a long forward position with forward price K and delivery time
T , that is,
(S (T ) − K)+ − (K − S (T ))+ = S (T ) − K.
As a result, the present value of such portfolio of options should be that of a forward contract
CHAPTER 6. FORWARD AND FUTURE CONTRACT. OPTION. 7

with forward price K, which is

S (0) − Ke−rT .

Theorem 6.4
European put-call parity. For a stock paying no dividends, the prices of European call
and put options, both with the same strike price K and exercise time T , satisfy

C E − P E = S (0) − Ke−rT . (6.7)

Theorem 6.5
American put-call parity estimates. For a stock paying no dividends, the price of
American call and put options, both with the same strike price K and expiry time T ,
satisfy

C A − P A ≤ S (0) − Ke−rT , (6.8)

C A − P A ≥ S (0) − K. (6.9)