Summary (Formulas) with tutorial questions for Topic 3

Notation to be used

S0 = Spot price today

F0 = Futures or forward price today
T = Time until delivery date for a forward or futures contract
r = Risk-free interest rate for maturity T ( LIBOR- London Interbank Offered
Rate is more commonly used as compare to treasury rate as risk free rate)

Forward Price of an Investment Asset

 For an investment asset that provides no income and has no storage costs,
with continuous compounding:

F0 = S0e rT

 If F0 > S0e rT arbitrageurs could earn a risk free profit by buying the asset and
shorting the forward;

 If F0 < S0e rT arbitrageurs can sell the asset short and go long the forward to
lock in a risk free profit

Example 1:
Gold (prices in US$ per troy ounce)
Assume: S = $1720; r = 1.0%; T = 1 year
o
If r is compounded continuously:

0.01 x 1
= $1720 e

= $1737.29 (theoretical price)

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Example 2:
Use previous data and assume the actual price of a 1 year gold futures contract is
$1,760 rather than $1,737.29.

Theoretical price $1,737.29 S0e rT

Futures market quoted at $1,760.00 F0

Therefore F0 > S0e rT

This 1 Year gold futures contract is overvalued/ overpriced! As market quoted at

$1760 and theoretical price only worth $1737.29

Is there a risk free Yes because actual futures is over priced

arbitrage profit to be
made?

How do you Arbitrage? 1. Sell 1 year futures now, close it out at spot
2. What is missing?
Underlying component
3. Borrow money to buy the underlying
a. Arbitrageur borrows $172,000 at 1.0% per year
b. Buys 100 ounces of gold at $1,720 per ounce

Today 1. Borrow $172,000 at 1% rate, to buy 100 ounces of

gold
2. Sell 1 contract of 1 year futures today at $1760

1 year time Sell gold at spot price

Buy futures at spot price to close out open position
The expense from futures bought and proceeds
from gold sold will cancel out since the spot price is
the same
Return money borrowed, principal + interest
(172,000xe0.01 = 173,729)
Net profit from Proceed from futures sold – (borrowing +interest)
arbitrage returned
= $176,000 - $173,729*
= $2,271 per futures contract

*Loan payment due in 1 year: $172,000e0.01 = $173,729

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Delivers the gold against the futures contract in 1 year and make a risk free arbitrage
profit of:
1 year time:
Today:
Sell gold at spot price
Sell 1 contract of 1 year
Buy futures at spot price to close out open position
futures today at $1,760
The expense from futures bought and proceeds from
gold sold will cancel out since the spot price is the
same

Short Hedge Underlying Asset

Futures $/ounce 100 (100 ounces $/ounce 100
ounces Gold) ounces
Today SELL 1,760.00 176,000 Today BUY 1,720

1 year BUY Spot Cancel 1 year SELL Spot Cancel out

price out price

Therefore:
Today:
Net profit from arbitrage
Borrow $172,000 at 1%
Proceed from futures sold – (borrowing +interest) rate, to buy 100 ounces
returned of gold
= $176,000 - $173,729 (must take into account
for the loan interest)
= $2,271 per futures contract

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What if the spot price after 1 year was $1,750 per ounce?

1 year time:
Today:
Sell gold at spot price
Sell 1 contract of 1 year
Buy futures at spot price to close out open position
futures today at $1,760
The expense from futures bought and proceeds from
gold sold will cancel out since the spot price is the
same

Short Hedge Underlying Asset

Futures $/ounce 100 (100 ounces $/ounce 100
ounces Gold) ounces
Today SELL 1,760.00 176,000 Today BUY 1,720

1 year BUY 1,750.00 Cancel out 1 year SELL 1,750 Cancel out
Gain 10.00 Gain 30.00

Borrow $172,000 at 1%
rate, to buy 100 ounces of
Gain in short futures $1,000 gold
= $10x100ounces (must take into account
for the loan interest)

Gain in underlying asset $3,000

= $30x100ounces

Total gain $4,000

Less: Loan interest ($1,729)

=$173,729-172,000

Net Gain/Profit from arbitrage $2,271

OR
Net profit from arbitrage
Proceed from futures sold – (borrowing +interest) returned
= $176,000 - $173,729
= $2,271 per futures contract

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What if the spot price after 1 year was $1,790 per ounce?

1 year time:
Today:
Sell gold at spot price
Sell 1 contract of 1 year
Buy futures at spot price to close out open position
futures today at $1,760
The expense from futures bought and proceeds from
gold sold will cancel out since the spot price is the
same

Short Hedge Underlying Asset

Futures $/ounce 100 (100 ounces $/ounce 100
ounces Gold) ounces
Today SELL 1,760.00 176,000 Today BUY 1,720.00

1 year BUY 1,790.00 Cancel 1 year SELL 1,790.00 Cancel out

out
Loss 30.00 Gain 70.00

Loss in short futures -$3,000

=-
Today:
Borrow $172,000 at 1%
rate, to buy 100 ounces of
gold
(must take into account
for the loan interest)

$30x100ounces

Gain in underlying asset $7,000

= $70x100ounces

Total gain $4,000

OR

Less: Loan interest ($1,729)

Net profit from arbitrage
=$173,729-172,000
Proceed from futures sold –
(borrowing +interest)
Net Gain/Profit from arbitrage $2,271 returned
= $176,000 - $173,729
= $2,271 per futures contract

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Example 3:
What would you do if the actual futures price was only $1,710?

Theoretical price $1,737.29 S0e rT

Futures market quoted at $1,710.00 F0

Therefore F0 < S0e rT

This 1 Year gold futures contract is undervalued/ underpriced! As market quoted at

$1,710 and theoretical price only worth $1,737.29

Is there a risk free

arbitrage profit to be
made? Yes because actual futures is under priced

How do you Arbitrage?

1. Buy 1 year futures now, close it out at spot
2. What is missing?
Underlying component
3. What then?
Sell Gold at spot price of $1720
a. Sell 100 ounces of gold at $1,720 per ounce
b. Arbitrageur invest $172,000 at 1.0% per year

Today 1. Buy 1 contract of 1 year futures today at $1710

2. Invest the proceed of gold sold, let it grow at rate
of 1% (172,000xe0.01 = 173,729)
1 year time
Buy gold at spot price

Sell futures at spot price to close out open position

The proceed from futures sold and expense from gold

bought will cancel out since the spot price
Net profit from
arbitrage Proceed from money invested (principal +interest) –
cost of futures bought
= $173,729 – $171,000
= $2,279 per futures contract

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Delivers the gold against the futures contract in 1 year and make a risk free arbitrage
profit of:
1 year time:
Today:
Buy gold at spot price
Buy 1 contract of 1 year
Sell futures at spot price to close out open position
futures today at $1,710
The proceed from futures sold and expense from gold
bought will cancel out since the spot price

Long Hedge Underlying Asset

Futures $/ounce 100 (100 ounces $/ounce 100
ounces Gold) ounces
Today BUY 1,710.00 176,000 Today SELL 1,720

1 year SELL Spot Cancel 1 year BUY Spot Cancel out

price out price

Therefore:
Today:
Proceed from money invested (principal +interest) –
cost of futures bought Sell 100 ounces of gold
invest $172,000 at 1%
= $173,729 – $171,000 rate
= $2,279 per futures contract (Must take into account
for the investment
interest earned)

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What if the spot price after 1 year was $1,750 per ounce?

1 year time:
Today:
Buy gold at spot price
Buy 1 contract of 1 year
Sell futures at spot price to close out open position
futures today at $1,710
The proceed from futures sold and expense from gold
bought will cancel out since the spot price

Long Hedge Underlying Asset

Futures $/ounce 100 (100 ounces $/ounce 100
ounces Gold) ounces
Today BUY 1,710.00 171,000 Today SELL 1,720.00 172,000

1 year SELL 1,750.00 Cancel out 1 year BUY 1,750.00 Cancel out
Gain 40.00 Loss 30.00

Sell 100 ounces of gold

invest $172,000 at 1% rate
Gain in short futures $4,000 (Must take into account
= $40x100ounces for the investment interest
earned)
Loss in underlying asset ($3,000)
= $30x100ounces

Total Gain $1,000

Add: interest earned from investment $1,729

=$173,729 – $172,000
Net Gain/Profit from arbitrage $2,279

OR
Therefore:
Proceed from money invested (principal +interest) – cost of futures bought
= $173,729 – $171,000
= $2,279 per futures contract

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What if the spot price after 1 year was $1,690 per ounce?

1 year time:
Today:
Buy gold at spot price
Buy 1 contract of 1 year
Sell futures at spot price to close out open position
futures today at $1,710
The proceed from futures sold and expense from gold
bought will cancel out since the spot price

Long Hedge Underlying Asset

Futures $/ounce 100 (100 ounces $/ounce 100
ounces Gold) ounces
Today BUY 1,710.00 171,000 Today SELL 1,720.00 172,000

1 year SELL 1,690.00 Cancel out 1 year BUY 1,690.00 Cancel out
Loss 20.00 Gain 30.00

Sell 100 ounces of gold

invest $172,000 at 1% rate
Loss in short futures ($2,000) (Must take into account
= $20x100ounces for the investment interest
earned)

Gain in underlying asset $3,000

= $30x100ounces

Total Gain $1,000

Add: interest earned from investment $1,729

= $173,729 – $172,000
Net Gain/Profit from arbitrage $2,279

OR
Therefore:
Proceed from money invested (principal +interest) – cost of futures bought
= $173,729 – $171,000
= $2,279 per futures contract

Forward price of an Investment Asset that provides a known dollar income

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  Some investment assets provide predictable income streams to the investor,
example dividends (Share) or interest (Bonds).

F0 = (S0 – I )erT

Where, I is the present value of the income stream

Example:

Consider a long forward contract on a share (stock) with a current price of $40
and the risk free rate is 5% per year for all maturities, the stock pays a dividend
of $0.70 every six months the next dividend is due in 6 months.
What should the one year forward price be?
Answer:
Present Value of Dividends:
= $0.70e -0.05 x 0.5 + $0.70e -0.05 x 1
= $0.683 + $0.666 = $1.349

F0 = (S0 – I) e rT

= ($40 – $1.349)e0.05 x 1
= $40.63

Where F0 is the theoretical forward price

If the forward price deviates from this price then profitable arbitrage activity will be
possible

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Forward price of an Investment Asset that provides a known yield

 Some investment assets gives a known “yield” rather than a known cash
income; for example a share price index futures - the index can be viewed
as an investment asset paying a dividend yield (estimated)

F0 = S0e (r – q )T

Where q is the estimated dividend yield on the shares that comprise the index
during the life of the contract.

 If F0 > S0e(r-q)T an arbitrageur could buy the stocks underlying the index and
sell futures.
 When F0 < S0e(r-q)T an arbitrageur could buy futures and short the stocks
underlying the index.

Example:
Assume a contract on SFE’s SPI (ASX 200) futures contract with 3 months to expiry.
Suppose that:
the shares comprising the index are estimated to give a dividend yield of 4% per
annum;
the current value of the SPI is 4300; and
the continuously compounded risk free interest rate is 6% per annum
then the 3 month SPI futures price should be:

Answer:
F0 = 4300e(0.06 – 0.04) x .25
= 4321.5

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Valuing a Forward Contract

 Unlike futures, forwards are not marked to market daily

 At initiation, the value of a forward contract is $0, and as time progresses, the
value of the forward (f) may become either positive or negative.

To value the forward contract:

The value of a long forward contract today (f) is:

f = (F0 – K )e –rT

The value of a short forward contract is:

f = (K – F0 )e –rT

K is the delivery price in a forward contract, and

F0 is the current forward price for a contract negotiated some time ago

Example:

A long forward contract on an asset that provides no income was entered into some
time ago.
 it currently has 4 months to maturity
 the risk free rate of interest (r) is 8% per year
 the current asset price (S0) is $100
 the delivery price (K) is $96

The current forward price Fo should be:

Fo = $100 e 0.08 x 4/12 = $102.70

and the value of the long forward is:

ƒ = (F0 – K )e–rT = (102.70 – 96)e -0.08 x 4/12

= $6.53

The value of a long forward contract on an asset that provides no income can also be
expressed as:
f = S0 – Ke–rT
f = 100 – 96e -.08 x 4/12 = $6.53
(refer Hull, pp 113)

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The value of the short forward position would be
f = Ke–rT – So
= 96e -.08 x 4/12 – 100
= - $6.53

Pricing Foreign Currency Futures and Forwards

 Pricing foreign currency futures and forwards is similar to pricing securities

with a dividend yield
 Instead of a continuous dividend yield we use the foreign risk-free interest rate
(rf )
 It follows that if rf is the foreign risk-free interest rate

F0 = S0e (r-rf) T

So = spot price in USD of one unit of foreign currency;

Fo = forward/futures price in USD of one unit of foreign currency

Note: If So is expressed as an amount of foreign currency per US dollar then r and rf

must be reversed in the formula:

 where So = current spot price in USD of one unit of foreign currency:

Fo = Soe(r – rf)T

 Where, So = current spot price in foreign currency of one USD, then

Fo = Soe(rf – r)T

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Example:
Assume that one year interest rates in Australia and the U.S.A. are 3.75% and 0.5%
respectively.
Assume spot exchange rate is A$1 = $US1.0450
Answer:
The one year forward rate (F0) of A$ is:

= $1.0450 * e (0.005 – 0.0375) * 1 = $1.0116

Note: r = US interest rate; rf = Aus interest rate
What would happen if the quoted forward rate was:
A$ 1 = US$1.0015? A$ forward underpriced
A$ 1 = US$1.0260 ? A$ forward overpriced
AUD forward ($1.0015) <Theoretical 1 Year forward Price ($1.0116)

Is there a risk free

arbitrage profit to be Yes because actual forward is under priced
made?

How do you Arbitrage? 1. Buy AUD Forward at 1.0015. (Lock in forward rate at
1.0015.)
2. Borrow and invest, utilising the current spot rate
Today borrow AUD and 1. Borrow AUD1,000 at 3.75% p.a. for 1 year
lock in USD rate
equivalent in 1 year Cost of borrowing , AUD1,000 * e0.0375 * 1
= AUD1,038.21
2. Lock in forward rate at 1.0015. i.e Buy AUD forward
Today, get exposure in 1. Convert borrowed AUD to USD in spot market
US market
1,000*1.0450 = USD1,045
2. Invest USD1,045 at 0.5%
1 year time Investment Grows to
USD1045 *e 0.005 *1 = USD1,050.24 in 1 year
Deliver the USD to receive AUD1051.81
1050.24 * 1.0015 = AUD1051.81 (forward rate)
Net profit from Pay back AUD borrowing cost
arbitrage
= 1051.81 – 1038.21 = 13.60
= AUD13.6

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 1 year time:
Today:
Investment Grows to
USD1045 *e 0.005 *1 = USD1,050.24 in 1 year
Buy AUD Forward at
1.0015.
Deliver the USD to receive AUD1051.81
1050.24 * 1.0015 = AUD1051.81 (forward rate)

Borrow and invest, utilising the current

spot rate
AUD
Today , borrow AUD and lock in USD rate
equivalent in 1 year
1 year time: 1,051.81 1. Borrow AUD1,000 at 3.75% p.a. for 1 year
Investment Grows to Cost of borrowing , AUD1,000 * e0.0375 * 1
= AUD1,038.21
USD1045 *e 0.005 *1 =
USD1,050.24 in 1 year
Today, get exposure in US market
1. Convert borrowed AUD to USD in spot
Deliver the USD to receive market AUD1,000*1.0450 = USD1,045
AUD1051.81
2. Invest USD1,045 at 0.5%
1050.24 * 1.0015 = (forward
rate)

Cost of borrowing , AUD1,000 1,038.21

* e0.0375 * 1

Net Gain/Profit from 13.16

arbitrage

Futures on Commodities (Investment Assets)

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Investment type commodities include, for example, gold and platinum, they may incur
some storage costs – this can be treated as negative income.

F0 = (S0+ U) e rT

Where U is the present value of the storage costs net of any income

Example:

Consider a 1 year silver future.

Assume that storage costs of $0.50 per ounce is payable at the start of the year
Assume spot price is $35 per ounce,
r = 0.5%, T = 1

What is the theoretical futures price?

Fo = ($35 + 0.50)e0.005 x 1 = $35.68

Futures on Commodities (Consumption Assets)

Consumption Assets usually provide no income but may require significant storage
costs (e.g grains, oil)

 Arbitrage activity is muted where F0 < (S0+ U)erT

 Therefore, we can only show an upper bound for a consumption asset’s price:

F0 ≤ (S0+U )erT

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Impact of Cost of Carry to Investment Asset

 The “cost of carry” (c) equals interest costs (r) plus storage costs (u) less
any income earned (q)

Therefore, for an investment asset:

F0 = S0e cT

Where c = (r – q + u)

Impact of Cost of Carry and Convenience Yield to Consumption Assets

 If a commodity is in short supply this may produce an abnormally high spot

price.
 The benefit from holding a physical asset (as distinct from a futures contract) is
that the asset can be used in production as required
 This “benefit” is known as the Convenience Yield - the premium earned by
those who hold inventory of a commodity in short supply.
 Since (y) cannot be observed directly it is generally calculated as the unknown
parameter

 This is converted into an equality by inserting a “convenience yield” (y) on a

consumption asset such that:

F0 = S0 e (c – y )T

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