Review of Previous Lecture

Derivatives • In last week’s lecture we went through a

Lecture 2 – Forwards and Futures 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

1 2

Lecture Overview 1. Consumption Vs. Investment Assets

• In today’s lecture we will discuss Forwards and • When considering forward and futures contracts, it is
important to distinguish between investment assets and
Futures contracts in greater detail, and how they consumption assets.
are related to the spot price of the underlying – Investment assets are assets held by significant numbers of
people purely for investment purposes.
asset. We will focus on the following topics: • Examples of investment assets are stocks, bonds, gold and
– Determination of interest rates; silver.
– What is short selling?; – Consumption assets are assets held primarily for consumption
and not usually for investment purposes.
– Determination of Forwards and Futures prices; and, • Examples of consumption assets are commodities such as
copper, oil and pork bellies.
– Hedging strategies using Forwards and Futures
– We can use arbitrage arguments to determine the forward and
contracts. futures price of an investment asset from its spot price and other
observable market variables. We cannot do this for consumption
assets.

3 4

3 4

2. Short Selling 2. Short Selling

• Short selling (also called shorting), involves selling an
asset that is not owned. • The investor is required to maintain a margin account
– It is not possible for all investment assets.
– Your broker borrows the securities from another client and sells them in with the broker.
the market in the usual way.
– At some stage you must buy the securities back so they can be • The initial margin is required so that possible adverse
replaced in the account of the client you originally borrowed them from. movements (increases) in the price of the asset that is
– 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 being shorted are covered.
words, the client you borrowed from should be no worse off as a result
of lending you their shares. • The margin account consists of cash or marketable
– Likewise, the client can be no better off. securities deposited by the investor with the broker to
• 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. guarantee that the investor will not walk away from the
– The investor (the person who has shorted the asset) benefits if prices short position if the share price increases.
fall, as they sell the asset for a higher price than what they buy it back
for.

5 6

5 6
 2. Short Selling 3. Measuring Interest Rates
• Regulators in the United States currently allow a stock to • The compounding frequency used for an interest rate is
be shorted only on an uptick – that is, when the most the unit of measurement.
recent movement in the price of the stock was an increase. • From Foundations of Finance, you are familiar with the
• In Australia, only a limited number of stocks are allowed to need to calculate the effective rate of interest.
be short sold, called the ASX Approved Securities List. • The difference between quarterly and annual
• Further, in 2008, we saw a ban on various forms of short compounding is analogous to the difference between
miles and kilometres.
selling in markets around the world.

7 8

7 8

3. Measuring Interest Rates 3. Measuring Interest Rates

• In this course, we will mainly use continuous
compounding. • Example: If a nominal rate of 10% p.a. is
– As such you will need to ensure that your interest rates are
expressed as continually compounded interest rates. compounded continuously what is the
– We will detail any exceptions to this rule as we progress through
the course.
effective rate?
• In the limit, as we compound more and more eR-1
frequently, we obtain continuously compounded
interest rates. e0.10-1
• For Example:
– $100 grows to $100eRT when invested at a
2.71828…0.10-1= 10.51%
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.
9 10

9 10

4. Assumptions 5. Forward and Futures Contract Prices

• In this lecture we make the following assumptions • Remember from Foundations of Finance:
regarding market participants: – It is well known in practice that if interest rates are constant, a
1. They are subject to no transaction costs when they trade; futures contract has the same value as an otherwise identical
2. They are subject to the same tax rate on all net trading forward contract.
profits; – That is, although a futures contract has a complicated cash
flow pattern (via the marking to market feature) it can be
3. They can borrow money at the same risk-free rate of
valued as though it were a forward contract.
interest as they can lend money; and,
– Since a forward contract has only a single cash flow, it is easy
4. They take advantage of arbitrage opportunities as they to value.
occur.
– Consequently, it is industry practice to value futures contracts
as though they were forward contracts.

11 12

11 12
 5. Forward and Futures Contract Prices 5. Forward and Futures Contract Prices

• Remember that: • Before illustrating this concept, we define the

– Forward and futures contracts can be valued by cost of carry (q) of the underlying commodity.
recognizing that, in many cases, forward and futures – This is the cost of holding a physical quantity of the
markets are redundant. This occurs when the payoff commodity. For wheat the cost of carry is the storage
from a forward or futures contract can be replicated cost; for live hogs it consists of storage and feed
by a position in: costs; and for gold it consists of storage and security
1. The underlying asset; and, costs.
2. Riskless bonds. – Some commodities have a negative cost of carry. For
example, holding a stock index provides the benefit of
receiving dividends.

13 14

13 14

5. Forward and Futures Contract Prices 5. Forward and Futures Contract Prices
• Consider the strategy of: • Arbitrage Relationship Between Spot and Forward
– Borrowing enough money to buy one unit of an investment Contracts
asset that provides the holder with no income, and has no
holding costs. Non-dividend paying stocks and zero-coupon Position Initial Cash Flow Terminal Cash
bonds are examples of such investment assets. The Flow
borrower incurs the obligation to pay for the associated Borrow and incur S0 -S0erT
interest through time T; and,
cost of carry
– Entering into a forward or futures contract to sell the
commodity at time T. Buy one unit of -S0 ST
commodity
• The value of this position in terms of the initial (time 0) Enter 6-month 0 F-ST
and terminal (time T) cash flows is tabulated in the forward sale
following table.
Net portfolio 0 F- S0erT
value

15 16

15 16

5. Forward and Futures Contract Prices 6. Arbitrage

• Example: • In general if:
– Consider a four-month forward contract to buy a zero-coupon F0  S0 e rT
bond that will mature one year from today.
• Note: this means that the bond will have eight months to go – Arbitrageurs can make a riskless profit from buying the asset
and entering into a short forward contract on the asset. This
when the forward contract matures.
strategy is financed by borrowing funds at the risk free-rate if
– The current price of the bond is $930. We assume that the interest.
four-month risk-free rate of interest (continuously
compounded) is 6% per annum. The forward price, F0, is
F0  S0 erT
given by: – Arbitrageurs can make a riskless profit by shorting the asset and
4
0.06 entering into a long forward contract. The excess funds are
F0  930e 12
 $948.79 invested at the risk-free rate of interest until they are needed to
buy back the asset.

17 18

17 18
 7. Forward and Futures Contract Prices on 7. Forward and Futures Contract Prices on
Assets with Known Income Assets with Known Income
• We now consider a forward contract on an investment • Example:
asset that will provide a perfectly predictable cash – Consider a long forward contract to purchase a
income to the holder. coupon-bearing bond whose current price is $900.
– Examples: Stocks paying known dividend yields and coupon- We will assume that the forward contract matures in
bearing bonds. nine months. We also assume that a coupon
payment of $40 is expected after 4 months. The four-
F0  ( S0  D )e rT month and nine-month risk-free interest rates
– Where D is the present value of the income. continuously compounded are 3% and 4% per
annum, respectively.

19 20

19 20

7. Forward and Futures Contract Prices on 8. Forward and Futures Contract Prices on
Assets with Known Income Assets with Known Yield
• How do we deal with a situation where the asset
underlying a forward contract provides a known
4
0.03 yield rather than known cash income?
I  40e 12
 39.60
– A yield implies that the known income is expressed as a
percentage of the asset’s price at the time the income is paid.
– We define d as the average yield per annum on an asset during
F0  (900  39.60)e0.040.75  $886.60 the life of a forward contract with continuous compounding.
– The formula we use is:

F0  S0 e ( r  d )T

21 22

21 22

8. Forward and Futures Contract Prices on 9. Forward and Futures Contract Prices on
Assets with Known Yield Stock Indices
• Example: Consider a six-month forward contract on an asset that is expected • A stock index can be viewed as an investment asset
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 paying a dividend yield.
annum. The asset price is $25. • The futures price and spot price relationship is
• The yield is 4% per annum with semi-annual compounding. Converting this to therefore:
continuous compounding we get:
F0  S0 e( r  d )T
Rm 0.04
Rc  m ln(1  )  2 ln(1  )  0.0396
m 2 – Where d is the dividend yield on the portfolio represented by the
• This formula is one of the many located on page 84 to convert nominal rates index.
to continuously compounded rates. – Remember, with indices, they are stated as points. Therefore,
the number of points must be multiplied by a factor to end up
• So the forward price is given by:
with a dollar value for the contract. In Australia, the convention
is $25 per point.
F0  25e(0.10 0.0396)0.5  $25.77

23 24

23 24
 9. Forward and Futures Contract Prices on 9. Forward and Futures Contract Prices on
Stock Indices Stock Indices
• Consider a 1-year futures contract on the ASX S&P200. • In general if:
Suppose that the stocks underlying the index provide a
dividend yield of 5% per annum continuously F0  S0 e( r  d )T
compounded, that the current value of the index is
3529, and that the continuously compounded risk-free – An arbitrageur can make a riskless profit by buying the
interest rate is 10% per annum. stocks underlying the index and shorting index futures
contracts. This strategy will be financed by borrowing
F0  S 0 e( r  d )T funds at the risk-free interest rate.

(0.10  0.05)
F0  S0 e( r  d )T
F0  3529e  3710 – An arbitrageur can make a riskless profit by shorting the
stocks underlying the index and taking a long position in
• If we multiply this value by $25 per point, each futures index futures contracts. The excess funds will be
contract will hedge a dollar value of $92,750. invested at the risk-free interest rate until needed to buy
back the stocks.
25 26

25 26

9. Forward and Futures Contract Prices on

10. Futures and Forwards on Currencies
Stock Indices
• The underlying asset in a forward or futures currency contract is a
certain number of units of a foreign currency.
• Index arbitrage involves simultaneous trades in • A foreign currency is analogous to a security providing a dividend
futures and many different stocks. yield. A foreign currency has the property that the holder of the
currency can earn interest at the risk-free interest rate prevailing in
– Very often a computer is used to generate the the foreign country. For example, the holder can invest the foreign
trades. currency in a foreign-denominated bond.
– Occasionally (e.g., on Black Monday) simultaneous • Thus, the continuous dividend yield is the foreign risk-free interest
rate.
trades are not possible and the theoretical no- • It follows that if rf is the foreign risk-free interest rate, S0 as the
arbitrage relationship between F0 and S0 does not current spot price in dollars of one unit of the foreign currency and
hold. F0 as the forward or futures price in dollars of one unit of the foreign
currency.
( r rf ) T
F0  S0e
27 28

27 28

11. Forwards and Futures on Commodities 11. Forwards and Futures on Commodities
• First, let us consider the futures prices of commodities • If storage costs and income are given as a
that are investment assets such as gold and silver.
percentage, then q is the percentage storage
• In the absence of storage costs and income the forward
price of a commodity that is an investment asset is costs less the percentage income during the
given by: life of the forward contract, and the forward
price is given by:
F0  S 0e 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
F0  S 0 e( r  q )T
forward contract, and the forward price is given by:

F0  ( S0  Q) e rT

29 30

29 30
 11. Forwards and Futures on Commodities 11. Forwards and Futures on Commodities

• Now let us consider Consumption Commodities: • As a result:

– Commodities that are consumption assets rather than – Due to the high storage costs of consumption
investment assets usually provide no income, but can commodities, Q is the present value of all of the
be subject to significant storage costs. storage costs, and the forward price is given by:
– Individuals and companies who keep such a
commodity in inventory do so because of its F0  ( S0  Q )e rT
consumption value, not because of its value as an
investment. – If storage costs are expressed as a proportion q of
• They are reluctant to sell the commodity and buy forward
contracts because forward contracts cannot be consumed. the spot price, the equivalent formula is:
• There is therefore nothing to keep the previous equations
holding (i.e. arbitrage). F0  S0 e( r  q )T
31 32

31 32

11. Forwards and Futures on Commodities 12. Valuing Forward Contracts

• The reason we do not have equality in the formula’s on the previous
slide is because users of a consumption commodity may feel that • The value of a forward contract at the time it is first entered into is zero. At
ownership of the physical commodity provides benefits that are not a later stage it may prove to have a positive or negative value.
obtained by holders of futures contracts. • Suppose that
– For example, an oil refiner is unlikely to regard a futures contract on crude oil in – K is delivery price in a forward contract (the initial forward price when the
the same way as crude oil held in inventory. contract was negotiated some time ago);
– The crude oil in inventory can be used in the refining process whereas a futures
contract cannot. – F is the current forward price for the contract that was negotiated some time
ago;
• The benefits from holding the physical asset is referred to as the – The delivery date is T years from today;
convenience yield.
– r is the T-year risk-free interest rate; and,
• As such we can re-write the equations on the previous slide, where y, – f is the value of the forward contract today.
the convenience yield simply measures the extent to which the left
hand side is less than the right hand side in those previous • The value of a long forward contract (on both investment and consumption
equations: assets, ƒ, is:  rT
f  ( F  K )e
F0 e yT
 ( S 0  Q )e rT

• And if the storage costs are a percentage, then: • Similarly, the value of a short forward contract is

F0 e yT  S0e ( r  q )T or F0  S0 e( r  q y )T f  ( K  F )e rT

33 34

33 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.
F0  25e0.10.5  $26.28
– It currently has six months to maturity.
– The risk-free rate of interest (with continuous f  (26.28  24)e 0.10.5  $2.17
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 36

35 36
 13. Forward vs Futures Prices 14. Delivery
• Forward and futures prices are usually assumed • In a futures contract, the party in the short
to be the same. When interest rates are
uncertain, they are, in theory, slightly different: position has the right to choose to deliver
– A strong positive correlation between interest rates the asset at any time during a certain
and the asset price implies the futures price is
slightly higher than the forward price. period (called the delivery period).
• This is due to the person in the long position in a • The person in the short position has to
futures contract receiving an immediate gain
because of daily settlement. give at least a few days notice of their
• The positive correlation indicates that interest rates
are also likely to have risen, therefore the gain will intention to deliver.
be invested at a higher than average interest rate.
– A strong negative correlation implies the reverse.
37 38

37 38

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

39
40

39 40

15. Hedging 15. Hedging

• A short hedge is a hedge which involves a • Arguments in favour of hedging include:
short position in futures contracts. – Companies should focus on the main business they
– It is appropriate when the hedger already owns an are in and take steps to minimize risks arising from
asset (or will own it at some definite date) and interest rates, exchange rates, and other market
expects to sell it at some time in the future. variables; and,
– This allows them to lock in the price they will – By hedging, they avoid adverse movements such
receive. 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.
41 42

41 42
 15. Hedging 16. Basis Risk
• Arguments against hedging include: • Hedges are not always perfect and
straightforward. Some of the reasons for this
– Shareholders are usually well diversified and
are:
can make their own hedging decisions;
– The asset whose price is to be hedged may not be
– It may increase risk to hedge when exactly the same as the asset underlying the futures
competitors do not; and, contract;
– Explaining a situation where there is a loss on – The hedger may not be certain of the exact date the
the hedge and a gain on the underlying can asset will be bought or sold; and,
be difficult. – The hedge may require the futures contract to be
closed out before its delivery month.

43 44

43 44

16. Basis Risk 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, Futures
Price Spot Price
the basis increases. We call this strengthening of the basis.
– When the futures price increases by more than the spot price, Spot Price Futures
the basis declines. We call this weakening of the basis. Price
– The formula for working out the basis in a hedging situation
is:
Time Time
Basis = Spot price of asset to be hedged - Futures price of contract used
(a) (b)

45 46

45 46

16. Basis Risk 16. Basis Risk

• Basis risk with a long hedge:
• Basis risk with a short hedge:
– Suppose that:
– Suppose that:
F1: Initial Futures Price
F1: Initial Futures Price
F2: Final Futures Price
F2: Final Futures Price
S2: Final Asset Price
S2: Final Asset Price
– You hedge the future purchase of an asset
– You hedge the future sale of an asset by
by entering into a long futures contract.
entering into a short futures contract.
– Cost of Asset= S2 –(F2 – F1) = F1 + Basis
– Price Realised= S2+ (F1 –F2) = F1 + Basis

47 48

47 48
 16. Basis Risk 17. Cross Hedging
• One key factor affecting basis risk is the choice • Cross hedging occurs when the asset underlying
of the futures contract to be used for hedging. the futures contract is different to the asset
This choice has two components: whose price is being hedged.
– Choose a delivery month that is as close as possible – For Example: an airline company may be concerned
to, but later than, the end of the life of the hedge; and, about the future price of aviation fuel. However, as
– When there is no futures contract on the asset being there are no futures contracts on aviation fuel, the
hedged, choose the contract whose futures price is company choose to use heating oil futures contracts
most highly correlated with the asset price. to hedge its exposure.

49 50

49 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. • Stock index futures can be used to hedge an equity
• The optimal hedge ration is calculated by: portfolio.
 • To hedge the risk in a portfolio the number of contracts
h S
F that should be shorted is:
Where: P

S : is the standard deviation of S, the change in the A
spot price during the hedging period;
F : is the standard deviation of F, the change in the • Where P is the value of the portfolio, is its beta, and
futures price during the hedging period; and, A is the value of the assets underlying one futures
 : is the coefficient of correlation between S and F. contract.

51 52

51 52

19. Hedging Using Index Futures 19. Hedging Using Index Futures
• Reasons for using index futures to hedge • Example:
an equity portfolio include: – Imagine that the value of SPI200 is 3500.
– Desire to be out of the market for a short period of – The value of the portfolio to be hedged is $5
time (Hedging may be cheaper than selling the million.
portfolio and buying it back).
– The beta of the portfolio is 1.5.
– Desire to hedge systematic risk (Appropriate when
you feel that you have picked stocks that will
outperform the market). What position in SPI200 futures contracts
is necessary to hedge the portfolio?

53 54

53 54
 19. Hedging Using Index Futures 19. Hedging Using Index Futures
• What position is necessary to reduce the beta of the
P portfolio to 0.75 (*)?
 = 1.5 x 5m/3500x25=86 contracts (SHORT) • Given we were hedging 100% with 86 contracts to
A reduce our risk to zero, we can take 43 to hedge 50% to
give us half of our previous risk of 1.5.
• What position is necessary to reduce
• Generally:
the beta of the portfolio to 0.75?
P 5m
(    *)  (1.5  .75)  43
A 87500

What position is necessary to increase the beta of the

portfolio to 2.00?

55 56

55 56

19. Hedging Using Index Futures 19. Hedging Using Index Futures
• What position is necessary to increase the beta of the
portfolio to 2.00? • We can use a series of futures contracts
to increase the life of a hedge.
P
(    *) • Each time we switch from 1 futures
A
contract to another we incur a type of
5M
(1.5  2.0)  29 basis risk.
3500 x 25

• Since this is negative we must go LONG!!!

57 58

57 58

20. Conclusion
• In today’s 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 week’s lecture we will discuss interest
rate contracts and swaps.

59

59