Determination of forward and future prices

Contents

• Determination of forward and future prices

Bid and Ask price

• Bid: Bank is prepared to buy GBP (Bid), offer mean bank is ready to sell the
sterling in the spot market (offer) (Ch-1 page 4)
Comparison of forward and future contracts
Investment assets and consumption assets

 An investment asset is an asset that is held for investment purpose by significant numbers
of investors. Stock and bonds are clearly investment assets. Gold and silver are also
examples of investment assets (investment assets do not have to be held exclusively for
investment).

 However, they do have to satisfy the requirement that they are held by significant numbers
of investors solely for investment.

 A consumption asset is an asset that is held primarily for consumption. It not usually held
for investment. Examples of consumption assets are commodities such as copper, oil etc.
Short selling
 Shorting involves selling an asset that is not owned. It is something that is possible for some-but not all
—investment assets.

 For example: An investor instructs a broker to short 500 IBM shares. The broker will carry out the
instructions by borrowing the shares form another client and selling them in the market in the usual
way.

 The investors can maintain the short position for as long as desired, provided there are always shares
for the brokers to borrow.

 At some stage, the investor will close out the position by purchasing 500 IBM shares. These are then
replaced in the account of the client form which the shares were borrowed.

 The investor takes profit if the stock price has declined and a loss if it has risen.
Short selling

 An investor with short position must pay to the broker any income, such as dividend or interest,
that would normally be received on the securities that have been shorted. The broker will transfer
this income to the account of the client from whom the securities have been borrowed.

 Example: consider the position of an investor who shorts 500 shares in April when the price per
share is $120 and closes out the position by buying them back in July when the price per share is
$100. Suppose that a dividend of $1 per share is pain in May. The dividend leads to a payment by
the investor of 500*$1 = $500. The investor also pays 500*$100 = $50,000 for shares when the
position is closed out in July.

 The net gain:

Cash flows from short sale and purchase of shares
Margin account

 The investor is required to maintain a margin account with the broker.

 The margin account consist of cash or marketable securities deposited by the
investor with the broker guarantee that the investor will not walk away from the
short position if the share price increases.

 An initial margin is required and if there are adverse movements in the price of
the asset that is being shorted, additional margin may be required.

 If the additional margin is not provided, the short position is closed out.
Assumption for market participants

 The market participants are subject to no transaction cost when they trade.
 The market participants are subject to the same tax rate on all net trading profits.

 The market participants can borrow money at the same risk free rate of interest as
they can lend money.

 The market participants take advantage of arbitrage opportunities as they occur.

Notation will be used

• T: Time until delivery in a forward of future contract (in years)

• Price of the asset underlying the forward or future contract today

• Forward or future price today

• r : Zero-coupon risk-free rate of interest per annum, expressed with continuous

compounding, for an investment maturing at the delivery date (i.e., in T years)

• The risk free rate, r, is the rate at which money is borrowed or lent when there is
no credit risk, so that the money is certain to be repaid.
Forward price for an investment

 The easiest forward contract to value is one written on an investment assets that
provides the holder with no income. Non-dividend-paying stocks and zero-coupon
bonds are example for such investment assets.

 Consider a long forward contract to purchase a non-dividend-paying stock in 3

months. Assume that the current stock price is $40 and the 3-month risk-free
interest rate is 5% per annum.
Arbitrage: First strategy: Forward price is $43

• Current price is = $40

• Forward price = $43

• An arbitrageur can borrow $40 at the risk-free interest rate of 5% per annum, buy
one share, and short a forward contract to sell one share in 3 months.

• At the end of three months, the arbitrageur delivers the share and receives $43.

• The sum of money required to pay off the = 40 = ?

• Locks in a profit of = ?
Second strategy

• Sport price = $40

• Forward price = $39

• An arbitrage can short one share, invest the proceeds of the short sale at 5% per
annum for 3 months, and take a long position in a 3-month forward contract.

• Proceeds of the short sale grow to 40 = $40.50

• At the end of three months, the arbitrageur pays $39, takes delivery of the share

under the terms of the forward contract, and uses it to close out the short position .
Arbitrage opportunities when forward price is out of line
with spot price
A generalization

• To generalize this example, we consider a forward contract on an investment asset

with price that provides no income.

• Using our notation, T is the time to maturity, r is the risk-free rate, and is the
forward price. The relationship between and is

• If arbitrageurs can buy the asset and short forward contracts on the asset.

• If then short the asset and enter into long forward contract on it.
Example

• Consider a 4-month forward contract to buy a zero-coupon bond that will mature
1 year form today. The current price of the bond is $930.

• Risk free interest rate is 6% per annual.

• Calculate the forward negotiable price, = ?

Known income

Consider a long forward contract to purchase a coupon-bearing bond whose

current price is $900. We will assume that the forward contract matures in 9
months.

We will also suppose that a coupon payment of $40 is expected after 4 months

We are also assuming that the 4-month and 9-moth risk free interest rates are,
respectively, 3% and 4% per annum.

Suppose first that the forward price is relatively high at $910 and low $870?
Known income: Generalization

 When an investment asset will provide income with a present value of I during
the life of a forward contract, we have

• If , an arbitrageur can lock in profit by buying the asset and shorting a forward
contract on the asset.

• If , an arbitrageur can lock in profit by shorting the asset and taking a long
position in a forward contract.
Known income

 Consider a long forward contract to purchase a coupon bearing-bond whose

current price is $900.

 We will suppose that the forward contract matures in 9 months. We will also
suppose that a coupon payment of $40 is expected after 4 months

 We also assume that 4-months and 9-months risk free interest rate are
respectively, 3% and 4% per annum.

 Suppose that the forward price is relatively high at $910 and low $870?
When the present value is high (F = $910)

 The first payment is received $40 as a coupon payment.

 The coupon payment has a present value = .60

 Off $900, $39.60 is therefore borrowed at 3% per annum and 4 months so that it can be repaid with the coupon
payment .

 The remaining 860.40 can is borrowed at 4% per annum for 9 months.

 The amount owing at the end of the 9-month period is 860.40 = $886.60

 A sum of $910 is received for the bond under the terms of the forward contract.

 The arbitrageur therefore makes a net profit of

 $910.00 – 886.60 = $23.40

When forward price is relatively low (F = $870)

 Forward price = $870

 An investor can short the bond and enter into a long forward contract.

 Of the $900 realized from shorting the bond, $39.60 is invested for 4 months a 3% percent per
annum so that it grows into an amount sufficient to pay the coupon on the bond.

 The remaining $860.40 is invested for 9 months at 4% per annum and grows to $886.60

 Under the terms of the forward contract, $870 is paid to buy the bond and the short position is
closed out.

 The investor therefore gains: ($886.60 – $870) = $16.60

Arbitrage opportunities
Example

• Consider a 10 month forward contract on a stock when the stock price is $50. We
assume that a risk free rate of return is 8 per annum for all maturities. We also assume
that dividends of $0.75 per share are expected after 3 months, 6 months and 9 months.

• The present value of the dividend I = ?

• The forward price = ?

• As an arbitrageur what would be your decision? If the forward price is 55$ and 49$
respectively.
Valuing the forward contract

 The value of a forward contract at the time it is first entered into is zero.

 At a later stage, it may prove to have a positive or negative value.

 It is important for banks and other financial institutions to value the contract each day.

• K : Delivery price that was negotiated some time ago

• T : Delivery date is from today,

• r: risk free rate of return

• : forward price that would be applicable

• f: value of the forward contract today

Valuing the forward contract

• We compare a long forward contract that has a delivery price of with an

otherwise identical long forward contract that has a delivery price of K.

• The difference between the two is only in the amount that will be paid for the
underlying asset at time T.

• A cash outflow difference between of at time T translate to a difference of ().

• The contract with a delivery price is therefore less valuable than the contract with
delivery price of K by an amount ().
Example: Valuing forward contract

• A long forward contract on a non-dividend paying stock was entered into some time ago. It
currently has 6 months to maturity.

• r = 10% per annum

• The stock price is $25 and the delivery price is $24

• The 6-month forward price, , is given by:

• The value of the forward contract is:

• F = = (26.28-24)
Forward and future contracts on currencies

 The underlying asset is one unit of foreign currency.

• : Current spot price in dollars of one unit of foreign currency

• : forward or futures price in dollars of one unit of the foreign currency

• r : dollar risk free rate of return

• : Foreign risk-free rate of return

The relationship between and

• The relationship:

• This is well known interest rate parity relationship from international finance.

• Let us suppose you have 1000 units foreign currency.

Two ways to converting
Example: forward exchange rate is less (say 0.6300 )

 Suppose that the 2-year interest rates in Australia and US are 5% and 7%,
respectively. Spot exchange rate between the Australian dollar and US dollar is
0.6200 USD per AUD.

 Two year forward exchange rate should be:

 Suppose first that the 2-year forward exchange rate is less than this, say 0.6300
Example: forward exchange rate is less (say 0.6300 )

 Suppose first that the 2-year forward exchange rate is less than this, say 0.6300

1) Borrow 1,000 AUD at 5% per annum for 2 years, convert to 620 USD and invest the USD at 7%.

2) Enter into a forward contract to buy 1105.17 AUD for 1,105.17 USD

 The 620 USD that are invested at 7% grow to 620 = 713.17

 Of this, 696.26 USD are used to purchase 1.105.17 AUD under the terms of the forward contract.

 This is exactly enough to repay principal and interest on the 1,000 AUD that are borrowed = (1000 =

1,105.17)

 This risk less profit = $713.17 – $696.26 = $16.91

Example: forward exchange rate is greater (say 0.6600 )

1) Borrow 1,000 USD at 7% per annum for 2 years, convert to 1,000/0.622 =

1,612.90 AUD and invest the AUD at 5%.

2) Enter into a forward contract to sell 1,782.53 AUD for 1,782.53x 0.66 =
1,176.47 USD.

 Calculate the risk less profit?

Reading material

• Chapter 5: Determination of Forward and futures prices

• Book: John C. Hull: Options, Futures and other Derivatives, Seventh Edition