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Financial Engineering and Risk Management: Forwards Contracts

This document discusses forward contracts and how to price them using no-arbitrage principles. It defines a forward contract as giving the buyer the right and obligation to purchase an asset at a specified future time at a predetermined price. The forward price F is set so that the initial value of the contract is zero. Short selling is also discussed as a way to establish a risk arbitrage portfolio to derive the no-arbitrage formula for determining the forward price based on the current spot price and interest rates. Examples are provided to demonstrate how to calculate forward prices.

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Amsalu Walelign
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82 views

Financial Engineering and Risk Management: Forwards Contracts

This document discusses forward contracts and how to price them using no-arbitrage principles. It defines a forward contract as giving the buyer the right and obligation to purchase an asset at a specified future time at a predetermined price. The forward price F is set so that the initial value of the contract is zero. Short selling is also discussed as a way to establish a risk arbitrage portfolio to derive the no-arbitrage formula for determining the forward price based on the current spot price and interest rates. Examples are provided to demonstrate how to calculate forward prices.

Uploaded by

Amsalu Walelign
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial Engineering and Risk Management

Forwards contracts

Martin Haugh

Garud Iyengar

Columbia University Industrial Engineering and Operations Research

Forward contract
Denition. A forward contract gives the buyer the right, and also the obligation, to purchase a specied amount of an asset at a specied time T at a specied price F (called the forward price) set at time t = 0 Example. Forward contract for delivery of a stock with maturity 6 months Forward contract for sale of gold with maturity 1 year Forward contract to buy 10m $ worth of Euros with maturity 3 months Forward contract for delivery of 9-month T-Bill with maturity 3 months.

Setting the forward price F


Goal: Set the forward price F for a forward contract at time t = 0 for 1 unit of an asset with asset price St at time t and maturity T ft = value/price at time t of a long position in the forward contract Value at time T : fT = (ST F ) long position in forward: must purchase the asset at price F spot price of asset: ST Forward price F is set so that time t = 0 value/price f0 is 0 Use no-arbitrage principle to set F

Short selling an asset


Short selling is the selling of shares in a stock that the seller doesnt own The seller borrows the shares from the broker The shares comes from the brokerages own inventory The shares are sold and the proceeds are credited to the sellers account However ... sooner or later the seller must close the short by buying back the shares (called covering) Prot/loss associated with a short sale Results in a prot when the price drops Results in a loss when the price increases Short positions can be very risky Price can only drop to zero ... potential prot is bounded Price can increase to arbitrarily large values ... potential loss is unbounded
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No-arbitrage argument to set F


Assume asset has no intermediate cash ows, e.g. dividends, or storage costs. Portfolio: Buy contract, short sell the underlying and lend S0 up to time T Cash ow Buy contract Short sell asset and buy back at time T Lend S0 up to T Net cash ow t=0 f0 = 0 + S0 S0 0 t=T fT = ST F ST S0 /d (0, T ) S0 /d (0, T ) F

The portfolio has a deterministic cash ow at time T and the cost = 0. Therefore, S0 S0 0= F d (0, T ) F = d (0, T ) d (0, T ) Why is F strictly greater than the spot price S0 ? Cost of carry
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Examples of forward contracts


Example. Forward contract on a non-dividend paying stock that matures in 6 months. The current stock price is $50 and the 6-month interest rate is 4% per annum. Solution. Assuming semi-annual compounding, the discount factor d (0, .5) = Therefore, F = 50/0.9804 = 51.0 1 04 = 0.9804. 1 + 0.2

Forward value ft for t > 0


Recall the value of a long forward position at time 0: f0 = 0 at time T : fT = ST F F0 : Forward price at time 0 for delivery at time T Ft : Forward price at time t for delivery at time T Pricing via the no-arbitrage arguments Cash ow Short Ft contract Long F0 contract Net cash ow t=t 0 ft ft t=T Ft ST ST F0 Ft F0

The portfolio has a deterministic cash ow. Therefore, ft = (Ft F0 )d (t , T )


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