LECTURE 2

FORWARDS AND
FUTURES – PRICING

FIN4003 FINANCIAL DERIVATIVES

DEPARTMENT OF ECONOMICS AND FINANCE

THE HANG SENG UNIVERSITY OF HONG KONG

 LEARNING OUTCOMES

After completing this lecture, you will be able to do the following:

01 02 03 04
Describe the Understand the Be familiar with Show the conditions
features of forward concept of price and mark-to-market and under which futures
and futures value for forward the operation of and forward prices
contracts and futures margin account are equivalent and
contracts when they are
different

2
FORWARDS

Definition: A forward contract is a commitment traded over-the-counter in which

the buyer will purchase from the seller at a future date a given amount of an underlying
asset at a fixed price agreed on today.
o Let Vforward(t,T) represent the value of a forward contract at time t and expired at T, for
t = 0, 1, 2, …, T.
o Let F(t,T) be the forward price at time t, expired at T, for t = 0, 1, 2, …, T.
o Let S(t) represent the spot price of the underlying asset at time t, for t = 0, 1, 2, …, T.

t=0 t=T
time

Buyer: Agree to pay F(0,T) at Buyer: Pay F(0,T) and

time T to buy the asset receive the asset worth S(T)

Seller: Agree to receive F(0,T) Seller: Receive F(0,T) and

at time T to sell the asset deliver the asset worth S(T)

3
FORWARDS

o Features of forward contracts

• trade over-the-counter (OTC)
• customized, tailor-made contract
• zero value at start i.e. zero entry cost (no money changes hands)
• counterparty default risk

Example: Consider a 3-month forward contract for 12,000 bushels of soybean at

$13.50/bushel. The long side is committed to buy 12,000 bushels of soybean from the
short side 3 months from now at the price of $13.50/bushel. How does it compare to
the contract specification of CME soybean futures?

4
PRICING FORWARD CONTRACTS
o Suppose you need to buy an asset at a future date, time T and want to fix the price today.
o You can either enter into a long forward position today with delivery at time T, or buy the
asset at current spot price and then carry the asset to time T. The cost of carry is the key
to derive the forward price.
o The process of pricing a forward contract is summarized as follows.
t=0 t=T

time

Long forward at F(0,T) Earn interest on proceeds Acquire asset from forward
Short selling asset at S(0) Pay F(0,T)
Proceeds S(0)

Short forward at F(0,T) Lose interest on outlay Deliver asset against forward
Long asset at S(0) Receive F(0,T)
Outlay S(0)

Definition: Short selling involves selling the underlying asset that you do not own. It
requires borrowing the asset through your broker and selling it on the open market. Any
dividend payout and other benefits that the lender of the underlying asset will receive during
the period must be compensated by the borrower. 5
PRICING FORWARD CONTRACTS
Portfolio at time 0 Value at time 0 Portfolio at time T Value at time T
Short asset -S(0) Asset value -S(T)
Long bond (lend at r) S(0) Bond value S(0)(1 + r)T
Long forward 0 Forward value S(T) – F(0,T)
Total 0 Total S(0)(1 + r)T – F(0,T)

Portfolio at time 0 Value at time 0 Portfolio at time T Value at time T

Long asset S(0) Asset value S(T)
Short bond (borrow at r) -S(0) Bond value -S(0)(1 + r)T
Short forward 0 Forward value F(0,T) – S(T)
Total 0 Total F(0,T) – S(0)(1 + r)T

o This is called cash-and-carry relationship between the spot and forward prices. The
payoff must be zero in order to avoid arbitrage. Otherwise, we can generate positive
cashflows at time T with no initial investment and no risk. This implies
F(0,T) = S(0)(1 + r)T
6
FORWARD PRICES AND ARBITRAGE

o Is there an arbitrage opportunity? What is the trading strategy?

o F(0,T) > S(0)(1 + r)T

To capture the opportunity, you can borrow money and buy the underlying asset at the
spot market and open a short forward contract.

o F(0,T) < S(0)(1 + r)T

To capture the opportunity, you can short sell the underlying asset at the spot market,
invest the proceeds, and open a long forward contract.

7
FORWARD PRICES AND ARBITRAGE

Example: The price of a non-dividend-paying stock is currently trading at $20. The risk-
free rate is 5%. The price of a 1-year forward contract would be
F(0,1) = 20(1.05) = $21
Example: If the 1-year forward is quoted at $23, what is the arbitrage strategy?
• At time 0, (i) enter into forward to sell stock in 1 year at $23, (ii) borrow $20 at 5% for 1 year to
acquire stock, (iii) long stock at $20.
• At time T, (i) receive $23 from selling stock at forward price, (ii) repay borrowing $20 along
with interest $1.
• Arbitrage profit = $23 – $21 = $2
Example: If the 1-year forward is quoted at $19, what is the arbitrage strategy?
• At time 0, (i) enter into forward to buy stock in 1 year at $19, (ii) short selling stock at $20, (iii)
lend the proceeds at 5% for 1 year.
• At time T, (i) receive from lending $20 along with interest $1, (ii) acquire stock at forward price
$19 to uncover short selling position.
• Arbitrage profit = $21 – $19 = $2

8
VALUING FORWARD CONTRACTS

o The value of a forward contract is zero when initiated at time t = 0. Hence, Vforward(0,T) = 0.

o The price of a forward contract that expires immediately is the spot price as the contract
will call for settlement and delivery an instant after trade. If it does not hold, an arbitrage
opportunity would exist.

o The price of a forward contract at time T, expired at T must equal the spot price at time T.
Hence, F(T,T) = S(T).

o The value of a forward contract at expiration, time T is

Vforward(T,T) = F(T,T) – F(0,T)

= S(T) – F(0,T) from a forward buyer perspective

Vforward(T,T) = F(0,T) – F(T,T)

= F(0,T) – S(T) from a forward seller perspective
9
VALUING FORWARD CONTRACTS

Portfolio Composition Value at time 0 Value at time t Value at time T

A Long forward at fixed price 0 Vforward(t,T) S(T) – F(0,T)
F(0,T) at time 0
B i. Borrow F(0,T) / (1 + r)(T – t) N/A S(t) – F(0,T) / (1 + r)(T – t) S(T) – F(0,T)
at time t
ii. Long asset at time t

o Portfolio A is a forward contract traded at time 0, which will pay off S(T) – F(0,T) at
expiration, time T.
o Portfolio B consists of a loan and a long position in the underlying asset. Nothing is done
at time 0. At time t, we borrow the present value of F(0,T) at risk-free rate r for purchasing
the asset worth S(t). At time T, we sell the asset for S(T) and use the proceed to pay back
the loan amount F(0,T).
o Portfolio A value must be the same as Portfolio B value at time t, for t = 1, 2, …, T. Hence,
Vforward(t,T) = S(t) – F(0,T) / (1 + r)(T – t)
10
VALUING FORWARD CONTRACTS
o The value of a forward contract prior to expiration is the spot price minus the present value of the
forward price.

Vforward(t,T) = S(t) – F(0,T) / (1 + r)(T – t)

o Substituting S(t) = F(t,T) / (1 + r)(T – t) gives the result

Vforward(t,T) = ( F(t,T) – F(0,T) ) / (1 + r)(T – t)

Example: Suppose that you buy a forward contract today at a price of $100. The contract
expires in 45 days. The risk-free rate is 10%. Then, 20 days after trade, the spot price of the
underlying asset is $102. The value of the forward contract with 25 days remaining is
102 – 100 / (1.10)25/365 = 2.65.

Example: Suppose that you buy a forward contract today at a price of $100. The contract
expires in 45 days. The risk-free rate is 10%. Then, 10 days after trade, the forward contract price is
$96. The value of the forward contract with 35 days remaining is
(96 – 100) / (1.10)35/365 = -3.96.
11
PRICING FORWARDS ON DIVIDEND-PAYING STOCK & INDEX
o The general principles are the same for a single stock forward and a stock index forward.
In either case, we assume that the stock pays a series of known dividends of D(T) at
expiration, time T.
o Suppose that an investor buys the stock at a spot price of S(0) and sell a forward
contract at a price of F(0,T).

Portfolio at time 0 Value at time 0 Portfolio at time T Value at time T

Long stock S(0) Stock value S(T)
Short bond (borrow at r) -S(0) Bond value -S(0)(1 + r)T
Short forward 0 Forward value F(0,T) – S(T)
Dividends 0 Dividends D(T)
Total 0 Total F(0,T) – S(0)(1 + r)T + D(T)

Receive dividend of d1, Receive dividend of d2, Receive dividend of d3, Dividend accumulate
reinvest at r reinvest at r reinvest at r to future value of D(T)

t=0 t=1 t=2 t=3 t=T

Today 1st ex-dividend date 2nd ex-dividend date 3rd ex-dividend date Expiration
12
PRICING FORWARDS ON DIVIDEND-PAYING STOCK & INDEX

o Since the payoff must be zero in order to avoid arbitrage, this implies
F(0,T) = S(0)(1 + r)T – D(T)

o Alternatively, we can instead find the present value of the dividends and subtract
this amount from the stock price before compounding it at the risk-free rate. In other
words, the present value of the dividends over the life of the contract would be
$𝑑(𝑡)
𝐷 0 =$ !
!"# (1 + 𝑟)

o The forward pricing formula would then be

F(0,T) = ( S(0) – D(0) )(1 + r)T

o Alternatively, it can be viewed as the dividend-adjusted stock price compounded to

expiration at the risk-free rate.

13
PRICING FORWARDS ON DIVIDEND-PAYING STOCK & INDEX

Example: Consider a 10-month forward contract on a stock. The stock price is

currently trading at $100. We anticipate a cash dividend payout of $2 per share after 3
months, 6 months, and 9 months from toady. Given 5% interest rate, what is the forward
price?

The present value of dividends during this period is

D(0) = 2 / (1.05)3/12 + 2 / (1.05)6/12 + 2 / (1.05)9/12 = $5.86

Then the forward price is

F(0,10) = (100 – 5.86)(1.05)10/12 = $98.05

14
PRICING FORWARDS ON DIVIDEND-PAYING STOCK & INDEX
Example: If the forward is quoted at $100, what is the arbitrage strategy?

• At time = 0,
(i) borrow PV of d(3) 1.9758 for 3 months
borrow PV of d(6) 1.9518 for 6 months
borrow PV of d(9) 1.9281 for 9 months
borrow 94.1443 for 10 months
(ii) buy stock at $100.
(iii) enter into forward to sell stock in 10 months at $100

• At time = 3, 6, 9 months,
(i) receive dividend $2, (ii) repay loan with interest $2.

• At time = 10 months,
(i) receive $100 from selling stock at forward price, (ii) repay loan with interest $98.05.

• Arbitrage profit = $100 – $98.05 = $1.95

15
PRICING FORWARDS ON DIVIDEND-PAYING STOCK & INDEX
Example: If the forward is quoted at $95, what is the arbitrage strategy?

• At time = 0,
(i) lend PV of d(3) 1.9758 for 3 months
lend PV of d(6) 1.9518 for 6 months
lend PV of d(9) 1.9281 for 9 months
lend 94.1443 for 10 months
(ii) short sell stock at $100.
(iii) enter into forward to buy stock in 10 months at $95

• At time = 3, 6, 9 months,
(i) receive from lending with interest $2, (ii) pay dividend $2.

• At time = 10 months,
(i) receive from lending with interest $98.05, (i) acquire stock at forward price $95 to uncover
short selling position.

• Arbitrage profit = $98.05 – $95 = $3.05

16
VALUING FORWARDS ON DIVIDEND-PAYING STOCK & INDEX

o To value a forward contract on a stock (index) that pays dividends, we simply adjust the
spot price to eliminate the present value of the cash payments.

Vforward(t,T) = S(t) – D(t,T) – F(0,T) / (1 + r)(T – t)

where D(t,T) is the present value from time t to T of any remaining dividends.

Example: Suppose that you buy a 10-month forward contract on a stock at $98. The
risk-free rate is 5%. Then, 8 months after trade, the spot price of the underlying asset is
$110. A cash dividend of $2 per share is expected to pay 1 month prior to contract
expiration. The present value of dividend during this period is

D(8,9) = 2 / (1.05)1/12 = $1.99

The value of the forward contract with 2 months remaining is

Vforward(8,10) = 110 – 1.99 – 98 / (1.05)2/12 = $10.80

17
PRICING FORWARDS ON CURRENCY

o Interest rate parity is a fundamental relationship between the spot and forward exchange
rates and the interest rates in two countries. The equation that governs the relationship
can be applied to forward pricing formula.
Fa/b(0,T) = Sa/b(0)(1 + ra)T / (1 + rb)T

where Fa/b(0,T) is the forward FX rate of currency a per unit of currency b agreed at
time 0, expired at T, S(0) is the spot FX rate of currency a per unit of currency b, ra is
the interest rate on currency a, and rb is the the interest rate on currency b.

Definition: Currency pairs are the national currencies from two countries coupled for
trading on the foreign exchange (FX) marketplace. Both currencies will have exchange
rates on which the trade will have its position basis. For example,
• USD/JPY - US dollar against Japanese Yen, quote as Yen per US dollar
• USD/HKD - US dollar against HK dollar, quote as HK dollar per US dollar
• EUR/USD – Euro against US dollar, commonly quoted as US dollar per Euro
• GBP/USD - British pound against US dollar, commonly quoted as US dollar per Pound
18
PRICING FORWARDS ON CURRENCY
Example: Calculate the 6-month USD/JPY forward rate given that the spot FX rate is
¥110. The USD interest rate is 3% while the JPY interest rate is 1%.
F¥/$(0,6) = 110(1.01)6/12 / (1.03)6/12 = ¥108.93

Example: If the 6-month USD/JPY forward is quoted at ¥112, what is the arbitrage
strategy?
• At time 0, (i) enter into forward to sell USD / buy JPY at ¥112 in 6 months, (ii) borrow ¥110 at
1%, (iii) convert ¥110 to $1 at FX spot rate, (iv) lend $1 at 3%.
• At time T, (i) receive $1.0149 from lending, (ii) sell $1.0149 for ¥113.6676 at forward rate, (iii)
repay borrowing ¥110.5486.
• Arbitrage profit = ¥113.6676 – ¥110.5486 = ¥3.12

Example: If the 6-month USD/JPY forward is quoted at ¥105, what is the arbitrage
strategy?
• At time 0, (i) enter into forward to buy USD / sell JPY at ¥105 in 6 months, (ii) borrow $1 at
3%, (iii) convert $1 to ¥110 at FX spot rate, (iv) lend ¥110 at 1%.
• At time T, (i) receive from ¥110.5486 lending, (ii) sell ¥110.5486 for $1.0528 at forward rate,
(iii) repay borrowing $1.0149.
• Arbitrage profit = $1.0528 – $1.0149 = $0.04 19
VALUING FORWARDS ON CURRENCY

o The value of a currency forward contract, following the same approach as used
previously, is

Va/b,forward(t,T) = Sa/b(t) / (1 + rb)(T – t) – Fa/b(0,T) / (1 + ra)(T – t)

Example: Suppose that you enter into a currency forward contract which buy USD
and sell JPY at ¥109 in 6 months. Then, 2 months after trade, the spot FX rate is ¥112. The
USD interest rate is 3% while the JPY interest rate is 1%. The value of the forward contract
with 4 months remaining is

Vforward(2,6) = 112 / (1.03)4/12 – 109 / (1.01)4/12 = ¥2.26

20
PRICING FORWARDS ON COMMODITY

o For non-financial assets, such as crude oil, gold, copper, soybean, the cash-and-carry
strategy must consider the cost of storing such commodities.
o Let the present value of storage cost for holding the underlying commodity be 𝛼.
o Suppose that a hedger buys the commodity at a spot price of S(0) and sells a forward
contract at a price of F(0,T).
Portfolio at time 0 Value at time 0 Portfolio at time T Value at time T
Long commodity S(0) Commodity value S(T)
Pay storage cost 𝛼
Short bond (borrow at r) - ( S(0) + 𝛼 ) Bond value - ( S(0) + 𝛼 )(1 + r)T
Short forward 0 Forward value F(0,T) – S(T)
Total 0 Total F(0,T) – ( S(0) + 𝛼 )(1 + r)T

o Since the payoff must be zero in order to avoid arbitrage, this implies
F(0,T) = ( S(0) + ⍺ )(1 + r)T

21
PRICING FORWARDS ON COMMODITY

Example: Consider a forward contract to buy 100 troy ounce of gold in 6 months. The
current gold price is $1,900/oz and storage costs are $2.25/oz payable at the maturity of the
forward contract. Interest rate is 5%. What is the forward price?

F(0,6) = 1900(1.05)6/12 + 2.25 = $1949.17

Example: Suppose that you observed the forward traded at $1,970. what is the
arbitrage strategy?
• At time 0, (i) enter into forward to sell 100oz of gold in 6 months at $1,970, (ii) borrow
$190,000 at 5% for 6 months to acquire gold, (iii) long 100oz of gold at $1,900.
• At time T, (i) receive $197,000 from selling 100oz of gold at forward price, (ii) repay
borrowing $190,000 along with interest $4,692, (iii) pay storage cost $225.
• Arbitrage profit = $197,000 – $194,692 – $225 = $2,083

22
PRICING FORWARDS ON COMMODITY

o There are many commodities held not for investment purpose but inventoried for usage in
production, e.g. crude oil, copper and soybean. Hence, the commodity inventory will not
be lent out for short sales.
o There is a benefit from holding physical commodity, called a convenience value, rather
than a long position on the commodity forward.
o This benefit needs to be incorporated in the cost-of-carry relationship in the form

F(0,T) = ( S(0) + ⍺ )(1 + r)T – y(0,T)

where y(0,T) represents the present value of the convenience value from holding the
commodity until time T.

23
FUTURES
Definition: A futures contract is a commitment traded on an exchange in which
the buyer will purchase from the seller at a future date a given amount of an
underlying asset at a fixed price agreed on today.
o Let Vfutures(t,T) represent the value of a futures contract at time t and expired at T, for
t = 0, 1, 2, …, T.
o Let f(t,T) be the futures price at time t, expired at T, for t = 0, 1, 2, …, T.
o Let S(t) represent the spot price of the underlying asset at time t, for t = 0, 1, 2, …, T.

t=0 t=T
daily mark-to-market
time

Buyer: Agree to pay f(0,T) at Buyer: Pay f(0,T) and

time T to buy the asset receive the asset worth S(T)

Seller: Agree to receive f(0,T) Seller: Receive f(0,T) and

at time T to sell the asset deliver the asset worth S(T)

24
FUTURES

o Features of futures contracts

• trade on exchanges
• standardized contract in terms of underlying asset, quantity, expiry, etc.
• zero value at start i.e. zero entry cost (no money changes hands)
• daily mark-to-market to eliminate counterparty default risk

Example: Consider a June 2021 futures contract for 100 troy ounces of gold at
$1,860/oz. The long side is committed to buy 100 ounces of gold from the short side
on the expiration date in June at the price of $1,860/oz. Click this link for contract
specification details.

25
MARGIN

o The exchange sets the minimum level for initial and maintenance margin.
o Margin is required for both long and short positions.
o Higher volatility in the price of the underlying asset results in higher margin level.
o Margin requirement could be lower for day trade (i.e. intending to close out the
position in the same day) and spread trade (i.e. with offsetting positions of different
months).
o The clearing house, an adjunct of the exchange, settles the daily mark-to-market of
margin accounts on the outstanding positions. A margin call will be issued when the
maintenance margin level is triggered.
o Margin minimizes the possibility of default.

26
MARGIN

Definition: A margin is cash or marketable securities deposited by an investor

with his broker.

Definition: Initial margin is the amount required to open a derivatives position.

Definition: Maintenance margin is the minimum margin account balance required

to retain the derivatives position.

Definition: Mark-to-market adjusts investor’s margin account to reflect his profit

or loss on the outstanding positions at the end of each trading day.

Definition: Margin call is a request for extra margin when the balance of the
margin account falls below the maintenance margin level.

Definition: Variation margin is the amount required in the margin call, which
equals the difference between initial margin and the balance of the margin account.

27
MARK-TO-MARKET CALCULATION
Example: An investor long two June 2021 gold futures at $1,860/oz. The size is 100
oz/contract. The initial margin is $30,000/contract. The maintenance margin is $10,000/contract.

Day Trade Price Settlement Price Daily PnL Cumulative PnL Margin Balance Margin Call
0 1,860.00 60,000.00
1 1,839.54 -4,092.00 -4,092.00 55,908.00
2 1,819.31 -4,046.99 -8,138.99 51,861.01
3 1,799.29 -4,002.47 -12,141.46 47,858.54
4 1,779.50 -3,958.44 -16,099.90 43,900.10
5 1,759.93 -3,914.90 -20,014.80 39,985.20
6 1,740.57 -3,871.84 -23,886.64 36,113.36
7 1,721.42 -3,829.25 -27,715.89 32,284.11
8 1,702.48 -3,787.13 -31,503.01 28,496.99
9 1,683.76 -3,745.47 -35,248.48 24,751.52
10 1,665.24 -3,704.27 -38,952.75 21,047.25
11 1,646.92 -3,663.52 -42,616.27 17,383.73 2,616.27
12 1,679.86 6,587.67 -36,028.59 26,587.67
13 1,713.45 6,719.43 -29,309.16 33,307.10
14 1,747.72 6,853.82 -22,455.35 40,160.92
15 1,782.68 6,990.89 -15,464.45 47,151.81
16 1,818.33 7,130.71 -8,333.74 54,282.52
28
FUTURES VS FORWARDS

Futures Forwards
Exchange traded market Over-the-counter market
Standardized contract terms Customized contract terms
Settled daily via mark-to-market Settled at expiration date
Close-out by another contract Delivery or cash settlement
Virtually no credit risk Some credit risk
Good liquidity Relatively less liquidity
Margin Collateral

29
ARE FUTURES AND FORWARD PRICES THE SAME?

o Forward contract prices can be determined using the cash-and-carry strategy.

o It could be difficult to use such a strategy to replicate futures contracts without any
assumptions.
o Consider both a forward contract and a futures contract with delivery at date 2 on an
asset whose date 2 spot price denoted by S(2).
o The forward contract only has a cashflow at date 2, while the futures contract has a
cashflow at date 1 and 2 due to mark-to-market.

0 Date 1 Date 2

Forward Price = F(0,2) Forward Price = S(2)

Cashflow = 0 Cashflow = S(2) – F(0,2)

0 Date 1 Date 2

Futures Price = f(0,2) Futures Price = f(1,2) Futures Price = S(2)

Cashflow = 0 Cashflow = f(1,2) – f(0,2) Cashflow = S(2) – f(1,2)
30
ARE FUTURES AND FORWARD PRICES THE SAME?

Forward Contract
o At date 0, long forward at a price F(0,2) with an initial cost of zero.
o At date 2, Vforward(2,2) = S(2) – F(0,2).
o At date 0, Vforward(0,2) = PV of Vforward(2,2) = 0.

Futures Contract
o Long futures at a price f(0,2) at date 0 until the contract matures at date 2.
o At date 1, the contract is mark-to-market, generating a cashflow of f(1,2) – f(0,2), which will be
reinvested or refinanced at a risk-free rate r(1,2) for the next period.
o At date 2, Vfutures(2,2) = S(2) – f(1,2) + ( f(1,2) – f(0,2) ) × ( 1 + r(1,2) ).
o Rearranging the result gives Vfutures(2,2) = S(2) – f(0,2) + ( f(1,2) – f(0,2) ) × r(1,2).
o At date 0, Vfutures(0,2) = PV of Vfutures(2,2) = 0

Both forward and futures contracts have zero value at date 0, which implies

F(0,2) = f(0,2) – [ 1 + r(0,2) ] × PV of [ ( f(1,2) – f(0,2) ) × r(1,2) ]

31
ARE FUTURES AND FORWARD PRICES THE SAME?
o As a result, the forward price equals the futures price minus an adjustment term for the
present value of interest earned or owed from market-to-market. It could be either positive,
zero, or negative.
o If interest rates are positively correlated with futures prices, f(0,T) > F(0,T).
• f(0,T) will generate mark-to-market profits when interest rates rise and will incur mark-
to-market losses when interest rates fall. This means that profits will be reinvested at
higher rates and losses will be incurred when the refinancing cost is falling.
o If interest rates are negatively correlated with futures prices, f(0,T) < F(0,T).
• f(0,T) will incur mark-to-market losses when interest rates rise and will generate mark-
to-market profit when interest rates fall. This means that profits will be reinvested at
lower rates and losses will be incurred when the refinancing cost is rising.
o If interest rates are certain and uncorrelated with futures prices, f(0,T) = F(0,T).
• The uncorrelation implies that the interest earned or owed from mark-to-market
should be, on average, zero.

o By not observing any notable differences in forward and futures prices, we can reasonably
assume that futures prices are the same as forward prices. Thus, the cash-and-carry
strategy discussed earlier can also apply to futures prices and values.
32