Chapter 5

Determination of Forward and

Futures Prices

Yun Pei
University at Buffalo

1
Investment vs Consumption Assets
When considering forward and futures contracts, we
need to distinguish between investment assets and
consumption assets
Investment assets are assets held by significant
numbers of people purely for investment purposes
Examples: stocks, gold
Consumption assets are assets held primarily for
consumption
Examples: copper, oil
Arbitrage argument will not work the same way for
consumption assets as they do for investment assets
2
Short Selling
Some arbitrage strategies involving short selling
Short selling involves selling securities that one does
not own
An investor tells the broker to short some securities
The broker borrows the securities from another client
and sells them in the market in the usual way
At some stage the investor must buy the securities,
so they can be replaced in the account of the client
The investor takes a profit if the price has declined
and a loss if it has risen
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Short Selling
An investor with a short position must pay
dividends and other benefits, which the owner
of the securities receives
There may be a small fee for borrowing the
securities
The investor must also maintain a margin
account with the broker

4
Example

5
Assumptions
We assume that the market participants
are subject to no transaction costs when they
trade
are subject to the same tax rate on all net trading
profit
can borrow money at the same risk-free rate as
they can lend money
take advantage of arbitrage opportunities as they
occur

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Notation
The following notation will be used
S0: Spot price today
F0: Forward or futures price today
T: Time until delivery date
r: Zero-coupon risk-free interest rate per
annum with continuous compounding

7
An Arbitrage Opportunity?
Consider a forward contract to purchase a non-
dividend-paying stock in 3 months
The current stock price is $40
The 3-month risk-free interest rate is 5% per annum

8
Another Arbitrage Opportunity?

The forward price must be $40.5 for there to be no

arbitrage

9
Forward Price
Consider a forward contract on an investment
asset that provides no income
S0 is the spot price of the asset, F0 is the
futures price, T is the time to maturity, and r is
the risk-free rate, then
F0 = S0erT
In our examples, S0=40, T=0.25, and r=0.05,
F0 = 40e0.05×0.25 = 40.50

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Forward Price
Arbitrageurs can buy the asset and short the
forward contract if
F0 > S0erT
Arbitrageurs can short the asset and long the
forward contract if
F0 < S0erT

11
If Short Sales Are Not Possible
Sometimes short sales are not possible
We can derive the same formula as long as there are
investors who hold the asset purely for investment
Suppose F0<S0erT, investor who owns the asset can
1. sell the asset for S0;
2. invest the proceeds at interest rate r for time T;
3. take a long position in the forward contract
At time T, the investor then makes a profit of S0erT–F0
relative to what would have been if the asset had
been kept

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 eg on how to do arbitrage

Known Income
can be any income
coupon or dividend

forward price when too expensive we should enter short position

We 39.6e^0.03*4/12 = 40
borrow short it right now and take long
900 to position after 9 months
buy this 860.4e^0.04*9/12 =
asset 886.6
and at
the 860.4 turned to 886.6 after 9
same months
time
enter a
contract
to sell it
in 4
months
time

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Known Income
Consider a forward contract on an investment
asset that provides a known income
Example: stocks paying known dividends,
coupon-bearing bonds
Define I to be the present value of the income
during life of the forward contract, then
F0 = (S0 – I)erT

Theoretical price is the breakeven price, not too high not too low. Sometimes referred to as a fair or hypothetical value, a theoretical
value is the estimated price of an option

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Known Income
We should look at which side is smaller; we always buy the smaller one
and sell the larger one

Arbitrageurs can buy the asset and short the

forward contract if
F0 > (S0 – I)erT
Arbitrageurs can short the asset and long the
forward contract if
F0 < (S0 – I)erT
If short sales are not possible, investors who own
the asset will find it profitable to sell the asset and
long the forward contract

If we have a profit of 1.9$ and a transaction cost is $2, then it is not profitable to engage in this. 15
Example

we receive 75 cents which is the first dividend

2nd dividend

We convert this to an asset without income . This is why we take the present value.

16
Known Yield
Consider a forward contract on an investment
asset that provides a known yield
This means the income is known when
expressed as a percentage of the asset’s
price at the time the income is paid
Define q to be the average yield during the life
of the contract (expressed with continuous
compounding), then
F0 = S0e(r–q)T
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Example

2% for 6 months and 2%

for the next 6 months

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Valuing Forward Contracts
A forward contract is worth zero (except for
bid-offer spread effects) when it is first
negotiated
Later it may have a positive or negative value
Suppose that
K is the delivery price for a contract that was
negotiated some time ago
F0 is the forward price for the contract that would
be negotiated today
f is the value of the forward contract today
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Valuing Forward Contracts
By considering the difference between a
contract with delivery price K and a contract
with delivery price F0, we can deduce that
the value of a long forward contract is
f = (F0 – K)e–rT
the value of a short forward contract is
f = (K – F0)e–rT

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Example

arbitrage price today should be equal to this

profit after 6 months discounted to the value of today

we enter into forward contract to buy this asset
at 24 but today the we can sell it at 26.28.

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 when we enter a forward contract its value is zero. As time progresses, we figure out if we have loss or profit,

Valuing Forward Contracts

Recall the value of a long forward contract is
f = (F0 – K)e–rT
For an asset that provides no income
f = S0 – Ke–rT
For an asset that provides a known income
f = S0 – I – Ke–rT
For an asset that provides a known yield
f = S0e–qT – Ke–rT
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Forward vs Futures Prices
In theory, when interest rates are uncertain, forward and futures
prices are slightly different usually there is a v strong correlation between asset price and int rates. Futures are
settled every day but forwards are settled on delivery date.
Suppose a strong positive correlation between interest rates and
the asset price
When price of underlying asset S increases, investor who holds a
long futures position makes an immediate gain.
Positive correlation implies interest rates have also increased, so
gains can be invested at a higher rate
When S decreases, investor makes an immediate loss. But this loss
can be financed at a lower rate
Hence, a long futures contract is slightly more attractive than a long
forward contract, and the futures price is slightly higher than the
forward price this is on paper but it does not dominate because the futures has a higher transaction cost and bec its
unorganised its difficult to find people to tade with. There are other things that affect prices eg taxes.
A strong negative correlation implies the reverse
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Forward vs Futures Prices
In practice, besides interest rates, factors
such as taxes, transaction costs, margin
requirement, counterparty default risk may
also cause forward and futures prices to differ
But this difference tends to be small
When the maturity and asset price are the
same, forward and futures prices are usually
assumed to be equal
Eurodollar futures are an exception
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Stock Index Futures
A stock index can be viewed as an
investment asset paying a dividend yield
The futures price and spot price relationship
is therefore
F0 = S0e(r–q)T
where q is the average dividend yield on the
portfolio represented by the index during life
of contract
Sometimes its difficult to understand how much money SP 500 index is paying us but its easier to calculate the yield.

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Example

T = 3/12 = 1/4 = 0.25

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Index Arbitrage
When F0 > S0e(r-q)T, an arbitrageur buys the
stocks underlying the index and sells futures
When F0 < S0e(r-q)T, an arbitrageur shorts or
sells the stocks underlying the index and buys
futures
Whichever side is lower, buy that.
Whichever is higher, sell it.

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Index Arbitrage
Index arbitrage involves simultaneous trades in
futures and many different stocks
For indices involving many stocks, index arbitrage is
sometimes done by trading a relatively small sample
of stocks whose movements closely mirror those of
the index
Very often a computer is used to generate the trades
Occasionally simultaneous trades are not possible
and the theoretical no-arbitrage relationship between
F0 and S0 does not hold

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Forward and Futures on Currencies
forex traders are people who trade in currencies

A foreign currency can be viewed as an

investment asset paying a known yield
The yield is the foreign risk-free interest rate
Define rf to be the foreign risk-free interest
rate, then
( r −rf ) T
F0 = S0e
The German bond is considered risk free.
When fed fund rate was increased by fed, we got a stronger $. Banks started competing for deposits and
started giving higher int rates. This appreciated the $.
This is assuming that we have complete capital mobility i.e risk free rate should be available for both countries.
When a currency is tied to $, increase in Fed fund rate forces that country to increase int rates bec otherwise $
will be appreciating and the other currency will be depreciating.
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Relationship Between Spot and
Forward Exchange Rate
1000 units of
foreign currency
at time zero

r T
1000e f units of
1000S0 dollars
foreign currency at time zero
at time T

1000 F0 e f
r T
1000S0erT
dollars at time T dollars at time T after time T this is how
much money we'll get

By the idea of arbitrage both of these should be equal.

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Example
always specify both currencies when
explaining exchange rate

In this case, US $ is cheaper. So we borrow AUD to buy $.

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Example Here we consider that 1 AUD = $0.7450 which means $ is strong as compared to when 1AUD =
0.76$ and $ is weak here.

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Futures on Commodities
Consider commodities that are investment
assets such as gold and silver
If U is the present value of the storage costs,
net of income, during the life of a contract
F0 = (S0+U)erTU is the present value

If u is the storage cost, net of income, as a

percent of the asset value
F0 = S0e(r+u)T
This is plus because we have to pay storage costs as opposed to
the minuses in slide 22 (highlighted in pink)

33
Example

34
Consumption Assets Eg: copper, iron, oil

Consider commodities that are consumption assets

If F0>(S0+U)erT, there is an arbitrage opportunity as
before
If F0<(S0+U)erT, there may not be an arbitrage
opportunity because agents who own the commodity
need to use it and are reluctant to sell
For a consumption commodity
F0 ≤ (S0+U)erT we can take long position for the futures and short position but if i am a
producer, I might only want to buy it and use it for production. Therefore,
arbitrage might fail in this case. That is why we only have this equation

or
F0 ≤ S0e(r+u)T
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Convenience Yield
Users of a consumption commodity derive benefits
from the ownership of the physical assets
Example: oil refiner needs crude oil
The benefits from holding the physical asset are
known as the convenience yield, y, defined as
F0eyT = (S0+U)erT
y is the extra benefit that you derive from holding this asset.
or F0eyT = S0e(r+u)T
Convenience yield reflects the market’s expectations
about the future availability of the commodity
The greater the possibility of a shortage, the higher
the convenience yield 36
The Cost of Carry c = storage cost + interest cost - income earned

The cost of carry, c, is the storage cost plus

the interest costs less the income earned
For a non-dividend-paying stock, c = r storage cost is 0
For a stock index, c = r – q for dividend paying stocks, we need to minus the return. Eg: if
we buy a stock with $10 and the dividend I receive is $6, then
cost of this stock is $10 - $6 = $4
For a currency, c = r – rf
For a commodity that provides income at rate q
and require storage at rate u, c = r – q + u
For an investment asset, F0 = S0ecT
For a consumption asset, F0 = S0e(c–y)T
37
Futures Prices & Expected Future
Spot Prices
Suppose k is the expected return required by an
investor in an asset
Investor can invest F0e–rT at the risk-free rate and
enter into a long futures contract to create a cash
inflow of ST at maturity
The investment should have a zero net present value
−𝐹𝐹0 𝑒𝑒 −𝑟𝑟𝑟𝑟 + 𝐸𝐸 𝑆𝑆𝑇𝑇 𝑒𝑒 −𝑘𝑘𝑇𝑇 = 0
Or
F0 = E ( ST )e ( r − k )T

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Futures Prices & Expected Future
Spot Prices
No Systematic Risk k=r F0 = E(ST)
Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic Risk k<r F0 > E(ST)

Positive systematic risk: stock indices

Normal backwardation: F0 < E(ST)
Negative systematic risk: gold (at least for some
periods)
Contango: F0 > E(ST)

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Summary
For consumption asset, no equality relationship
between futures and spot prices, and convenience
yield matters
For investment asset,

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