Topic 3 Forward and Futures Pricing

I. Continuous Compounding

We first look at the case of discrete compounding. Suppose that an amount A is invested
for n years at an interest rate of R per annum. If the rate is compounded once per annum,
the terminal value of the investment is
A(1+R)ⁿ

If the rate is compounded m times per annum, the terminal value of the investment is
A(1 + (R/m))mn

The continuous compounding is the case when m tends to infinity. With continuous
compounding, it can be shown that an amount A invested for n years at rate R grows to
AeRn
where e=2.71828.

If there is a future cash flow A that will accrue in n years, the present value of A can be
written as
Ae-Rn

II. Conversion between Compounding of Different Frequencies

Suppose that Rc is a rate of interest with continuous compounding and Rm is the

equivalent rate with compounding m times per annum. From the above two results, we
must have
AeRc n =A(1+(Rm/m))mn
or
eRc =(1+Rm/m)m

This means that

Rc = m ln(1+Rm/m)

and

Rm =m(eRc/m - 1)

These equations can be used to convert a rate with a compounding frequency of m

times per annum to a continuously compounded rate and vice versa.

III. Notation

A few notations here:

T: time until delivery date in a forward or futures contract (in years)
S0: Price of the asset underlying the forward or futures contract today.
F0: forward or futures price today

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 r: Risk-free rate of interest per annum, expressed with continuous compounding, for an
investment maturing at the delivery date (i.e., in T years).

IV. Spot-forward parity relationship

How are forward and futures prices determined? There are different alternative ways to
derive it. All of them have the same conclusion:

F0 = S0 erT

4.1 Approach 1 -- Hedged "Cash and Carry" Strategy

Simple parity argument can be based on hedged "cash and carry" strategy:

1. Borrow S0 dollars at an interest rate r for T years.

2. Buy the asset (e.g., stock index or stock).

3. Short sell a forward or futures contract on the asset (e.g., stock index or stock).

The cash flow at present (t=0) and at time T is shown as follows:

CF(0) CF(T)
Buy the asset -S0 ST
Short forward contract 0 F0-ST
Borrowing +S0 -S0 erT
------------------------------------------------------------------
Total 0 F0- S0 erT

To avoid arbitrage, we need to have F0 = S0erT ≡ F*.

F* is called the parity value for the forward or futures price.

What happens if this parity condition does not hold?

If F0 > S0 erT, arbitrageurs can buy the asset and short the forward contract on the asset,
that is, the cash and carry strategy itself provides riskless profits.

If F0<S0 erT, they can short the asset and buy forward contracts on it, that is, the reverse
cash and carry strategy provides riskless profits.

4.2. An Example

Consider a four-month forward contract to buy a zero-coupon bond that will mature one
year from today. The current price of the bond is $930. (Because the bond will have eight
months to go when the forward contract matures, we can regard the contract as on an
eight-month zero-coupon bond.) We assume that the four-month risk-free rate of interest

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(continuously compounded) is 6% per annum. Because zero-coupon bonds provide no
income, we can use spot-forward parity condition with T=4/12, r=0.06, and S0=930. The
forward price, F0, is given by
F0 = 930e0.06*4/12 = $948.79.

This would be the delivery price in a contract negotiated today.

4.3 Other Approaches to Parity

Zero-NPV Approach

We can think of the "balance sheet" of a long position on a forward or a futures contract.
Asset Liabilities and net worth
---------- ---------------------------------
Receive stock at time T. Pay F0 at time T.
Net worth of contract = 0 (at inception) [Why?]

Note: net worth to be zero is to rule out arbitrage profits.

Then, we can have NPV=0, which implies

PV0(F0) = PV0(ST)

Which gives rise to

F0 e-rT = S0

Prepaid Forward Contract Approach

McDonald's notion of the prepaid forward contract.

Let's do a counterfactual thought experiment. Imagine you pay the forward price up front
-- this is a "prepaid" forward.

Then when we rewrite the zero-NPV condition, we obtain

PV0 (F0PP}= PV0 (ST) which implies

F0PP = S0

The only difference between a prepaid and "normal" forward is the timing of the payment
of F. So F0 = F0PP erT, which again gives us the parity condition.

V. Spot-forward parity relationship: Assets with Known Income

5.1 Formula from the hedged "cash and carry" strategy

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 We consider a forward contract on an investment asset that will provide a perfectly
predictable cash income to the holder. Examples are stocks paying known dividends, and
coupon-bearing bonds. Let's consider a stock that pays dividends.

Again we look at the hedged "cash and carry" strategy. Let the present value of the
dividend be D.

CF(0) CF(T)
---------- ----------
Buy the stock -S0 ST + DerT
Sell forward contract 0 F0 – S T
Borrowing +S0 -S0 erT
------------------- ----------- -------------
Total 0 F0-S0 erT + DerT

Again, to avoid arbitrage, F0 = (S0 - D)erT.

Generally, when an investment asset will provide income with a present value of I
during the life of a forward contract, we have
F0 = (S0 - I) erT

If F0 > (S0 - I) erT, an arbitrageur can lock in a profit by buying the asset and shorting a
forward contract on the asset.

If F0 < (S0 - I)erT, an arbitrageur can lock in a profit by shorting the asset and taking a
long position in a forward contract.

5.2. An Example

Consider a 10-month forward contract on a stock with a price of $50. We assume that the
risk-free rate of interest (continuously compounded) is 8% per annum for all maturities.
We also assume that dividends of $0.75 per share are expected after three months, six
months, and nine months. The present value of the dividends, I, is given by
I = 0.75e-0.08*3/12 + 0.75e-0.08*6/12 + 0.75e-0.08*9/12 = 2.162

The variable T is 10 months so that the forward price, F0 is given by

F0 = (50-2.162)e0.08*10/12 = $51.14.

If the forward price were less than this, an arbitrageur would short the stock spot and buy
forward contracts. If the forward price were greater than this, an arbitrageur would short
forward contracts and buy the stock spot.

VI. Spot-forward parity relationship: Assets with Known Yield

6.1 Formula

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We next consider the situation where the asset underlying a forward contract provides a
known yield rather than a known cash income. This means that the income is known
when expressed as a percent of the asset's price at the time the income is paid.

Suppose q is the average yield per annum on the asset during the life of a foward
contract. It can be shown that
F0 = S0 e(r-q)T

6.2 An Example

Consider a six-month forward contract on an asset that is expected to provide income

equal to 2% of the asset once during a six-month period. The risk-free rate of interest
(with continuous compounding) is 10% per annum. The asset price is $25. In this case S0
= 25, r=0.10, and T=0.5. The yield is 4% per annum with semiannual compounding.

We first convert the yield of 4% per annum with semiannual compounding into a yield
rate with continuous compounding.

Rc = mln(1+ Rm/m) = 2ln(1+4%/2) = 3.96%.

The forward price F0 is given by

F0 = 25e(0.10-0.0396)*0.5 = $25.77

VII. Valuing Forward Contracts

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. We suppose F0 is the current forward
price for contract that was negotiated some time ago, the delivery date is in T years, and r
is the T-year risk-free interest rate.

We also define
K: Delivery price in the contract.
f: Value of the forward contract today.

A general result that applies to all forward contracts is

f = (F0 - K)e-rT

When the forward contract is first negotiated K is set equal to F0 and f = 0. As time
passes, both the forward price F0 and the value of the forward contract f change, while K
is unchanged.

Notice that the change in f will reflect the change in F₀ , but will discount this change
back into the present value.

To see why the above equation is correct, we compare a long forward contract that has a
delivery price of F0 with an otherwise identical long forward contract that has a delivery

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price of K. The difference between the two is only in the amount that will be paid for the
underlying asset at time T. Under the first contract this amount is F0; under the second
contract it is K. A cash outflow difference of F0-K at time T translates to a difference of
(F0 - K)e-rT today. The contract with a delivery price F0 is therefore less valuable than the
contract with delivery price K by an amount (F0-K)e-rT. The value of the contract that has
a delivery price of F0 is by definition zero. It follows that the value of the contract with a
delivery price of K is (F0-K)e-rT. This proves the above equation.

Similarly, the value of a short forward contract with delivery price K is

(K-F0)e-rT.

Example 1: p 51-52 on the textbook (version 4) or pp 106-7 on the textbook (version 5)

Example 2: problem 3.26 on page 70 of the textbook (version 4)

A foreign exchange trader working for a bank enters into a long forward contract to buy 1
million pounds sterling at an exchange rate of 1.6000 in three months. At the same time,
another trader on the next desk takes a long position in 16 three-month futures contracts
on sterling. The futures price is 1.6000, and each contract is on 62,5000 pounds. Within
minutes of the trades being executed the forward and the futures prices both increase to
1.6040. Both traders immediately claim a profit of $4,000. The bank's systems show that
the futures trader has made a $4,000 profit, but the forward trader has made a profit of
only $3,900. The forward trader immediately picks up the phone to complain to the
systems department. Explain what is going on here. Why are the profits different?

Answer:

The daily marking to market of futures contracts ensures that the futures trader makes an
immediate profit of $4,000. For the forward trader, the gain is not realized until the end
of the forward contract (which is in three months). The gain made by the forward trader
is therefore the present value of $4,000, rather than $4,000. Presumably the risk-free
interest rate is about 10% per year or 2.5% per three months so that the impact of the
discounting is to reduce the $4,000 gain to $3,900. The discounting effect shows that
when the forward price, F0, changes by a certain amount, the value of a forward contract,
f, changes by the present value of that amount.

The effect is symmetrical. If the forward and futures exchange rates had both gone down
by 0.004, the futures trader would have taken an immediate loss of $4,000 while the
forward trader would have taken a loss of only $3,900.

VIII. Stock Index Futures, Futures Mispricing and Index Arbitrage

8.1 Stock index

A stock index is constructed to track the changes in the value of a hypothetical portfolio
of stocks. The weight of a stock in the portfolio equals the proportion of the portfolio

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invested in the stock. The percentage increase in the stock index over a small interval of
time is set equal to the percentage increase in the value of the hypothetical portfolio.

There are futures contracts on a number of different stock indices such as the Dow Jones
Industrial Average, the Standard & Poor's 500 index, the Nikkei 225 stock average, the
Nasdaq 100 etc.

8.2 Futures Prices of Stock Indices

A stock index can be regarded as the price of an investment asset that pays dividends.
The investment asset is the portfolio of stocks underlying the index, and the dividends
paid by the investment asset are the dividends that would be received by the holder of this
portfolio. It is usually assumed that the dividends provide a known yield rather than a
known cash income. If q is the dividend yield rate, F0 = S0 e(r-q)T .

Example:

Consider a three -month futures contract on the S&P 500. Suppose that the stocks
underlying the index provide a dividend yield of 1% per annum, that the current value of
the index is 400, and that the continuously compounded risk-free interest rate is 6% per
annum. In this case, r=0.06, S0 = 400, T=0.25, and q=0.01. Hence, the futures price, F0, is
given by
F0 = 400e(0.06-0.01)*0.25 = $405.03.

8.3 Futures Mispricing and Index Arbitrage

The parity relationship is the basis of the index arbitrage industry.

If F0 >S0 e(r-q)T, profits can be made by buying spot (i.e., for immediate delivery) the
stocks underlying the index and shorting futures contract.

If F0 < S0 e(r-q)T, profits can be made by doing the reverse -- shorting or selling the stocks
underlying the index and taking a long position in futures contracts.

These strategies are known as index arbitrage.

When F0 > S0 e(r-q)T, it is often done by a corporation holding short-term money market
investments. For indices involving many stocks, index arbitrage is sometimes
accomplished by trading a relatively small representative sample of stocks whose
movements closely mirror those of the index. Often index arbitrage is implemented
through program trading, with a computer system being used to generate the trades.

Example: S0 = 1421.06.

For March contract, T=3 months=0.25 year.

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r = 5.4% (March maturity T-bills)
d=1.25% approximately (i.e. D=1421.06∗0.0125 per year = $4.44)

Then, F*(March) = 1421.06*exp[(0.054-0.0125)*0.25]=1421.06*1.01

=1435.27

The actual value of F0 = 1444.50

Error= 9.23/1435.27=0.64%.

How can we exploit any futures mispricing?

Arbitrage strategy: buy the cheap asset; sell the expensive one; finance with borrowing

CF(now) CF at maturity [incremental CF vs. doing nothing]

Buy stock -1421.06 Sell ST + 4.48
Sell futures 0 Close out 1444.50-ST
borrow +1421.06 Repayment -1421.06e(0.054-0.0125)*0.25 +1440.50= - S0 e(r-d)T +
F0 = F0 – F* = 9.23
(riskless and zero net investment)

The potential profit from the arbitrage is exactly the deviation of the futures price from
the parity value.

IX. Variations on the Parity Relationship -- Foreign Exchange Futures

What if the income yield is constant as the spot price fluctuates, rather than the dollar
dividend? An application of this problem is found in the foreign exchange futures.

9.1 Interest Rate Parity -- An Example

In the forward and futures contracts on foreign currency, the underlying asset is a certain
number of units of the foreign currency.

Consider a US investor who invests in the UK. The UK interest rate is 10% and the
exchange rate is currently E0 = $2/£1.

So, the US investor can convert $2 into 1 pound currently. At the end of the year, it will
amount to 1.10 pounds. And then convert back into dollars at the exchange rate of E1.

If the exchange rate does not change so that E1= $2/£1, then rUS = 0.10, the same as rUS.

But, what if the pound depreciates?

If E1 = $1.80/£1, then rUS = -0.01 since 1.10 pound*$1.80/pound=$1.98.

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In general,

$1 $[E1/E0(1+rUK)]
↓ ↑
£(1/E0) → £1/E0(1+rUK)]

So, we see that the UK investment is a joint investment on both UK return and exchange
rate appreciation. It is thus risky to US investor even if the investment is in riskless UK
bills.

But what if you enter a contract to sell the pounds forward? Then you can lock in the rate
at which your pounds are converted back into domestic currency. You replace E1 with the
known value F0. For example, suppose that today's forward price for delivery in one year
is F0=$1.90/£1. Then the final proceeds are
(1.90/2.00)(1.10)=$1.045, so risk-free return is 4.5%.

Conclusion: 1+rUS = (1 + rUK) (F0/E0).

Equivalently, F0 = E0(1+rUS)/(1+rUK) ≈ E0 [1+rUS – rUK]

This is called the interest rate parity or covered interest arbitrage relationship.

Generally, if we denote E0 as the current spot price in dollars of one unit of the foreign
currency, r as the domestic risk-free rate, rf as the value of the foreign risk-free interest
rate when money is invested for time T. The relationship between F0 and E0 can be
expressed as

F0 = E0 e(r-rf)T

This is the interest rate parity relationship in international finance.

9.2 A Different Perspective -- Zero-NPV Approach

Notice that we can obtain the same result using the zero-NPV approach. A contract to
buy 1 pound in one year requires you to pay $F0 at that time. The present value (in
dollars) of the payment is F0 / (1+rUS). The present value (in pounds) of 1 pound is
1/(1+rUK), which has a dollar value of E0(1/(1+rUK).

Equating, we find that

F0/(1+rUS) = E0/(1+rUK)

Rearranging, we obtain the covered interest arbitrage relations:

F0 = E0 (1 + rUS) / (1+rUK)

Using continuously compounded rates, F0 = E0 e(rUS-rUK)T.

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If F0 > E0, we have rUS > rUK. (The higher US interest rate is offset by a depreciation in
the value of a dollar: more dollars required to buy one pound.)

Warning: if the exchange rate is quoted as foreign/dollar (e.g. Yen 105/$), the interest
rates in the above relationship switch.

e.g. F0 = E0 (1+rUK) / (1+rUS) = E0 e(rUK-rUS)T

X. Points to Remember

After learning this topic, you should be able to do the following:

⋅ Know how to calculate the future value and present value using continuous
compounding

⋅ Convert interest rate between different compounding frequencies

⋅ Understand the formula of the spot-forward parity relationship and the basic rationale
behind it.

⋅Understand the parity formula for assets with known income and known yield

⋅Understand the formula for valuing forward contracts

⋅Understand how to calculate the futures price of stock index, how to find the futures
mispricing and conduct index arbitrage

⋅Understand the interest rate parity on currency futures

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