MA 592: Mathematical Finance
Lecture 21
Prof. Siddhartha Pratim Chakrabarty
Department of Mathematics
Indian Institute of Technology Guwahati
Theorem
If the interest rate r is constant, then f (0, T ) = F (0, T ).
Proof
For simplicity, suppose that the marking to market (for a futures contract) is
done at only two intermediate time points t1 and t2 , such that
0 < t1 < t2 < T . The argument given below can easily be extended to more
frequent marking to market.
Proof: Strategy Using Forward Contract
1 At time t = 0:
(A) We take a long forward position (at no cost) with the forward price
F (0, T ).
(B) Invest an amount of e −rT F (0, T ) in a risk-free account.
2 At time t = T :
(A) We receive an amount F (0, T ).
(B) Close the forward position by buying a share for F (0, T ).
(C) Sell the share for the market price S(T ).
Thus the final wealth is S(T ).
The idea is to replicate this payoff, S(T ), by using futures contracts, which we
examine in the next slide
Proof: Strategy Using Futures Contract
1 At time t = 0:
(A) We take a fraction e −r (T −t1 ) of a long futures position (at no cost).
(B) We invest an amount e −rT f (0, T ) in a risk-free account (this will
grow to v0 := f (0, T ) at time T ).
2 At time t = t1 :
(A) We receive (or pay if negative) the amount
e −r (T −t1 ) [f (t1 , T ) − f (0, T )] as a result of marking to market.
(B) We invest (or borrow if negative) e −r (T −t1 ) [f (t1 , T ) − f (0, T )] (this
will grow to v1 := f (t1 , T ) − f (0, T ) at time T ).
(C) We take long futures position for e −r (T −t2 ) of a contract (at no cost).
Proof: Strategy Using Futures Contract (Contd ...)
1 At time t = t2 :
(A) We receive (or pay if negative) an amount
e −r (T −t2 ) [f (t2 , T ) − f (t1 , T )] as a result of marking to market.
(B) We invest (or borrow if negative) e −r (T −t2 ) [f (t2 , T ) − f (t1 , T )] (this
will grow to v2 := f (t2 , T ) − f (t1 , T ) at time T ).
(C) We take long futures position for 1 of a contract (at no cost).
2 At time t = T :
(B) We receive an amount v0 + v1 + v2 = f (t2 , T ) from the risk-free
investments.
(B) We close the futures position by paying f (t2 , T ).
(B) We sell the stock for S(T ).
The final wealth level will be S(T ), as before. Thus, in order to avoid arbitrage
we have,
e −rT f (0, T ) = e −rT F (0, T ) ⇒ f (0, T ) = F (0, T ).
Hedging with Futures
One can hedge an exposure to stock price variations by entering into a forward
contract. However, an appropriate forward contract might not be easily
available, not to speak of the default risk. Instead one could hedge using the
futures market.
Hedging with Futures: An Example
1 Let S(0) = 100 and let the constant risk-free rate be r = 8%.
2 Assume that the marking to market takes place once a month, the time
1
step being .
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3 Suppose that we intend to sell the stock after three months.
4 To hedge the exposure to stock prices, we enter into a futures contract,
with delivery in three months.
5 The payments from marking to market attract risk-free interest. The
results for two such stock price scenarios are given below.
Hedging with Futures: An Example (Contd ...)
n 3
n S(n) f , m2m Interest
12 12
0 100 102.02
1 102 103.37 −1.35 −0.02
2 101 101.68 +1.69 +0.01
3 105 105.00 −3.32 0.00
Total −2.98 −0.01
(A) In this case, one can sell the stock for 105.00, but marking to market
causes loss, bringing the sum to 105.00 − 2.98 − 0.01 = 102.01.
(B) If the marking to market did not attract interest, then the realized sum
would be 105.00
− 2.98 = 102.02, which is exactly equal to the futures
3
price of f 0, .
12
Hedging with Futures: An Example (Contd ...)
n 3
n S(n) f , m2m Interest
12 12
0 100 102.02
1 98 99.32 +2.70 +0.04
2 97 97.65 +1.67 +0.01
3 92 92.00 +5.65 0.00
Total 10.02 +0.05
(A) In this case, one can sell the stock for 92.00 and along with the amount
for marking to market and interest accrued, receive a final amount of
92.00 + 10.02 + 0.05 = 102.07.
(B) Without the interest the final amount would be92.00
+ 10.02 = 102.02
3
which is exactly equal to the futures price of f
0, .
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A Few Observations
1 Some limitations arise because of the standardized nature of futures
contract. As a result there are difficulties in matching the terms of the
contract to the specific needs of the individual.
2 The exercise dates for futures are typically certain fixed days in a year, for
example, third Friday of March, June, September and December.
3 If we want to close out our investment at the end of April, then we need to
hedge with futures contracts with a delivery date after April, such as June.
Basis and Optimal Hedge Ratio
1 The difference between the spot price, and the futures price is called the
basis, and is given by:
b(t, T ) := S(t) − f (t, T ).
2 The basis converges to zero as t → T , since f (T , T ) = S(T ).
3 We consider the problem of designing a hedging strategy.
4 Suppose that we wish to sell the asset at time t < T .
5 In order to hedge ourselves against a potential fall in the price of the
asset, we short a futures contact with futures price f (0, T ) at time t = 0.
6 Accordingly, at time t we receive S(t) from selling the asset, in addition
to a cash flow of f (0, T ) − f (t, T ), resulting from marking to market (we
neglect any intermediate cash flow).
7 The total cash flow thus is:
f (0, T ) + S(t) − f (t, T ) = f (0, T ) + b(t, T ).
Basis and Optimal Hedge Ratio (Contd ...)
1 The price f (0, T ) is known at time 0, so the risk involved with the
hedging position is reflected by the basis.
2 The hedger seeks to minimize the risk associated with the basis. In order
to determine an optimal hedge ratio, the hedger enters into N futures
contract, where N need not necessarily be the number of units of the
underlying asset.
3 In order to determine the optimal N, we compute the risk as measured by
the variance of the basis bN (t, T ) := S(t) − Nf (t, T ), that is,
2
Var (bN (t, T )) = σS(t) + N 2 σf2(t,T ) − 2NσS(t) σf (t,T ) ρS(t),f (t,T ) .
4 The variance is a quadratic in N and attains a minimum at,
σS(t)
N = ρS(t),f (t,T ) ,
σf (t,T )
which is the optimal hedge ratio.
