Forward Price and Valuation

Forward Rate Agreement

Futures Contracts
Hedging using Futures

Forward and Futures Contracts

Liming Feng

Dept. of Industrial & Enterprise Systems Engineering

University of Illinois at Urbana-Champaign

Readings: Hull Chapters 2, 3, 5

c Liming Feng. Do not distribute without permission of the author

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Forward contracts

Forward contract: agreement to buy/sell an asset at a future

time T (maturity or expiration date) for a certain price K
(delivery price)
Long position: agrees to buy; short position: agrees to sell
Settlement: at maturity, short position delivers asset, long
position delivers cash of amount K
May be settled in cash without physical delivery of the asset
Long position payoff ST − K , short position payoff K − ST
(ST : asset price at T )

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Forward price

Forward price: specific delivery price K so that the forward

contract has no initial cost
The value of the forward contract changes over time
How to compute forward price? How to value an existing
forward contract?
Notations
t = 0 and T : forward inception and maturity
S0 , ST : underlying asset prices at t = 0 and T
K : delivery price
F0 : forward price
r : risk free interest rate per year for the time period [0, T ],
with continuous compounding

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Assumptions

No transaction costs
No trading restrictions (such as short selling) unless mentioned
No tax issues
Market participants can borrow and lend at the same risk free
interest rate
No arbitrage

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Investment assets with no income

Consider forwards on investment assets (not commodities)

Investment asset: held mainly for investment purposes:
stocks, bonds
Consumption asset: held primarily for consumption: oil,
wheat
Assume that the asset doesn’t pay income such as coupons,
dividends during [0, T ]

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

No arbitrage implies that F0 = S0 e rT

Buy an asset now for S0 , and take a short forward position to
sell the asset at T for F0 . This is risk free and should earn risk
free interest rate:
S0 = F0 e −rT
Create a synthetic forward contract

Position Time 0 Time T

Long forward no cost ST − F0
Synthetic long forward borrow S0 , buy asset ST − S0 e rT

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Suppose that F0 > S0 e rT , consider the following trading

strategy:
At time 0:
Buy the asset for S0
Short forward (to sell the asset for F0 at maturity)
Borrow S0 at interest rate r
Zero cost (no capital is needed from the investor)
At time T :
Forward contract: deliver the asset and receive F0
Repay the loan: S0 e rT

A costless, riskless income F0 − S0 e rT > 0, arbitrage!

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Suppose that F0 < S0 e rT , consider the following trading

strategy:
At time 0:
Short sell the asset for S0 and deposit S0 at interest rate r
Long forward (to buy the asset at maturity)

At time T :
Deposit account: receive S0 e rT
Forward contract: buy the underlying asset for F0
Close the short selling account: return the asset
A costless, riskless income S0 e rT − F0 > 0, arbitrage!

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

With restriction on short selling

Arbitrage opportunities exist for investors who hold the asset
for long turn investment
Sell the asset now, and buy back at T and enjoy a riskfree
profit S0 e rT − F0

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Example (forward price of a non-dividend paying stock)

Current stock price of Amazon is $80/share. 3-month LIBOR rate
is 5% with continuous compounding. Are there arbitrage
opportunities if the 3-month forward price quoted by a bank is 82?

Forward price:

F0 = S0 e rT = 80 × e 5%/4 = 81.01

Arbitrage (buy low sell high):

Now: borrow 80 at 5%, buy one Amazon share, short forward
At time T : sell the share for 82, repay 80 × e 5%/4 = 81.01,
earn 0.99

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Investment assets with known income

Suppose the asset pays c1 , c2 , · · · , cn at times

t1 , t2 , · · · , tn ∈ [0, T ]
Cost of the asset: S0 − I0 , where I0 is the present value of all
payments. Suppose the risk free interest rates are
r1 , r2 , · · · , rn for time periods [0, t1 ], [0, t2 ], · · · , [0, tn ]:

I0 = c1 e −r1 t1 + · · · + cn e −rn tn

No arbitrage implies that F0 = (S0 − I0 )e rT

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Suppose F0 < (S0 − I0 )e rT , consider the following trading

strategy:
At time 0
Short sell the asset for S0 , long forward
Deposit ck e −rk tk at rate rk for time period [0, tk ], deposit
S0 − I0 at rate r for time period [0, T ]
At time tk
Get ck , return it to the asset lender
At time T
Get (S0 − I0 )e rT , buy the asset for F0 , return the asset to the
lender
Costless, riskless income (S0 − I0 )e rT − F0 > 0, arbitrage!
Short sell an asset with income, need to return those income

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Suppose F0 > (S0 − I0 )e rT , consider the following trading

strategy:
At time 0
Buy the asset for S0 , short forward
Borrow ck e −rk tk at rate rk for the time period [0, tk ], borrow
S0 − I0 at rate r for the time period [0, T ]
At time tk
Receive ck and repay the loan that is due at tk
At time T
Sell the asset for F0 , repay the loan (S0 − I0 )e rT
A costless, riskless income F0 − (S0 − I0 )e rT > 0,
arbitrage!

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Example (forward price of a stock paying dividends)

GM stock price is $30/share today. It will pay dividends of
$0.25/share in 2 months and in 5 months. What should be the
forward price of a 9-month contract? What arbitrage opportunities
exist if a bank quotes 30.5? 2-, 5-, and 9-month LIBOR rates are
5.2%, 5.3% and 5.4%, respectively (continuous compounding).

The forward price should be

F0 = (S0 − I0 )e rT
= (30 − 0.25e −5.2%×2/12 − 0.25e −5.3%×5/12 )e 5.4%×9/12
= 30.73

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

If the bank quotes 30.5, an investor planning to hold GM shares for

more than 9 months can (buy low sell high)

sell shares for 30 each, deposit 0.25e −5.2%×2/12 for 2 months,

deposit 0.25e −5.3%×5/12 for 5 months, deposit the remaining
at rate 5.4% for 9 months, take a long forward position
In 2 months, receive 0.25, in 5 months, receive 0.25
At maturity, get
(30 − 0.25e −5.2%×2/12 − 0.25e −5.3%×5/12 )e 5.4%×9/12 = 30.73,
buy back shares for 30.5, earn $0.23/share

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Investment assets with known yield

Suppose the asset provides a known yield at rate q per year

(continuous compounding): one unit of the asset at time 0
grows to e qT units at T
E.g., when the asset is GBP
The interest rate for GBP is q with continuous compounding
One pound today is worth e qT pounds at time T
One pound at time T is worth e −qT pounds today
Cost (at time 0) of one unit of the asset (at time T ): S0 e −qT
Forward price for delivery of one unit of the asset at T :

F0 = S0 e −qT e rT = S0 e (r −q)T

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Create a synthetic forward contract

Position Time 0 Time T

Short forward no cost F0 − ST
Synthetic short forward Short e −qT assets, S0 e (r −q)T − ST
deposit S0 e −qT

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Suppose F0 > S0 e (r −q)T , consider the following trading

strategy
At time 0
Buy e −qT units of the asset
Short forward (to sell one unit of the asset)
Borrow e −qT S0 at rate r

At time T , e −qT units of the asset grow into one unit of the
asset
Forward contract: sell the asset and receive F0
Repay the loan: e (r −q)T S0

A costless, riskless income F0 − e (r −q)T S0 > 0, arbitrage!

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Suppose F0 < S0 e (r −q)T , consider the following trading

strategy
At time 0
Long forward (to buy one unit of the asset)
Short sell e −qT units of the asset and receive S0 e −qT
Deposit S0 e −qT at rate r

At time T
Deposit account: get e (r −q)T S0
Forward contract: buy the asset for F0
Short selling account: return one unit of the asset

A costless, riskless income e (r −q)T S0 − F0 > 0, arbitrage!

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Example (forward price of a foreign currency)

USD/GBP exchange rate is 2 today. 6-month LIBOR rates for
USD and GBP are 5.2% and 6.2%, respectively. Are there
arbitrage opportunities if the 6-month forward price is 1.95?

Forward price:

F0 = S0 e (r −q)T = 2e (5.2%−6.2%)/2 = 1.99

Arbitrage (buy low sell high):

Long forward to buy £1 at T , borrow £e −qT , sell for
$S0 e −qT , deposit at rate r
At maturity: get S0 e (r −q)T = 1.99, buy £1 for 1.95 and repay
the loan

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Valuing existing forward contracts

Forward contracts have zero cost at time 0 by letting K = F0

At an arbitrary time t ∈ (0, T ], the value of the forward is not
necessary 0
Banks evaluate forward contracts frequently (marking to
market)
Notations
t ∈ [0, T ] : valuation time
St : underlying asset price at time t
Ft : forward price determined at time t with maturity T
Vt : value at time t of the long forward contract with delivery
price K

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Decompose the payoff of a (long) forward contract

Payoff of the long forward contract at maturity

ST − K = (ST − Ft ) + (Ft − K )

A forward contract with forward price Ft as the delivery price

A contract with fixed payoff Ft − K at time T
Suppose that the riskfree interest rate for the time period
[t, T ] is r , then

Vt = e −r (T −t) (Ft − K )

Pricing forward contracts: discount the payoff as if the

forward price were realized

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Summary of forward contracts for investment assets

(t ∈ [0, T ])
Investment assets with no income

Ft = e r (T −t) St

Investment assets with known income

Ft = e r (T −t) (St − It )

It : present value at time t of income received during [t, T ]

Investment assets with known continuous yield

Ft = e (r −q)(T −t) St

Value of the (long) forward contract (with delivery price K )

Vt = e −r (T −t) (Ft − K )

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Investment Assets with No Income
Forward Rate Agreement Investment Assets with Known Income
Futures Contracts Investment Assets with Known Yield
Hedging using Futures Valuing Forward Contracts

Example (valuing forward contracts)

The delivery price of a 3-month forward contract to buy one
Amazon share was determined to be $81.01. The forward contract
expires in 1 month. The current share price is $85/share. 1-month
LIBOR rate is 5.2%. What is the value of the long forward
contract?
The value of the long forward contract is

Vt = e −r (T −t) (Ft − K ) = e −5.2%/12 (Ft − 81.01)= 4.34

The current forward price Ft is

Ft = e r (T −t) St = 85e 5.2%/12 = 85.37

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

Forward rate agreement (FRA)

Example (forward rate agreement)

GM needs to borrow $1 million in 2 months. The money will be
borrowed for 8 months. Currently, interest rates are relatively low.
GM would like to lock the rate today to reduce interest rate risk.
GM enters an FRA with a bank.

FRA: agreement to borrow/lend L (principal) at a certain rate

rK for a certain future time period [t1 , t2 ]
An important interest rate derivative: total notional amount
of outstanding FRAs was $51,749 billions by End-Dec-2009
No cost to enter an FRA by selecting appropriate interest
rate: forward rate; How to determine the forward rate?

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

Determining forward rate

Notations (assume continuous compounding)

r1 : interest rate for period [0, t1 ]
r2 : interest rate for period [0, t2 ]
r0f : forward rate to be applied for period [t1 , t2 ]
No arbitrage implies that r0f = (r2 t2 − r1 t1 )/(t2 − t1 ).
Deposit $1 at rate r1 for the period [0, t1 ], deposit e r1 t1 at rate
r0f for the period [t1 , t2 ]
Deposit $1 at rate r2 for the period [0, t2 ]
f r2 t2 − r1 t1
e r2 t2 = e r1 t1 e r0 (t2 −t1 ) ⇒ r0f =
t2 − t1

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

If the interest rate agreed on is r > r0f , consider the following:

At time 0
Deposit 1 for the period [0, t1 ] at rate r1
Enter an FRA to deposit e r1 t1 at rate r for time period [t1 , t2 ]
Borrow 1 for the period [0, t2 ] at rate r2

At time t1
Receive e r1 t1 , deposit for the period [t1 , t2 ] at rate r

At time t2
Receive e r1 t1 e r (t2 −t1 ) , repay the loan e r2 t2

A costless, riskless income of e r1 t1 +r (t2 −t1 ) − e r2 t2 > 0,

arbitrage!

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

Suppose r < r0f , consider the following strategy:

At time 0
Borrow 1 for the period [0, t1 ] at rate r1
Enter an FRA to borrow e r1 t1 at rate r for the period [t1 , t2 ]
Deposit 1 for the period [0, t2 ] at rate r2

At time t1
Borrow e r1 t1 at rate r for period [t1 , t2 ] and repay the first loan

At time t2
Receive e r2 t2 , and repay the second loan e r1 t1 e r (t2 −t1 )
A costless, riskless income of e r2 t2 − e r1 t1 +r (t2 −t1 ) > 0,
arbitrage!

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

Speculating on interest rate

Zero rates and forward rates

Year Zero rate Forward rate
1 3.0
2 4.0 5.0
3 4.6 5.8
Forward rate seems higher than 1-year zero rate
A speculator may bet that 1-year zero rate will be consistently
lower than 1-year forward rate resulted from the zero curve:
borrow for 1-year and roll over, deposit for longer periods
Used by the Treasurer at Orange County; Led to $1.5 billion
loss when interest rate rose, and Orange County bankrupted

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

Valuing FRAs

FRA has no cost when entered at time 0 by letting rK = r0f

Value of FRA no more zero after the inception of the contract
Notation
t ∈ [0, t1 ]: valuation time
r1∗ : interest rate for period [t, t1 ]
r2∗ : interest rate for period [t, t2 ]
rtf : time t forward rate for period [t1 , t2 ]

r2∗ (t2 − t) − r1∗ (t1 − t)

rtf =
t2 − t1

Vt : time t value of FRA to the lender (lend L at rate rK for

the period [t1 , t2 ])

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

The lender will deposit L at rate rK at time t1 , and receive

Le rK (t2 −t1 )
Decompose the FRA into two contracts
f
Deposit L at rate rtf at time t1 , and receive Le rt (t2 −t1 ) at t2
f
Receive Le rK (t2 −t1 ) − Le rt (t2 −t1 ) at t2
Value at time t of the FRA to the lender
∗ f
Vt = Le −r2 (t2 −t) (e rK (t2 −t1 ) − e rt (t2 −t1 ) )

In particular, at t = t1 , rtf = r2∗ ,

∗
Vt1 = L(e (rK −r2 )(t2 −t1 ) − 1)

FRA often settled at t1 . Borrower pays Vt1 to the lender

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

Example (forward rate agreement)

GM needs to borrow $1 million in 2 months. The money will be
borrowed for 8 months. 2- and 10-month LIBOR rates are 5.24%
and 5.35%, respectively. GM enters an FRA with a bank. Suppose
in 2 months, the 8-month LIBOR rate turns out to be 5.6%. How
should the FRA be settled?
Forward rate
r2 t2 − r1 t1 5.35% × 10/12 − 5.24% × 2/12
r0f = = = 5.38%
t2 − t1 8/12

Value of the FRA to GM two months later:

∗
1m · (1 − e (rK −r2 )(t2 −t1 ) ) = 1m · (1 − e (5.38%−5.6%)×8/12 ) = $1465.59

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

Forward contracts on commodities

Commodities for investment: gold

Commodities are subject to storage costs
Let U be the present value of storage costs for each unit of
the asset
Adjusted cost of the asset: S0 + U
Forward price for a commodity as an investment asset

F0 = (S0 + U)e rT

If the asset receives income, U is the PV of storage costs, net

of income

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation
Forward Rate Agreement Forward Rate
Futures Contracts Valuing FRAs
Hedging using Futures

Consumption commodities: wheat

No arbitrage implies that F0 ≤ (S0 + U)e rT (otherwise, buy
now and short a forward contract)
To show F0 ≥ (S0 + U)e rT by contradiction, need to short
sell: often not possible (assets held for consumption)
Forward price for a consumption asset: F0 ≤ (S0 + U)e rT
Convenience yield y is such that F0 e yT = (S0 + U)e rT

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Futures contracts

Futures contract: agreement to buy/sell an asset at a future

time for a certain price (delivery price)
Specific delivery price so that the futures contract has no
initial cost: futures price
Forwards are traded in the over-the-counter market
Futures are exchange-traded, highly standardized
The exchange specifies: what to deliver, when to deliver,
where to deliver
Futures are settled daily

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Terms specified by the exchange

The asset: quality of a commodity, maturity of treasuries

Contract size: amount of the asset to be delivered per
contract; e.g., a corn futures contract on CBOT is for 5000
bushels of corn
Delivery location: if alternatives are specified, seller selects
the location
Maturity: when maturity is a whole month, seller picks the
date
Price movement limits, position limits: prevent speculators
from manipulating the market

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

CBOT Corn futures

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Daily settlement and margining

Example (daily settlement)

Consider a long futures contract for 100 ounces of gold traded on
NYMEX (http://www.nymex.com). The current futures price is
$880 per ounce

The investor needs to open a margin account

Initial margin: the amount required to be deposited at the
contract inception, e.g., $4000;
Marking to market: the margin account is adjusted at the
end of each trading day to reflect the investor’s gain/loss

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Date Current futures price Initial margin

day 1 F0 = 880 4000
Date End of day futures price Gain Margin account balance
day 1 F1 = 874 -600 3400
day 2 F2 = 876 200 3600
day 3 F3 = 860 -1600 2000 → 4000 (-2000)
day 4 F4 = 865 500 4500

At the end of day 1, $600 is transferred to the margin account

of a short position through the exchange clearinghouse
In effect, a futures contract is closed out every day and
rewritten at a new futures price

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Maintenance margin: minimum amount required in the

margin account, e.g., $3000
Margin call: if the balance falls below the maintenance
margin, receives a margin call and needs to top up the margin
account to the initial margin
May withdraw any balance in excess of the initial margin
The exchange specifies the minimum initial and maintenance
margins. Depend on the variability of the underlying asset
price
Credit risk is minimized through the margining system

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Suppose day 4 is the maturity: futures price = spot price =

865
Futures price converges to spot price as time to maturity
decreases
Payoff of the long futures position:
−1500 = −600 + 200 − 1600 + 500
= 100(F1 − F0 ) + 100(F2 − F1 ) + 100(F3 − F2 ) + 100(F4 − F3 )
= 100(F4 − F0 ) = 100(ST − F0 )

equal to the payoff of a long forward with delivery price F0

Profit is realized at maturity for a forward contract; It is
realized over time for a futures contract.

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Futures price

Deterministic interest rates: futures price = forward price

Stochastic interest rates:
Asset price and interest rate positively correlated: futures
price > forward price typically. For long futures,
Asset price increases ⇒ immediate profit + invested at higher
rate
Asset price decreases ⇒ immediate loss + financed at lower
rate
Asset price and interest rate negatively correlated: futures
price < forward price typically
Difference not significant for short maturities

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Currency futures

Currency forwards and futures widely used to hedge exchange

rate risks
Popular currency futures on CME

Currency Contract size Minimum fluctuation

Euro 125,000 Euro $0.0001/Euro = $12.5/contract
GBP £62,500 $0.0001/GBP = $6.25/contract
Japanese yen U12,500,000 $0.000001/yen = $12.5/contract
CAD 100,000 CAD $0.0001/CAD = $10/contract
Swiss francs 125,000 CHF $0.0001/ = $12.5/contract

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Terms of Futures
Forward Rate Agreement Margining
Futures Contracts Futures Price
Hedging using Futures Futures Traded on Exchanges

Index futures

Index futures: underlying financial variables are major market

indices
Used by investors to manage risk of stock market fluctuation
(hedging, changing portfolio beta, etc)
Popular index futures on CME:

Index Contract size Minimum fluctuation

E-mini S&P 500 50 $0.25/index = $12.5/contract
E-mini NASDAQ-100 20 $0.25/index = $5/contract
S&P 500 250 $0.10/index = $25/contract
NASDAQ-100 100 $0.25/index = $25/contract
E-mini Russell 2000 100 $0.1/index = $10/contract

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Hedging using futures

Hedgers use futures to reduce risks due to: asset price

fluctuation, exchange rate movement, interest rate uncertainty
Long and short hedges
Current position Risk Hedge Example
will sell an asset asset price may fall short farmer who will harvest corn
will buy an asset asset price may rise long company that will buy corn

Compared to forward contracts: futures are traded on

exchanges (more liquid), almost no credit risk

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Short hedge example

Example (short hedge)

A heating oil producer enters a contract to sell 420,000 gallons of
heating oil at the market price on December 15. How can the
producer hedge its position? Current December futures price is
$2.08/gal

Short hedge: fixes the price at $2.08/gal (potential loss due

to price drop canceled by gain in short futures)
Perfect hedge possible since
heating oil futures are traded (NYMEX)
each heating oil futures contract is on 42,000 gallons
December futures contracts are available

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Basis risk

Perfect hedging often not possible because

futures with desired maturity not available
futures with desired underlying (asset or size) not available
Suppose the sale/purchase will occur at T , futures with
maturity T not available:
Choose the first available maturity after T
The sale/purchase price cannot be fixed at the futures price:
basis risk
Basis = spot price at time T - futures price of the contract at
time T
If maturity of the futures = T , no basis risk: basis = 0

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Basis risk example

Example (basis risk)

A company will receive and sell U50 million in 5 months. The next
available delivery month for Yen futures on CME is in 7 months.
Current futures price F0 = 0.7800 cents/yen. In 5 months, spot
price S1 = 0.7200, futures price with 2 months to maturity
F1 = 0.7250.

Short hedge: desired maturity not available; yen futures with

7 months to maturity used
Short 4 futures (1 contract is for U12.5 million). In 5 months,
Gain on the futures: F0 − F1 = 0.7800 − 0.7250 = 0.0550
Sell yen: Effective price: F0 + S1 − F1 = 0.7750 cents/yen
| {z }
basis risk

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Cross hedging

Futures with desired underlying not available

Choose contracts with best matching underlying asset (cross
hedging)
American Airlines need to buy jet fuel in 3 months (long
hedge). Jet fuel futures not available. Use heating oil futures
Cross hedging
Hedge ratio: amount of asset underlying the futures
contracts for each unit of the asset to be hedged
American Airlines: the amount of heating oil underlying (long)
futures contracts to hedge the purchase of 1 gallon of jet fuel
Minimize the variance of the outcome of the hedged position

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Suppose maturity of hedge is T (buy/sell at this time)

Futures with maturity ≥ T used, with underlying asset highly
correlated with the asset to be hedge. h: hedge ratio

0 T Long hedge Short hedge

S0 ST buy at ST sell at ST
F0 FT gain h(FT − F0 ) = h∆F gain h(F0 − FT ) = −h∆F
effective price ST − h∆F effective price ST − h∆F

With perfect hedging (same maturity, futures with the same

underlying), h = 1, ST = FT , effective price = F0
In general, effective price F0 + (ST − h∆F − F0 ) 6= F0

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Hedge ratio

Notations
∆S : change in spot price during the life of the hedge [0, T ]
∆F : change in futures price during the life of the hedge
σS , σF : standard deviation of ∆S and ∆F
ρ : correlation coefficient between ∆S and ∆F
h∗ : minimum variance hedge ratio
Minimize the variance of ∆S − h∆F
∂V
V (∆S − h∆F ) = σS2 + h2 σF2 − 2hρσS σF , =0
∂h
minimum variance achieved when h = h∗ = ρσS /σF
ρ, σS , σF estimated from historical data

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Linear regression interpretation

∆S = h∆F + const + random error

least square estimation of the coefficient h

cov(∆S,
ˆ ∆F )
h∗ =
var(∆F
ˆ )

Hedging with the minimum variance hedge ratio h∗ ,

V (∆S − h∗ ∆F ) = (1 − ρ2 )σS2

in contrast to (without hedging) V (∆S) = σS2

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Effectiveness of cross hedging

hedging reduces the variance by a factor of 1 − ρ2
for the underlying asset of the futures contract, choose one
that is highly correlated with the original asset
Number of futures contracts needed:
NA : amount of the asset to be hedged
QF : amount of the asset underlying each futures contracts
Number of futures contracts needed: h∗ × NA /QF

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Cross hedging example

Example (cross hedging)
American Airlines need to buy 2 million gallons of jet fuel in 1
month and will use heating oil futures for hedging. Each heating
oil futures contract is on 42000 gallons of heating oil. The
standard deviations of the spot price change and futures price
change in 1 month are estimated to be 0.0263 and 0.0313,
respectively. The correlation coefficient is estimated to be 0.928.
How many futures contracts should be used?

σS
h∗ = ρ = 0.928 × 0.0263/0.0313 = 0.78
σF
Number of contracts needed:
h∗ × NA /QF = 0.78 × 2000, 000/42000 = 37.14 ≈ 37
Liming Feng Forward and Futures Contracts
 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Hedging using stock index futures

Index futures are used to manage risks due to stock market

fluctuation
An investor holding a well diversified equity portfolio faces the
risk of a market crash
Cross hedge: short a stock index futures (a stock index is
highly correlated to a well diversified equity portfolio)
Compute the optimal number of futures contracts

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Notations:
S, I , F : current portfolio value, index value, index futures
price
∆S : the value change of the portfolio
∆F : the futures price change
∆I : the value change of the index
σS , σF : standard deviation of ∆S and ∆F
ρ : correlation coefficient between ∆S and ∆F
QF : the amount of underlying assets for each futures contract
(e.g., for CME S&P 500 index futures, QF = 250)
Optimal hedge ratio
σS
h∗ = ρ
σF

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Beta of a portfolio measures the variability of the portfolio

relative to the overall market (represented by a stock index)

cov(∆S/S, ∆I /I ) I cov(∆S, ∆I )
β= =
var(∆I /I ) S var(∆I )

Assume maturities of the hedge and the futures are the same
I cov(∆S, ∆F ) I ρσS I βS
∆F = ∆I +const, β = = = h∗ ⇒ h∗ =
S var(∆F ) S σF S I

The number of futures contracts needed

h∗ × QA /QF = h∗ /QF = βS/(IQF )

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Example (hedging using index futures)

A fund manager holding a portfolio worries that there will be a big
change in the value of the portfolio in a month (due to expected
release of news). S&P 500 index futures will be used for the short
hedge. The current values of the portfolio and the S&P 500 index
are 5000,000 and 1000, respectively. Each futures contract is on
250 indices. The beta of the portfolio is 1.5. How many futures
contracts should be used?

βS 1.5 × 5000, 000

= = 30
IQF 1000 × 250

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Manage portfolio beta

Beta of the hedged portfolio in the previous example

Current value of the hedged portfolio: P = S
Value change of the hedged portfolio

∆P = ∆S + 30 · 250 · (F − IT ) = ∆S + 30 · 250 · (F − I − ∆I )

Beta of the hedged portfolio

cov( ∆P ∆I
P , I ) cov( ∆S−30·250·∆I , ∆I
I ) 250I
β∗ = = S
= β−30· =0
var( ∆I
I ) var( ∆I
I ) S

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

If desired beta is 0.75: short 15 futures

250I 1
β ∗ = β − 15 × = 1.5 − × 1.5 = 0.75
S 2
If desired beta is 2: long 10 futures
250I 1
β ∗ = β + 10 × = 1.5 + × 1.5 = 2
S 3

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Hedging going wrong

Metallgesellschaft (MG) enter 5- and 10-year supply

contracts with its customers to sell heating oil
Long futures to hedge its positions: all available maturities
not long enough
Rolling the hedge forward: enter another short maturity long
futures when the previous expires
Oil price fell, margin requirements put huge short term cash
flow pressure on MG, causing a loss of $1.33 billion

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Speculating using futures

GBP/USD futures on CME is on 62,500 British pounds.

Initial margin is $2430 (maintenance margin $1800,
http://www.cmegroup.com). Current exchange rate is
1.5541 USD/GBP. Current 3-month futures price is 1.5524
USD/GBP
An investor who believes that GBP will strengthen relative to
USD and with $24,300 available can
1 Buy 15,636.06 GBPs with $24,300
2 Enter 10 long futures contacts on 625,000 GBPs

Liming Feng Forward and Futures Contracts

 Forward Price and Valuation Basis Risk
Forward Rate Agreement Cross Hedging
Futures Contracts Hedging Using Index Futures
Hedging using Futures Speculation

Profit when the exchange rate moves

spot rate/futures price

1.5735/1.5718 1.5347/1.5330
strategy 1 15,636.06(1.5735-1.5541)=$303.34 $-303.34
strategy 2 625,000(1.5718-1.5524)=$12,111.67 $-12,111.67

Leverage effect

Liming Feng Forward and Futures Contracts