CHAPTERS Determination of Forward and Futures Prices 149

148
The concept of cost of carry is sometimes useful. The cost of carry is the storage cost Practice Questions
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of the underlying asset plus the cost of financing it minus the income receive� from it.
In the case of investment assets, the futures price is greater than the spot pnce by an 5.1. What is the difference between the forward price and the value of a forward contract?
amount reflecting the cost of carry. In the case of consumption assets, the futures price 5.2. Suppose that you enter into a 6-month forward contract on a non-dividend-paying stock
is greater than the spot price by an amount reflecting the cost of carry net of the when the stock price is $30 and the risk-free interest rate (with continuous compounding)
convenience yield. is 5% per annum. What is the forward price?
If we assume the capital asset pricing model is true, the relationship between the
5.3. A stock index currently stands at 350. The risk-free interest rate is 4% per annum (with
futures price and the expected future spot price depends on whether the return o� �he continuous compounding) and the dividend yield on the index is 3% per annum. What
asset is positively or negatively correlated with the return on the stock market. Pos1t1ve should the futures price for a 4-month contract be?
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correlation will tend to lead to a futures price lower than the expected future spot pnce,
whereas negative correlation will tend to lead to a futures price high�r than the expected 5.4. Explain carefully why the futures price of gold can be calculated from its spot price and
_ other observable variables whereas the futures price of copper cannot.
future spot price. Only when the correlation is zero will the theoretical futures pnce be
equal to the expected future spot price. 5.5. Explain why a foreign currency can be treated as an asset providing a known yield.
5.6. Is the futures price of a stock index greater than or less than the expected future value of
the index? Explain your answer.
5.7. A 1-year long forward contract on a non-dividend-paying stock is entered into when the
stock price is $40 and the risk-free rate of interest is 5% per annum with continuous
FURTHER READING compounding.
Cox, J. C., J. E. Ingersoll, and S. A. Ross. "The Relation between Forward Prices and Futures (a) What are the forward price and the initial value of the forward contract?
Prices:' Journal of Financial Economics, 9 (December 1981): 321-46. (b) Six months later, the price of the stock is $45 and the risk-free interest rate is still 5%.
Jarrow, R . A., and G. S. Oldfield. "Forward Contracts and Futures Contracts;• Journal of What are the forward price and the value of the forward contract?
Financial Economics, 9 (December 1981): 373-82. 5.8. The risk-free rate of interest is 7% per annum with continuous compounding, and the
Richard, S., and S. Sundaresan. "A Continuous-Time Model of Forward and Futures Prices in a dividend yield on a stock index is 3.2% per annum. The current value of the index is 150.
Multigood Economy," Journal of Financial Economics, 9 (December 1981): 347-72. What is the 6-month futures price?
Routledge, B. R ., D. J. Seppi, and C. S. Spatt. "Equilibrium Forward Curves for Commodities;•
5.9. Assume that the risk-free interest rate is 4% per annum with continuous compounding
Journal of Finance, 55, 3 (2000) 1297-1338.
and that the dividend yield on a stock index varies throughout the year. In February,
May, August, and November, dividends are paid at a rate of 5% per annum. In other
months, dividends are paid at a rate of 2% per annum. Suppose that the value of the index
on July 31 is 1,300. What is the futures price for a contract deliverable in December 31 of
the same year?
5.10. Suppose that the risk-free interest rate is 6% per annum with continuous compounding
and that the dividend yield on a stock index is 4% per annum. The index is standing at
400, and the futures price for a contract deliverable in four months is 405. What arbitrage
opportunities does this create?
5.11. Estimate the difference between short-term interest rates in Japan and the United States
on May 21, 2020, from the information in Table 5.4.
5.12. The 2-month interest rates in Switzerland and the United States are, respectively, 1 % and
2% per annum with continuous compounding. The spot price of the Swiss franc is
$1.0500. The futures price for a contract deliverable in 2 months is $1.0500. What
arbitrage opportunities does this create?
5.13. The spot price of silver is $25 per ounce. The storage costs are $0.24 per ounce per year
payable quarterly in advance. Assuming that interest rates are 5% per annum for all
maturities, calculate the futures price of silver for delivery in 9 months.
5.14. Suppose that F1 and F2 are two futures contracts on the same commodity with times to
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maturity, t1 and t2, where t2 > tI• Prove that F2 :5 F 1 e , < 12 -1 il, where r is the interest rate
150 CHAPTER 5 Determination of Forward and Futures Prices 151
(assumed constant) and there are no storage costs. For the purposes of this problem, 5.22. The spot exchange rate between the Swiss franc and U.S. dollar is 1.0404 ($ per franc).
assume that a futures contract is the same as a forward contract. Interest rates in the United States and Switzerland are 0.25% and 0% per annum,
5.15. When a known future cash outflow in a foreign currency is hedged by a company using a respectively, with continuous compounding. The 3-month forward exchange rate was
forward contract, there is no foreign exchange risk. When it is hedged using futures 1.0300 ($ per franc). What arbitrage strategy was possible? How does your answer change
contracts, the daily settlement process does leave the company exposed to some risk. if the forward exchange rate is 1.0500 ($ per franc).
Explain the nature of this risk. In particular, consider whether the company is better off 5.23. An index is 1,200. The three-month risk-free rate is 3% per annum and the dividend yield
using a futures contract or a forward contract when: over the next three months is 1.2% per annum. The six-month risk-free rate is 3.5% per
(a) The value of the foreign currency falls rapidly during the life of the contract. annum and the dividend yield over the next six months is 1 % per annum. Estimate the
(b) The value of the foreign currency rises rapidly during the life of the contract. futures price of the index for three-month and six-month contracts. All interest rates and
(c) The value of the foreign currency first rises and then falls back to its initial value. dividend yields are continuously compounded.
(d) The value of the foreign currency first falls and then rises back to its initial value. 5.24. Suppose the current USD/euro exchange rate is 1.2000 dollar per euro. The six-month
Assume that the forward price equals the futures price. forward exchange rate is 1.1950. The six-month USD interest rate is 1 % per annum
5.16. It is sometimes argued that a forward exchange rate is an unbiased predictor of future continuously compounded. Estimate the six-month euro interest rate.
exchange rates. Under what circumstances is this so? 5.25. The spot price of oil is $50 per barrel and the cost of storing a barrel of oil for one year is
5.17. Show that the growth rate in an index futures price equals the excess return on the $3, payable at the end of the year. The risk-free interest rate is 5% per annum
portfolio underlying the index over the risk-free rate. Assume that the risk-free interest continuously compounded. What is an upper bound for the one-year futures price of oil?
rate and the dividend yield are constant. 5.26. A company that is uncertain about the exact date when it will pay or receive a foreign
5.18. Explain carefully what is meant by the expected price of a commodity on a particular currency may try to negotiate with its bank a forward contract that specifies a period
future date. Suppose that the futures price for crude oil declines with the maturity of the during which delivery can be made. The company wants to reserve the right to choose the
contract at the rate of 2% per year. Assume that speculators tend to be short crude oil exact delivery date to fit in with its own cash flows. Put yourself in the position of the
futures and hedgers tend to be long. What does the Keynes and Hicks argument imply bank. How would you price the product that the company wants?
about the expected future price of oil? 5.27. A company enters into a forward contract with a bank to sell a foreign currency for K1 at
5.19. The Value Line Index is designed to reflect changes in the value of a portfolio of over time T1 . The exchange rate at time T1 proves to be S1 (> K1 ). The company asks the bank
1,600 equally weighted stocks. Prior to March 9, 1988, the change in the index from one if it can roll the contract forward until time T2 (> Ti ) rather than settle at time.T1• The
day to the next was calculated as the geometric average of the changes in the prices of the bank agrees to a new delivery price, K2 • Explain how K2 should be calculated.
stocks underlying the index. In these circumstances, does equation (5.8) correctly relate
the futures price of the index to its cash price? If not, does the equation overstate or
understate the futures price?
5.20. A U.S. company is interested in using the futures contracts traded by the CME Group to
hedge its Australian dollar exposure. Definer as the interest rate (all maturities) on the
U.S. dollar and r1 as the interest rate (all maturities) on the Australian dollar. Assume
that r and r1 are constant and that the company uses a contract expiring at time T to
hedge an exposure at time t (T > t).
(a) Show that the optimal hedge ratio is e <rr r)(T-,J, ignoring daily settlement.
(b) Show that, when tis 1 day, the optimal hedge ratio is almost exactly S0/ F0, where S0 is
the current spot price of the currency and F0 is the current futures price of the
currency for the contract maturing at time T.
(c) Show that the company can take account of the daily settlement of futures contracts
for a hedge that lasts longer than 1 day by adjusting the hedge ratio so that it always
equals the spot price of the currency divided by the futures price of the currency.
5.21. What is the cost of carry for:
(a) a non-dividend-paying stock
(b) a stock index
(c) a commodity with storage costs
(d) a foreign currency.