CHAPTER 3:

DETERMINATION OF
FORWARD AND FUTURES PRICES
1
CONTENT

v Introduce a number of different types of interest rate

vExplain the compounding frequency used to define an interest rate and the meaning of
continuously compounded interest rates, which are used extensively in the analysis of
derivatives
vCover forward rates and forward rate agreements and reviews different theories of the
term structure of interest rates
vExplain the use of duration and convexity measures to determine the sensitivity of
bond prices to interest rate changes

2
I. TYPES OF RATES

v An interest rate in a particular situation defines the amount of money a borrower

promises to pay the lender.
v For any given currency, many different types of interest rates are regularly quoted,
including mortgage rates, deposit rates, prime borrowing rates, and so on.
v Types of rates:
§ Treasury rates
§ Overnight rates
§ Repo rates

3
I. TYPES OF RATES

v Treasury rates:
§ Rate on instrument issued by a government in its own currency.
§ It is usually assumed that there is no chance that the government of a developed
country will default on an obligation denominated in its own currency.

4
I. TYPES OF RATES

v Overnight rates:
§ Banks are required to maintain a certain amount of cash, known as a reserve, with
the central bank.
§ The reserve requirement for a bank at any time depends on its outstanding assets and
liabilities.
§ At the end of a day, some financial institutions typically have surplus funds in their
accounts with the central bank while others have requirements for funds.
Ø This leads to borrowing and lending overnight.
§ US: Federal Funds Rate
§ UK: Sterling Overnight Index Average (SONIA)
§ EU: Euro Short-term Rate (ESTER)
§ Japan: Tokyo Overnight Average Rate (TONAR)
5
§ Switzerland: Swiss Average Rate Overnight (SARON)
I. TYPES OF RATES

v Repo Rates:
§ Repurchase agreement is an agreement where a financial institution that owns
securities agrees to sell them for X and buy them back in the future (usually the next
day) for a slightly higher price, Y
§ The financial institution obtains a loan.
§ The rate of interest is calculated from the difference between X and Y and is known
as the repo rate

6
I. TYPES OF RATES

v Repo Rates:
§ A repo involves very little credit risk.
Ø If the borrower does not honor the agreement, the lending company simply keeps
the securities.
Ø If the lending company does not keep to its side of the agreement, the original
owner of the securities keeps the cash provided by the lending company.
§ The most common type of repo is an overnight repo, where funds are lent overnight.
However, longer-term arrangements, known as term repos, are sometimes used.
Because it is a secured rate, a repo rate is theoretically very slightly below the
corresponding fed funds rate.
§ The secured overnight financing rate (SOFR) is an important volume-weighted
median average of the rates on overnight repo transactions in the United States.
7
I. TYPES OF RATES

v LIBOR (London Interbank Offered Rate)

§ LIBOR is the rate of interest at which a AA-rated bank estimates it can borrow
money on an unsecured basis from another bank at 11am.
§ Several currencies and maturities
§ There is not enough borrowing between banks for a bank’s estimates to be
determined by market transactions.
Ø As a result, LIBOR sub-missions by banks involved a certain amount of judgment
and could be subject to manipulation.
Ø Bank regulators are uncomfortable with this and have developed plans to phase
out the use of LIBOR.

8
I. TYPES OF RATES

v LIBOR (London Interbank Offered Rate)

§ Regulators plan to phase out LIBOR by the end of 2021 and replace it with rates
based on transactions observed in the overnight market.
§ The new reference rates (e.g. for a 3-month period) will be calculated at the end of
the period as the compounded overnight rates for that period

9
I. TYPES OF RATES

v The New Reference Rates

§ US dollar: SOFR (secured overnight funding rate)
§ GBP: SONIA (sterling overnight index average)
§ EU: ESTER (euro short-term rate)
§ Switzerland: SARON (Swiss average overnight rate)
§ Japan: TONAR (Tokyo average overnight rate)

10
I. TYPES OF RATES

v The New Reference Rates

§ SOFR (secured overnight funding rate) is calculated from repos and is therefore a
secured rate.
§ The others are calculated from unsecured overnight borrowing and lending between
banks

11
I. TYPES OF RATES

v The risk – free rate

§ The usual approach to valuing derivatives involves setting up a riskless portfolio and
the return on the portfolio should be the risk-free rate.
§ The risk-free reference rates created from from overnight rates are the ones used in
valuing derivatives.

12
II. MEASURING INTEREST RATES
vA rate expressed with one compounding frequency can be converted into an
equivalent rate with a different compounding frequency.
v Effect of the compounding frequency on the value of $100 at the end of 1 year when
the interest rate is 10% per annum:
Compounding frequency Value of $100 in one year at 10%
Annual (m = 1)
Semiannual (m = 2)
Quarterly (m = 4)
Monthly (m = 12)
Weekly (m = 52)
Daily (m = 365)
13
Continuous compounding
II. MEASURING INTEREST RATES

v 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

§ If the rate is measured with continuous compounding, the terminal value of the
investment is

14
II. MEASURING INTEREST RATES

v For most practical purposes, continuous compounding can be thought of as being

equivalent to daily compounding.

v Continuously compounded interest rates are used to such a great extent in pricing
derivatives.

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

equivalent rate with compounding m times per annum:

15
II. MEASURING INTEREST RATES

v Conversion Formulas

Define:

§ Rc : continuously compounded rate

§ Rm: same rate with compounding m times per year

16
II. MEASURING INTEREST RATES

v Conversion Formulas

Example: Consider an interest rate that is quoted as 10% per annum with semiannual
compounding. With m = 2 and Rm = 0.1, the equivalent rate with continuous
compounding is:
!.#
2 ln (1 + $
) = 0.09758

Ø 10% with semiannual compounding is equivalent to 9.758% with continuous

compounding

17
II. MEASURING INTEREST RATES

v Conversion Formulas

Example: Suppose that a lender quotes the interest rate on loans as 8% per annum with
continuous compounding, and that interest is actually paid quarterly.

With m = 4 and Rc = 0.08, the equivalent rate with quarterly compounding is:

4 (𝑒 !.!%/' − 1 ) = 0.0808

Ø 8% with continuous compounding is equivalent to 8.08% with quarterly compounding

Ø On a $1,000 loan, interest payments of $20.20 would be required each quarter.

18
II. MEASURING INTEREST RATES

v Zero Rates (or Spot rate) is the rate of interest earned on an investment that starts
today and lasts for n years. All the interest and principal is realized at the end of n
years. There are no intermediate payments.

Example: Suppose a 5-year zero rate with continuous compounding is quoted as 5% per
annum. This means that $100, if invested for 5 years, grows to:

100 x 𝑒 !.!( ) ( = 128.40

19
II. MEASURING INTEREST RATES

v Zero Rates (or Spot rate) is the rate of interest earned on an investment that starts
today and lasts for n years. All the interest and principal is realized at the end of n
years. There are no intermediate payments.

Zero rate
Maturity (years)
(% continuously compounded)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
20
III. BOND PRICING

v The theoretical price of a bond can be calculated as the present value of all the cash
flows that will be received by the owner of the bond.
v Sometimes bond traders use the same discount rate for all the cash flows underlying a
bond, but a more accurate approach is to use a different zero rate for each cash flow.
Example: Calculate the price of a 2-year bond with a principal of $100 providing a 6%
coupon semiannually. Zero rates, measured with continuous compounding, are as in
Table.
Maturity (years) Zero rate (% continuously compounded)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8 21
III. BOND PRICING

v A bond’s yield (yield to maturity) is the single discount rate that, when applied to all
cash flows, gives a bond price equal to its market price.
Example: Calculate YTM of a 2-year bond with a principal of $100 providing a 6%
coupon semiannually. The market price of the bond is $98.39. Zero rates, measured with
continuous compounding, are as in Table.

Maturity (years) Zero rate (% continuously compounded)

0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

22
III. BOND PRICING

v The par yield for a certain bond maturity is the coupon rate that causes the bond price
to equal its face value.
Example: Calculate the 2-year par yield per annum of a 2-year bond with a principal of
$100. Zero rates, measured with continuous compounding, are as in Table.

Maturity (years) Zero rate (% continuously compounded)

0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

23
IV. DETERMINING ZERO RATES

v The bootstrap method can be used to determine zero rates.

Example: The data in Table on the prices of five bonds. Calculate the 3-month zero rate,
the 6-month zero rate, 1-year zero rate, 1.5-year zero rate, 2-year zero rate.

Bond Principal Time to maturity Annual coupon Bond price

($) (years) ($)* ($)
100 0.25 0 99.6
100 0.50 0 99.0
100 1.00 0 97.8
100 1.50 4 102.5
100 2.00 5 105.0

*Half the stated coupon is assumed to be paid every 6 months 24

V. FORWARD RATES

vForward interest rates are the rates of interest implied by current zero rates for
periods of time in the future.

Year (n) Zero rate for n- Forward rate

year investment for nth year
(% per annum) (% per annum)
1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.5 6.5

25
V. FORWARD RATES

v The 3% per annum rate for 1 year means that, in return for an investment of $100
today, an amount 100e0.03*1 = $103.05 is received in 1 year.
v The 4% per annum rate for 2 years means that, in return for an investment of $100
today, an amount 100e0.04*2 = $108.33 is received in 2 years.
v The forward interest rate in Table for year 2 is 5% per annum. It can be calculated
from the 1-year zero interest rate of 3% per annum and the 2-year zero interest rate of
4% per annum.

26
V. FORWARD RATES

v A rate of 3% for the first year and 5% for the second year gives:
100e0.03*1e0.05*1 = $108.33
v At the end of the second year. A rate of 4% per annum for 2 years gives:
100e0.04*2 = $108.33
Ø 3% for the first year and 5% for the second year average to 4% over the 2 years.
Ø The result is only approximately true when the rates are not continuously
compounded.

27
V. FORWARD RATES

vSuppose that the zero rates for time periods T1 and T2 are R1 and R2 with both rates
continuously compounded.
The forward rate for the period between times T1 and T2 is:

ØThis formula is only approximately true when rates are not expressed with
continuous compounding.

28
VI. FORWARD RATE AGREEMENT

vA forward rate agreement (FRA) is an agreement to exchange a predetermined fixed

rate for a reference rate that will be observed in the market at a future time.
§ It is an agreement to lock a certain rate of interest on borrowings in the future.
§ FRAs are forward contracts that allow participants to make a known interest
payment at a later date and receive in return an unknown interest payment.
§ This is an OTC agreement between (generally) a party and a bank exchanging a
fixed interest rate for a floating one. Parties do NOT exchange the notion amount or
principal.
§ Usually, the agreement is settled in cash through cash payment at the beginning of
the forward period.
§ When used: Parties use a FRA if they expect (or fear) interest rate will increase.
29
VI. FORWARD RATE AGREEMENT

v FRA involves two counterparties:

§ Borrower: Long the loan – Pay Fixed, Receive Floating. Think “buying money”
§ Lender: Short the loan – Pay Floating, Receive Fixed. Think “selling money”
Ø The buyer of the FRA enters into contract to protect itself from a future increase in interest
rates
Ø The seller of the FRA enters into contract to protect itself from a future decrease in interest
rates
v Historically, the reference rate has usually been LIBOR. As LIBOR is phased out, we can
expect to see more FRAs based on floating rates such as SOFR and SONIA.
For example: A trader who is due to receive a rate based on three-month SOFR on a certain
principal during a certain future time period can lock in the rate by entering into an FRA where
SOFR is paid and a fixed rate is received.
Similarly, a trader who is due to pay a rate based on three-month SOFR on a certain principal
during a certain future time period can lock in the rate by entering into an FRA where SOFR is
received and a fixed rate is paid. 30
VI. FORWARD RATE AGREEMENT

For example: You want to borrow $5M. You lock in a FRA of 3.5% for 6 months
borrowing and it will be done in 3 months time. The rate at the beginning of the FRA
period is 4%.

31
VI. FORWARD RATE AGREEMENT

For example:
v Suppose that company X lends money to company Y from T1 to T2:
§ RK: the fixed rate agreed to in the FRA
§ RF: the current forward rate for the reference rate (SOFR)
Ø The value of an FRA is the present value of the difference between the interest that would
be paid at interest at rate RF and the interest that would be paid at rate RK
§ t: the period of time to which the rates apply (6 months in the above example)
§ FM: SOFR interest rate on the market at time T1 for the loan from T1 to T2
§ L: the principal in the contract
At T2:
Ø Company X's cash flow = L * (RK – RM) * (T2 – T1)
Ø Company Y's cash flow = L * (RM – RK) * (T2 – T1)
FRA is usually paid at T1
32
Ø Cash flow of X company = . ; Cash flow of Y company =
VI. FORWARD RATE AGREEMENT

For example: Consider an agreement to exchange 3% for three-month SOFR in two

years with both rates being applied to a principal of $100 million. One side (Party A)
would agree to pay SOFR and receive the fixed rate of 3%. The other side (Party B)
would agree to receive SOFR and pay the fixed rate of 3%. Assume all rates are
compounded quarterly. If three-month SOFR proved to be 3.5% in two years, how much
would Party A receive from Party B at time 2.25 years?

33
VI. FORWARD RATE AGREEMENT

For example:
§ Suppose a bank lends customers 100M USD with an interest rate of 8.5%/year from
October 5, 2022 to October 5, 2023.
§ The bank mobilised a deposit of 100M USD with an interest rate of 7.5%/year from
October 5, 2022 to April 5, 2023 to finance the above credit. However, the
mobilization can only fund in the first 6 months, so the bank will have to find new
capital sources for the remaining 6 months.
§ But after April 5, 2023, the 6-month deposit may have a different interest rate due to
the fluctuation of interest rates, so the bank may have interest rate risk.
§ To prevent interest rate risk, the bank will sign a loan contract of 100M USD with a 6-
month SOFR interest rate and an FRA with a notional principal of 100M USD with an
interest rate of 7.5%/year on October 5, 2022, the settlement date of April 5, 2023 and
maturity date of October 5, 2023.
34
VI. FORWARD RATE AGREEMENT

For example:
§ Suppose that on April 5, 2023, the 6-month SOFR is 9.5%/year for 100M USD. Hence,
compared to the interest rate of 8.5%, the bank will suffer a loss.
§ However, because the bank signed an FRA; hence, although the loan with a 6-month
SOFR of 9.5%/year had an interest payment of 4.75 million USD but the bank received
a compensation from the FRA of 1 million USD.
Ø Therefore, the total interest payable during the period from April 5, 2023 to October 5,
2023 is 3.75 million USD, equivalent to an interest rate of 7.5%/year.
Ø Thus, the bank effectively hedged interest rate risk on April 5, 2023. Without FRA, the
bank would have suffered a loss.

35
DETERMINATION OF FORWARD AND FUTURES PRICES

v Consumption vs Investment Assets

§ Investment assets are assets held by significant numbers of people purely for
investment purposes (Examples: gold, silver)
§ Consumption assets are assets held primarily for consumption (Examples: copper,
oil)

36
SHORT SELLING

v Short selling involves selling securities you do not own.

v Your broker borrows the securities from another client and sells them in the market in
the usual way.
v At some later stage, you must buy the securities back so they can be replaced in the
account of the client. The investor takes a profit if the stock price has declined and a
loss if it has risen.
v You must pay dividends and other benefits the owner of the securities receives.
v There may be a small fee for borrowing the securities.
v You must pay dividends and other benefits the owner of the securities should receive
on the shares.
v The investor is required to maintain a margin account with the broker. The margin
account consists of cash or marketable securities deposited by the investor with the
broker to guarantee that the investor will not walk away from the short position if the
share price increases. 37
SHORT SELLING

Example:
An investor shorts 500 shares in April when the price per share is $120 and close out the
short position three months later when the price per share is $100. Suppose that a
dividend of $1 per share is paid in May. What is his profit? What would be his loss if he
had bought 500 shares?

38
SHORT SELLING

Table 5.1 shows that the cash flows from the short sale are the mirror image of the cash
flows from purchasing the shares in April and selling them in July. (Again, the fee for
borrowing the shares is not considered.)

39
DETERMINATION OF FORWARD AND FUTURES PRICES

v Assumption and Notation

§ Assumption: For market participants:
ü subject to no transaction costs when they trade.
ü subject to same tax rate on all net trading profits.
ü can borrow money at the same risk-free rate of interest as they can lend money.
ü take advantage of arbitrage opportunities as they occur.

40
DETERMINATION OF FORWARD AND FUTURES PRICES

v Assumption and Notation

§ Notation:
ü S0 : Spot price today
ü F0 : Futures or forward price today
ü T : Time to maturity
ür : Risk-free interest rate, expressed with continuous compounding, for an investment
maturing at the delivery date

41
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset

§ An Arbitrage Opportunity?

Example: Consider a long forward contract to purchase a non-dividend-paying stock in 3

months. Assume the current stock price is $40 and the 3-month risk-free interest rate is
5% per annum. Is there an arbitrage opportunity if:
a. The 3-month forward price is US$43?
b. The 3-month forward price is US$39?

42
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset

§ An Arbitrage Opportunity?

Answer:

43
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset

§ Ifthe spot price is S0 and the forward price for a contract deliverable in T years is F0, r
is the risk-free interest rate, to avoid arbitrage, F0 should be equal to:
F0 = S0erT
Ø This equation relates the forward price and the spot price for any investment asset that
provides no income and has no storage costs.
Ø If F0 > S0erT, arbitrageurs can buy the asset and short forward contracts on the asset.
Ø If F0 < S0erT, they can short the asset and enter into long forward contracts on it
§ E.g., non-dividend-paying stocks, zero-coupon bond.
§ In our example, S0 = 40, T = 3/12, and r = 0.05: F0 =S0erT = 40*e(0.05*3/12) = $40.5 44
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset with no income and has no storage costs
§ If F0 > S0erT :
• Borrow S0 dollars at an interest rate r for T years.
• Buy 1 unit of the asset.
• Enter into a forward contract to sell 1 unit of the asset.
Ø At time T, the asset is sold for F0.
Ø An amount S0erT is required to repay the loan at this time and the investor makes a
profit of F0 - S0erT .

45
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset with no income and has no storage costs
§ If F0 < S0erT :
• Sell the asset for S0.
• Invest the proceeds at interest rate r for time T.
• Enter into a forward contract to buy 1 unit of the asset.
ØAt time T, the cash invested has grown to S0erT, the asset is repurchased for F0
Ø The investor makes a profit of S0erT - F0 relative to the position the investor would
have been in if the asset had been kept.

46
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset with a known income

§ Consider a forward contract on an investment asset that will provide a perfectly
predictable cash income to the holder.
§ E.g., stock paying known dividends and coupon-bearing bonds.
F0 = (S0 – I)erT
where I is the present value of the income during life of forward contract.

47
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset with a known income

Example: Consider a forward contract to purchase a coupon-bearing bond whose current
price is $900. The forward contract matures in 9 months. A coupon payment of $40 (i.e.,
income) is expected after 4 months. 4- and 9-month rates (continuously compounded) are
3% and 4% per annum.
Is there an arbitrage opportunity if:
a. The 9-month forward price is $910?
b. The 9-month forward price is $870?

48
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset with a known income

Answer:

49
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset with a known income

§ 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
§ If
short sales are not possible, investors who own the asset will find it profitable to sell
the asset and enter into long forward contracts.
For example: Consider a 10-month forward contract on a stock when the stock price is
$50. We assume that the risk-free rate of interest (continuously compounded) is 8% per
annum for all maturities and also that dividends of $0.75 per share are expected after 3
months, 6 months, and 9 months. Calculate the forward price of the contract. 50
DETERMINATION OF FORWARD AND FUTURES PRICES

v Forward price for an investment asset with a known yield

§ Consider the situation where the asset underlying a forward contract provides a known
yield rather than a known cash income.
F0 = S0e(r-q)T
where q is the average yield during the life of the contract (expressed with continuous
compounding).
Example: Consider a 6-month forward contract on an asset that is expected to provide
income equal to 2% of the asset price once during a 6-month period. The risk-free rate of
interest (with continuous compounding) is 10% per annum. The asset price is $25.
Calculate the forward price of the contract.
51
DETERMINATION OF FORWARD AND FUTURES PRICES

v Valuing a Forward Contract

§ When a forward contract is first entered into, its value is zero. At a later stage, the
contract may have a positive or negative value.
§ Suppose that:
• K is delivery price in a forward contract
• F0 is forward price that would apply to the contract today
• f is the value of forward contract today
§ The value of a long forward contract is:
ƒ = (F0 – K)e–rT
§ Similarly, the value of a short forward contract is:
ƒ = (K – F0)e–rT
52
DETERMINATION OF FORWARD AND FUTURES PRICES

v Valuing a Forward Contract

Example: A long forward contract on a non-dividend-paying stock was entered into some
time ago. It currently has 6 months to maturity. The risk-free rate of interest (with
continuous compounding) is 10% per annum, the stock price is $25, and the delivery
price is $24, what is the value of this contract now?

53
FORWARD VS FUTURES PRICES

v When the maturity and asset price are the same, forward and futures prices are usually
assumed to be equal. (Eurodollar futures are an exception)
v In theory, when interest rates are uncertain, they are slightly different:
§ A strong positive correlation between interest rates and the asset price implies the
futures price is slightly higher than the forward price
§ A strong negative correlation implies the reverse

54
FUTURES PRICES OF STOCK INDICES

v Stock Index
§ Can be viewed as an investment asset paying a dividend yield
§ The futures price and spot price relationship is:
F0 = S0e(r–q )T
where q is the average dividend yield on the portfolio represented by the index during
life of contract
§ For the formula to be true it is important that the index represent an investment asset.
In other words, changes in the index must correspond to changes in the value of a
tradable portfolio
Example: Consider a 3-month futures contract on VN30 index. Suppose that the stocks
underlying the index provide a dividend yield of 1% per annum (continuously
compounded), that the current value of the index is 1,300, and that the continuously
compounded risk-free interest rate is 5% per annum. Calculate the futures price.
55
FUTURES PRICES OF STOCK INDICES

v Index Arbitrage
§ When F0 > S0e(r-q)T, an arbitrageur buys the stocks underlying the index at the spot
price and shorts futures ocntracts
§ When F0 < S0e(r-q)T, an arbitrageur buys futures and shorts the stocks underlying the
index
§ Index arbitrage involves simultaneous trades in futures and many different stocks
§ 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.

56
FUTURES AND FORWARDS ON CURRENCIES

v Underlying asset: one unit of the foreign currency.

v Holder of the currency can earn risk-free IR prevailing in foreign country.
v The yield is the foreign risk-free interest rate
v If rf is the foreign risk-free interest rate:
F0 = S0e(r– rf )T
Where:
S0: spot price in local currency in one unit of foreign currency.
F0: forward/futures price in local currency in one unit of foreign currency.
rf: foreign risk-free IR.
57
r: domestic risk-free IR.
FUTURES AND FORWARDS ON CURRENCIES

v Explanation of the Relationship Between Spot and Forward

§ Starts with 1,000 units of the foreign currency. Two ways it can be converted to
dollars at time T:
1000 units of
foreign currency
Ø Investing for T years at rf. Entering a forward contract (time zero)

to sell the proceeds for dollars at time T. r T

1000e f units of
1000S0 dollars
Ø Exchanging foreign currency for dollars foreign currency at time zero
at time T
in the spot market today and investing for
r T
T years at rate r. 1000 F0 e f 1000S0erT
dollars at time T = dollars at time T

F0 = S0e(r– rf )T 58
FUTURES AND FORWARDS ON CURRENCIES

v Explanation of the Relationship Between Spot and Forward

Example: Suppose that the 2-year interest rates in Australia and the United States
(domestic) are 3% and 1%, respectively, and the spot exchange rate is 0.7500 USD per
AUD.
2-years forward exchange rate = 0.7500e(0.01 – 0.03)*2 = 0.7206
§ If forward rate = 0.7000 USD/AUD possibility of arbitrage.
§ If forward rate = 0.7600 USD/AUD possibility of arbitrage.

59