Derivatives
Forwards and Futures prices
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)
Short Selling
• Short selling involves selling securities
you do not own
• Your broker borrows the securities
from another client and sells them in
the market in the usual way
Short Selling (continued)
• At some stage you must buy the
securities so they can be replaced in the
account of the client
• You must pay dividends and other
benefits the owner of the securities
receives
• There may be a small fee for borrowing
the securities
Example
• You short 100 shares when the price is $100 and close out the
short position three months later when the price is $90
• During the three months a dividend of $3 per share is paid
• What is your profit?
• What would be your loss if you had bought 100 shares?
Notation for Valuing Futures and Forward
Contracts
S0: Spot price today
F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T
An Arbitrage Opportunity?
• Suppose that:
• The spot price of a non-dividend-paying stock
is $40
• The 3-month forward price is $43
• The 3-month US$ interest rate is 5% per
annum
• Is there an arbitrage opportunity?
Another Arbitrage Opportunity?
• Suppose that:
• The spot price of non dividend-paying stock is $40
• The 3-month forward price is US$39
• The 1-year US$ interest rate is 5% per annum
(continuously compounded)
• Is there an arbitrage opportunity?
The Forward Price
If the spot price of an investment asset is S0 and
the futures price for a contract deliverable in T
years is F0, then
F0 = S0erT
where r is the T-year risk-free rate of interest.
In our examples, S0 =40, T=0.25, and r=0.05 so
that
F0 = 40e0.05×0.25 = 40.50
If Short Sales Are Not Possible..
Formula still works for an investment asset because investors
who hold the asset will sell it and buy forward contracts when
the forward price is too low
When an Investment Asset
Provides a Known Income
F0 = (S0 – I )erT
where I is the present value of the income
during life of forward contract
When an Investment Asset
Provides a Known Income
A 9-month forward contract priced at a) Rs. 910 or b) Rs. 870. The
underlying asset (Bond) has a spot price of Rs. 900 with a coupon
payment of 4% due in 3 months. The risk-free rates for 3 and 9 months
are 3% and 4% respectively
Is there an arbitrage opportunity?
When an Investment Asset
Provides a Known Yield
F0 = S0 e(r–q )T
where q is the average yield during the life
of the contract (expressed with continuous
compounding)
Valuing a Forward Contract
• Two trades on the adjacent desks buy 16 3-months forward and
future contracts respectively in currency exchange of pound sterling
to dollar at 1.5. The underlying quantity is 62,500 pounds.
• The price moves to 1.504 but the bank reflects the two traders’
accounts with different gains.
• Is there an error from the bank?
Valuing a Forward Contract
• A forward contract is worth zero (except for bid-offer spread effects)
when it is first negotiated
• Later it may have a positive or negative value
• Suppose that K is the delivery price and F0 is the forward price for a
contract that would be negotiated today
Valuing a Forward Contract
• By considering the difference between a contract with
delivery price K and a contract with delivery price F0 we
can deduce that:
• the value of a long forward contract is
(F0 – K )e–rT
• the value of a short forward contract is
(K – F0 )e–rT
Forward vs Futures Prices
• When the maturity and asset price are the same, forward
and futures prices are usually assumed to be equal.
(Eurodollar futures are an exception)
• 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
Stock Index
• Can be viewed as an investment asset paying
a dividend yield
• The futures price and spot price relationship
is therefore
F0 = S0 e(r–q )T
where q is the average dividend yield on the
portfolio represented by the index during life
of contract
Stock Index (continued)
• 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
• The Nikkei index viewed as a dollar number
does not represent an investment asset
Index Arbitrage
• When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the
index and sells futures
• When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells
the stocks underlying the index
Index Arbitrage
(continued)
• 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
Index Arbitrage
(continued)
• The Nifty Bank Index is currently at 46,863.75 and offers a
dividend yield of 0.86%. If the risk-free rate is 6% and the
BANKNIFTY Futures contract price is 48,000, is there an
arbitrage opportunity?
• What will be your strategy?
Futures and Forwards on Currencies
• Foreign / Domestic direct quote means 1 unit of foreign
currency is quoted in terms of So units of domestic currency
• A foreign currency is analogous to a security providing a yield
• The yield is the foreign risk-free interest rate
• It follows that if rf is the foreign risk-free interest rate
" $ !$& # %
!! = "!#
Explanation of the Relationship Between Spot and
Forward
1000 units of
foreign currency
(time zero)
# !
0111" $ !(*#"/!-, 1000S0 dollars
,-)%#.*!'())%*'+ at time zero
!!!&"!"#$%!!
,--- #- "
$% ! 1000S0erT
'())&*+!&"!"#$%!! dollars at time T
1000F0erf T times foreign currency = 1000S0erT dollars at time T
Q. The two-month interest rates in Switzerland and the United States are 2% and 5% per annum,
respectively, with continuous compounding. The spot price of the Swiss franc is $0.8000. The
futures price for a contract deliverable in two months is $0.8100. What arbitrage opportunities
does this create?
Q. Estimate the difference between short-term interest rates in Mexico and the United States in
JUNE, from the information
Sept: 0.76375
Dec: 0.75625
• A 2-year AUD/USD forward contract is selling @ 0.7000. Current
continuous compounding interest rates for AUD and USD are 3% and
1% respectively. If the spot AUD/USD rate is 0.7500 is there an
arbitrage opportunity? What will be the arbitrage strategy to exploit
this opportunity?
• What if the AUD/USD forward rate is 0.7600
Consumption Assets: Storage is Negative Income
F0 £ S0 e(r+u )T
where u is the storage cost per unit time as a percent of the asset value.
Alternatively,
F0 £ (S0+U )erT
where U is the present value of the storage costs.
To establish equality we write,
F0 eyT £ (S0+U ) erT Or
F0 eyT £ S0 e(r+u )T
F0 = S0 e(r+u-y )T
Where y is convenience yield
Futures Prices & Expected Future Spot Prices
• Suppose k is the expected return required by investors in an asset
• We can invest F0e–r T at the risk-free rate and enter into a long futures
contract to create a cash inflow of ST at maturity
• This shows that
'# $ ! #! $ "! = & " %! !
$%
'# = & " %! !$ " # ! " !!
Futures Prices & Future Spot Prices
(continued)
No Systematic Risk k=r F0 = E(ST)
Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic Risk k<r F0 > E(ST)
*Positive systematic risk: stock indices
*Negative systematic risk: Crude oil (at least for some periods)
Practice Problems
q A forward contract and a futures contract on silver are one day to maturity. Suppose the futures
price is $7.00/ounce, but the forward price is $6.90/ounce. Assume the spot price tomorrow will be
either $6.85 or $7.05. Assume futures have cash settlement. Construct an arbitrage.
q Arbitrage or Not
• Feb millet futures are 30% more expensive than Mar millet futures
• Jun corn futures are 30% cheaper than Sep corn futures
• Jan gold is 30% more expensive than Mar gold
• Feb electricity is 30% cheaper than Mar electricity (at the same location)
Practice Problems
q A six-month forward contract is written on a stock that does not pay dividends and sells at 340. The risk-free
interest rate is 12% p.a. continuously compounded. Calculate the forward price. What will the price be if the
expected dividend is 3% after 2 months and a special dividend of 5% after 5 months?
q A sugar mill M expects to produce 300 MT (1MT = 1000 kg) of sugar in 3 months' time. The current price of
sugar is 42 per kg. The three-month futures contract is trading at 45 per kg. The lot size is 10 MT. A
chocolate factory F wants to purchase 300 MT of sugar in three months' time. M wants a 50% cover, while F
wants a 100% cover on commodity futures.
(i) Identify the parties in the long and short positions in the spot and futures market.
(ii) Identify the respective outflows and inflows for both these parties if, after three months, the price
increases to 46 or drops to 40 per kg.
q The current price of a stock is 200, and the continuously compounded risk-free interest rate is 4%. A
dividend will be paid every quarter for the next 3 years, with the first dividend occurring 3 months from
now. The amount of the first dividend is 1.50, but each subsequent dividend will be 1% higher than the one
previously paid. Calculate the fair price of a 3-year forward contract on this stock.
Practice Problems
q A one-year-long forward contract on a non-dividend-paying stock is entered into when the stock price is $40
and the risk-free interest rate is 10% per annum with continuous compounding. What are the forward price
and the initial value of the forward contract? Six months later, the stock price is $45, and the risk-free
interest rate is still 10%. What are the forward price and the value of the forward contract?
q The spot price of silver is $25 per ounce. The storage costs are $0.24 per ounce annually, payable quarterly
in advance. Assuming that interest rates are 5% per annum for all maturities, calculate the futures price of
silver for delivery in nine months.
q In Feb 2025, the spot exchange rate between the Swiss Franc and the U.S. dollar was 1.0404 ($ per franc).
Interest rates in the U.S. and Switzerland were 0.25% and 0% per annum, respectively, with continuous
compounding. The three-month forward exchange rate was 1.0300 ($ per franc). What arbitrage strategy
was possible? How does your answer change if the exchange rate is 1.0500 ($ per franc)?
The Coffee Conundrum
Café Nova, a speciality coffee chain, is expanding rapidly and needs a steady supply of high-
quality Arabica coffee beans. To hedge against price fluctuations, the company is
considering purchasing futures contracts on coffee beans. However, pricing these futures
contracts is complex due to additional factors like storage costs and convenience yield.
The Problem: It’s January, and Café Nova plans to secure coffee beans for
delivery in six months (July). The current spot price of coffee is $2.00 per pound,
and the risk-free interest rate is 5% per annum (continuously compounded).
The storage cost for coffee beans is $0.10 per pound per month, and due to
uncertainties in the supply chain, Café Nova values the ability to access physical
inventory at a convenience yield of 2% per annum.
The challenge is to determine the fair price of the six-month futures contract, incorporating
storage costs and convenience yield.
The Cocoa Futures Dilemma
ChocoDelight Ltd., a leading chocolate manufacturer,
relies on a steady supply of high-quality cocoa beans to
produce its premium chocolate products. Given the
volatility of cocoa prices in global commodity markets,
ChocoDelight has traditionally used futures contracts to
hedge its procurement costs.
It is now March, and the company is considering
entering into a six-month cocoa futures contract
to secure its supply for September delivery. The
procurement team must determine the fair price
of this futures contract, factoring in interest
rates, storage costs, and the convenience yield
associated with holding physical inventory.
The Cocoa Futures Dilemma
Market Conditions and Key Data
• Current Spot Price of Cocoa: $2,500 per metric ton
• Risk-Free Interest Rate: 6% per annum (continuously
compounded)
• Storage Costs: $5 per metric ton per month, payable at
the beginning of each month
• Annual Convenience Yield: 3%
Storage Costs: The cocoa beans must be stored in climate-controlled
warehouses, and the storage costs are incurred monthly. The
company must decide whether to include these costs on a simple
additive basis or assume continuous compounding.
• Convenience Yield: Holding physical cocoa inventory provides
strategic advantages such as ensuring uninterrupted production,
responding to sudden demand spikes, and capitalizing on short-
term arbitrage opportunities. This is represented as a convenience
yield, which reduces the effective cost of carry.
