CHAPTER 5

Determining Forward Prices and

Futures Prices

This chapter explains the theory of forward pricing. The forward price of a commodity is the price
that is quoted today for delivery of the commodity in the future; the price is contracted today but
is paid when the good is delivered in the future. Forward exchange rates exist for the forward pur-
chase or sale of foreign exchange. Forward interest rates are rates that exist for future borrowing
and lending opportunities.
All the ideas introduced in this chapter also apply to the pricing of futures contracts. In
Chapter 6, we explain why futures prices and forward prices might differ. Since, however, the
forces that might cause futures prices to differ from forward prices do not seem to be important,
we can fairly safely conclude that they ought to be identical.
In theory, forward prices are determined by the force of arbitrage. In other words, if forward
prices are “wrong,” then arbitrage opportunities will exist. A fundamental assertion in the theory
of finance is that well-functioning markets will not permit arbitrage. When arbitrage opportunities
exist, markets are not in equilibrium (1.e., supply does not equal demand), and traders will quickly
act to exploit arbitrage profits. (An arbitrage profit is riskless, involving a positive cash inflow at
one or more dates, and zero cash flows at all dates. In other words, arbitrage requires no invest-
ment and no cash outlay. The arbitrageur generates only cash inflows at one or more dates.)
In the first section of this chapter, we discuss the cost-of-carry model for forward commodity
prices. Under perfect markets assumptions, this model should determine one forward price.
However, markets are imperfect; in particular, the convenience yield must be considered when one
is determining the theoretical forward prices of commodities. The convenience yield is a unob-
servable theoretical construct that arises because there are problems in short selling commodities,
and those who own the commodities may be reluctant to sell them. Because of this, it turns out that
the cost-of-carry model determines only a maximum forward price that precludes arbitrage. Actual
forward prices can be less than the theoretically correct forward price.
In contrast, however, this short selling problem does not exist for financial assets such as
foreign currencies and interest rates. Thus, ignoring transaction costs, we will be able to compute
one single forward price for these items. Theoretical forward exchange rates are computed in
Section 5.2 and theoretical forward interest rates in Section 5.3.

5.1 ForwarD COMMODITY PRICES

5.1.1 The Cost-of-Carry Model

Assume that markets are perfect. This means that there are Se ea
or bid—ask spreads. There are no taxes. Market participants can buy or sell goods without affecting
————— ae

87
88 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

prices. There are no impediments to short selling.! Traders who short sell get full use of the
proceeds. There is no default risk; each of the two parties to every transaction knows that the coun-
terparty will perform as contractually required. Also assume that all individuals are wealth maxi-
mizers. This is equivalent to saying that everyone prefers more wealth to less, or that everyone’s
marginal utility of wealth is positive. Under these assumptions, the basic forward pricing model is:
a a

[F=S+CC-CR (3.1)

forward price = spot price + carry costs — carry return

The forward price F is the theoretical price for forward delivery of one unit of the commodity. The
spot price S is the current price per unit of the good in the cash market.
Carry costsarebestthought ofastheadditional costsinenssed hybuying andholding Oneunit
of the commodity. Interest charges on borrowing to buy the good and the opportunity cost of hav=
ing cash tied up in the asset are the most prominent of the carry costs. They are the only costs that
are relevant in forward exchange and forward interest rate determination. Carry costs for physical
commodities would also include the costs of insurance, storage, obsolescence, spoilage, and so on.
Typically, we assume that all carry costs are paid at delivery.
There is no carry return for commodities.
For financial assets, the carry return consists of the
Ee eee eon raiaateaga For example, dividend payments
on stocks (and the interest earned on any dividends received prior to the forward contract’s deliv-
ery date) would represent the carry return for a forward contract on common stock. Actual
or accrued coupon income on bonds (and any interest that can be earned on coupons received)
represents carry return for forwards on bonds. The interest that can be earned on a foreign currency
is a carry return for forward exchange contracts. CR is the future value of these benefits of owning
the cash asset.
An alternative interpretation of the cost-of-carry model is to view the purchase of a forward
contract as a substitute for the actual purchase of the underlying asset in the cash market. If the
forward price is correct, an investor should be indifferent between the two methods (forward
purchase or spot purchase) of buying the asset. Consider the choice between buying 1000z. of
gold, or going long one gold forward contract. Buying the actual commodity requires a cash
outlay. Moreover, there is an opportunity cost to that cash outlay: either interest is lost on the
dollar amount if the money is withdrawn from an interest-earning asset, or else funds must be
borrowed and interest paid on the principal. This makes the long forward position more desirable.
To make the two choices equivalent, the forward price must be higher by the amount of interest
that is saved by buying forward. Thus F=S+CC. When buying spot gold we must also account for
any costs of insuring and storing physical gold between today and the delivery date; the forward
price must be even higher to reflect those costs. If the cash asset supplies its owner with benefits
such as dividends or interest income, then to reflect the benefits of owning the cash asset, the
forward price will be lower.

5.1.2 Proof of the Cost-of-Carry Model

As with all proofs of propositions that are based on the absence of arbitrage, the proof of the
forward pricing model will first ask what if forward prices are too high (more than what the
theoretical pricing model specifies) and then analyze what will happen if forward prices are too
low (less that what the model specifies).
 5.1 FORWARD COMMODITY PRICES 89

Proof: What if F>S+CC-—CR?

Then+ F—S—CC+CR>0
Next, we will trade so that the cash flows are generated in the directions contained in this
inequality. For example, to create a ‘“— S$”, the underlying spot asset must be purchased; “—S” is a
cash outflow (the minus sign) of S dollars. To create a “+F,” the forward contract is sold (even-
though there is really no cash flow until delivery).
Today, time 0
Sell forward at Fo. No cash flow. As explained in Chapter 3, buying or selling a
forward contract at its equilibrium price is costless.
Buy deliverable spot asset — So
Borrow + So
Cash flow at time 0: 0
On the delivery date, time T

Make delivery to satisfy the terms

of the forward contract +Fo
Pay back loan principal and interest? —So— CC=—So~-int=—Sol1+h(0,T)]
Receive any carry return? +CR
Mo Gm CrCl)
Thus, if F exceeds S+CC-— CR, an arbitrage profit can be realized.
The steps one takes to arbitrage if F>S+CC—CR is frequently called a cash-and-carry
arbitrage. In a cash-and-carry arbitrage, the arbitrageur borrows to buy the spot asset, sells a for-
ward contract, and carries the deliverable asset until the forward delivery date.
The set of trades that an arbitrageur takes to exploit the situation when forward prices are too
low, F<S$+CC-—CR, is frequently called a reverse cash-and-carry arbitrage. In a reverse cash-
and-carry arbitrage, the spot good is sold short, the proceeds of the short sale are lent, and a long
position in a forward contract is taken.
Proof: What if F<S+CC—CR?
Then F—S—CC+CR<0O, or
—F+S+CC-—CR>0

Today, time 0
Buy forward at Fo. 0
Sell deliverable spot asset +So
Lend the proceeds from the short sale of the spot asset —So

On the delivery date, time T

Take delivery to satisfy the terms of the
forward contract, and pay the
contractually agreed-upon price —Fo
90

Receive loan principal and interest +So+int=+So9+CC=S[1+hO0,T)]

Pay any carry return to the person
to whom you sold the asset = CR
—Fy+Sg+CC—CR>0
In this part of the proof, we assume that the short seller receives full use of the proceeds of the
short sale.4 However, if the forward price is below its theoretical value, any individual who has a
long position in the deliverable cash asset could quasi-arbitrage by selling it out of her portfolio,
thereby receiving the full proceeds from the sale, and then performing all the steps just described.
On the delivery date, this individual will be better off than had she continued to hold the cash asset.
Thus, the cost-of-carry formula will determine forward prices when short selling is costly as long
as some individuals have the deliverable asset in inventory and do not plan to consume it between
time 0 and time T.

5.1.3 Examples
5.1.3.1 An Example: No Carry Return
Suppose the spot price of gold is $280/oz., the gold forward price for delivery six months hence is
$300/oz., and the yearly interest rate is 10%. The theoretical forward pricing model states that the
forward gold price should be $294/oz.:

F=S$+CC= S[1+ h(0, T)]

F = 280(1.05) = 294

Because F'>S'+ CC, borrow to buy an ounce of gold, and sell one overpriced gold forward contract
for delivery six months from today:
Today

Sell one forward contract No cash flow

Buy | oz. of gold —280
Borrow (for six months at 10% annual interest) +280
0
At delivery, with gold at F,=S;=270 Fr,=S;=300 F,=S,=330
Deliver 1 oz. of gold, fulfilling
the contract’s terms +300 +300 +300
Pay back loan with interest —294 —294 — 294
+6 +6 +6
Thus, regardless of the delivery day price of gold, the arbitrage profit is $6 per ounce of gold.
Note that the profit is independent of the final spot price of gold on the delivery day.
The FinancialCAD function, aaCDF can be used to compute the forward price of a commodity,
as shown in Figure 5.1. The slight difference between the FinancialCAD output forward price
of 293.9616439 and the price of 294 we just computed is due to the use of the day count method>
for unannualizing the annual interest rate of 10%. In this example, the FinancialCAD function
uses a periodic rate of (182/365)(10%) =4.9863% because it uses an actual/365 day count
method.
 5.1 FORWARD COMMODITY PRICES 91

spot price per unit of underlying

commodity ]
rate - simple interest
value (settlement) date
expirydate
accrual method actual/365 (fixed)
storage cost
convenience value
statistic air value
es

fair value 293.9616438

Figure 5.1 FinancialCAD function aaCDF computes the theoretical forward price of a commodity. Note
the two dates and the day count method (accrual method).

spot price per unit of underlying 280

commodity
rate - simple interest
value (settlement) date [24-Sep-2000]
expiry date 23-Mar-2001
accrual method 2 actual/360
storage cost are
ee |
convenience value warn os. |
statistic | __ 2}fair value

aaAccrual_days
effective date — | 24-Sep-2000
terminating date 23-Mar-2001} ©
accrual method |
___—actual/a60 ne)

number of business days from an

effective date to a terminating
date

Figure 5.2 FinancialCAD function aaCDF computes the theoretical forward price of a commodity. Note
the two dates and the day count method (accrual method).

In our earlier example, we implicitly used a 30/360 day count method, which produces a SiX-
month interest rate of h(0, 1/2 yr)=5%.
In contrast, Figure 5.2 solves the same problem, except that the expiry date (delivery date) is
March 23, 2001, and the day count method is actual/360. The expiry date is chosen so that deliv-
the
ery occurs 180 days after the contract initiation date; now, delivery takes place a half-year in
92

future, and h(0,'/2yr)=5%. Thus, the theoretical forward price is 294. The FinancialCAD
function, aaAccrual_days is used to compute the number of days until delivery.

5.1.3.2 An Example: The Underlying Asset has a Carry Return

Suppose that a forward contract on a share of General Mills stock exists. The delivery day is five
months hence. Today’s stock price is $36.375. The stock will trade ex-dividend in the amount of
$0.275/share two months hence. The interest rate is 6% for all maturities. Compute the theoretical
forward price.
The theoretical price is found by using the cash-and-carry pricing model:

f= S +-CC>CR

0.06)(3
P=36375+ (36.375,(0.00{ =}= (0.275) + oe |

F = 36.375 + 0.909375 — 0.279125 = 37.00525

Note in particular how the future value of the dividend is subtracted from S+CC. The divi-
dend is paid two months hence. It will earn interest over the subsequent three months, until the
delivery date. Figure 5.3 shows how the FinancialCAD function aaEqty_fwd solves this problem.

5.1.4 Transactions Costs

If there are transactions costs, there is no single theoretically correct forward price. Instead, the
forward price will lie between a lower and upper bound. The cost-of-carry formula becomes:

S(bid) + CC1— CR- T1S F < S(asked) + CC2 -CR+T2 (5.2)

aaEqty_fwd
value (settlement) date _ | 24-Sep-2000] -
expiry date — 24-Feb-2001
accrual method —
rate - simple interest
cash price of the underlying
equity index
statistic fair value of forward or futures _
dividend payment table t_14 :

t_14
dividend payment table
all the dividend dates from the dividend amount
value date to the expiry date
24-Nov-2000 0.275

fair value of forward or futures 37.00525

Figure 5.3 Using aaEqty-fwd to find the theoretical forward price when there is a carry
return.
 5.1 FORWARD COMMODITY PRICES 93

where

T|=transactions costs from the reverse cash-and-carry arbitrage trades of selling the spot
good at the bid price, lending the proceeds and buying a forward contract, 71 is paid at delivery
T2=transactions costs from the cash-and-carry arbitrage trades of borrowing to buy the spot
good at the asked price and selling a forward contract, T2 is paid at delivery
CCl =carry costs from the reverse cash-and-carry arbitrage, which should incorporate the
arbitrageur’s lending rate and, if needed, should be adjusted to reflect the possibility that the short
seller will not earn the full amount of interest on the proceeds from the short sale
CC2=the carry costs from the cash-and-carry arbitrage trades, which should utilize the arbi-
trageur’s borrowing rate

The lower bound (left-hand side of the inequality) is set by the reverse cash-and-carry arbitrage
trades. If the lower bound is violated, buy the cheap forward, sell the spot good, and lend the proceeds.
The upper bound (right-hand side of the inequality) is set by the cash-and-carry arbitrage
trades. If the forward price is above the upper bound, sell the overpriced forward, borrow, and buy
the spot good.

EXAMPLE 5.1 Consider the example from Section 5.1.3.1 in which the spot price of
gold is $280/oz. and the yearly interest rate is 10%. The forward contract calls for the
delivery of 100 0z. of gold. Also assume that the total transaction cost of buying or selling
100 oz. of spot gold, and trading one forward contract, is $1/oz. There is no carry return.
The range of possible forward prices per ounce of gold that precludes arbitrage is then

StUCl-TizFes+CC2412
280+14-1<
Fs 280+14+1
2935
7's 295

The forward price itself can lie between $293 < F < $295 per ounce, for a forward con-
tract on 100 oz. of gold. Any forward price below $293/oz. will allow reverse cash-and-carry
arbitrage. If the forward price is above $295/oz., then cash-and-carry arbitrage is possible.
Alternatively, suppose that the bid price for spot goldis $279.50/oz and that the
asked price for spot gold is $280.50/oz. In setting the lower bound, spot gold is sold at
the bid price. In setting the upper bound, gold is bought at the asked price. Therefore, the
no-arbitrage range of forward prices, in dollars per ounce, is

279.50(1.05) —1 s F $ 280.50(1.05) +1
or,
292.4155 F 5 295.525

Note that transactions costs widen the no-arbitrage bounds.

Next, suppose that in addition, the individual who is lending you the gold to short
sell will allow you to use only 60% of the proceeds of the short sale. This means that
94

your relevant carry costs (interest earned on the short sale of the spot asset) on the reverse
cash-and-carry arbitrage (left-hand side of the inequality) is only [(279.50)(0.6)(0.05) =]
$8.385/oz. You can only earn $8.385/oz. if you sell gold short and lend the proceeds that
you will receive. The range of no-arbitrage forward prices for you, for a contract on
100 oz. of gold, is

279.5 + 8.385—15 F S$ 295.525

286.885 < F S$ 295.525

You are at a disadvantage for performing the reverse cash-and-carry arbitrage trades
relative to a quasi-arbitrageur who already has the gold in storage and therefore would
receive the full proceeds from selling this asset. A quasi-arbitrageur will arbitrage if F
falls below 292.475, but you cannot arbitrage unless F declines below 286.885/o0z.

Example 5.1 illustrates that different individuals will have the ability to arbitrage at different
forward prices, depending on their borrowing and lending rates and on the levels of transactions
costs they face.

5.1.5 Implied Repo Rates and Implied Reverse Repo Rates

The implied _r rate is the rate earned on the cash-and-carry trades. In other words,
it is the rate of return that a trader earns from buying the deliverable spot asset and simultaneously
selling a forward contract.° The implied repo rate is effectively a lendipg rate. The trader buys
the spot asset at time O for So. This requires a cash outflow, just as if money was lent. The sale of
the forward contract guarantees a future cash inflow of F at time T. The implied repo rate is the
lending rate from performing these trades, from time 0 to time T. It can be found by solving for
h(O,T) in the cost-of-carry formula. If there are no carry returns, then

Fo = Soll +h, T)]

Solving for h(O,7) yields the unannualized implied repo rate when carry returns do not exist:

Fo — So
a3
So Ce)
This periodic, or unannualized implied repo rate can be annualized by multiplying it by
(365/d), where d is the number of days between time 0 and time T. Arbitrageurs will compare the
implied repo rate on forward contracts to their own borrowing rate. If they can borrow money at a
rate below the implied repo rate (which is a riskless lending rate), then there is a cash-and-carry
arbitrage opportunity.
If there are carry returns, the cost-of-carry formula can be used to solve for h(O,T) to compute
IRR, the unannualized implied repo rate:

0 (5.4)
 5.1 FORWARD COMMODITY PRICES OS

EXAMPLE 5.2 You spend $582,500 to buy 10,000 shares of a common stock (at
$58.25/share), and you sell a forward contract on these shares at a forward price of
$58.50/share. The delivery date is three months hence. The future value of dividends that
will be received on the shares during the next three months is $4078; this includes
dividends received and the interest that can be earned on those dividends. Thus, the
implied repo rate is:

(58.50)(10, 000) + 4078 — 582, 500

= 1.129%
582,500

The unannualized implied repo rate is 1.129%. The annualized implied repo rate is
4.517% (0.01129 x4). If you can borrow at a rate below 4.517%/year, and face no trans-
actions costs, you can cash-and-carry arbitrage.

The FinancialCAD function aaCDF-repo can be used to compute the annualized implied repo
rate for a forward contract on a commodity. See Figure 5.4.
The best borrowing rate available to market participants is the rate that corporations, dealers,
institutions, and so on can obtain by engaging in what is called a repurchase agreement, or repo.
In a repurchase agreement, party A owns some securities. He sells them to party B for a sum of
money and agrees to repurchase them at a later date for a somewhat greater sum of money. Thus,
A has effectively used the securities as collateral to borrow money from B. The interest rate asso-
ciated with a repo is called the repo rate. Most repos are overnight loans, and sometimes the
phrase overnight repo rate is used to describe the annualized borrowing rate for individuals who
use repurchase agreements for one day. Repos of longer duration are called term repos.

aaCDF_repo
spot price per unit of underlying 58.25
commodity
futures price
value (settlement) date 24-Sep-2000
expiry date 23-Dec-2000
accrual method actual/360
storage cost |
convenience value 0.4078
statistic annual repo rate incl. convenience
value

annual repo rate incl. 0.045170815

convenience value

Figure 5.4 The FinancialCAD function aaCDF_repo computes the annualized implied repo rate for a
forward contract on a commodity.
96 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

EXAMPLE 5.3 Party A owns $1 million face value of Treasury bills that currently
have a market value of $950,000. Party A needs cash, and she can raise the needed funds
by entering a repurchase agreement. Party A sells the T-bills to party B for $945,000’
and agrees to repurchase them tomorrow for $945,311. Thus the annualized interest rate
on this repurchase agreement is®:

F-S Pe
FO 360 a day 360 311 x 360 (= 0.0003291 x 360) = 11.848%
gg es ous oe
Arbitrage is possible if the implied repo rate for a forward contract exceeds actual
market repo rates. This is equivalent to saying that the effective lending rate available in
the forward market by buying the spot good and selling a forward contract exceeds the
arbitrageur’s borrowing rate.

The implied reverse repo rate is the rate of return earned by selling short the spot good and
buying a forward contract. These two transactions are part of the reverse cash-and-carry arbitrage.
The implied reverse repo rate is effectively a borrowing rate because the short sale of the spot good
will provide a cash inflow, just as would any borrowing transaction. Going long a forward contract
locks in a delivery date cash outflow. Arbitrageurs will compare the implied reverse repo rate to
their own riskless lending rates. Whenever possible, they will risklessly borrow at the implied
reverse repo rate in the forward market and lend at the higher lending rate available to them in the
securities or real goods markets.
Summarizing, individuals will engage in cash-and-carry arbitrage if the implied repo rate in a
forward contract exceeds the market repo rates. Under these conditions, they will borrow money at
the market repo rate, buy the deliverable asset, and sell a forward contract. Individuals will engage
in reverse cash-and-carry arbitrage whenever the implied reverse repo rate in a forward contract is
less than the riskless lending rate. Recall that a reverse cash-and-carry arbitrage requires the short
sale of the underlying asset, the purchase of a forward contract, and the lending of the proceeds of
the short sale.
When markets are perfect, the implied repo rate and the implied reverse repo rate are equal.
However, if (a) the purchase price of the spot good (the asked price) is greater than its selling price
(the bid price), (b) there is a bid—asked spread on the forward contract, and/or (c) there are trans-
actions costs required to do the trades, then the implied repo rate (the lending rate available in the
forward market) will be less than the implied reverse repo rate (the borrowing rate available in the
forward market). These market imperfections increase the range of forward prices that can exist
without permitting arbitrage.

5.1.6 Forward Prices of Commodities:

The Convenience Yield
The cost-of-carry model invokes perfect markets assumptions to determine theoretical forward
prices. In particular, it is assumed that the commodity can be sold short and that those who own the
commodity have no reservations about selling it.
 97

However, for most goods other than financial assets and gold, the cost-of-carry model can
be used only to determine an upper bound. In other words, for agricultural, energy, and metal
forwards, we can say that F<S+CC—CR. If the forward price is above S+CC-—CR, one can
perform cash-and-carry arbitrage by using borrowed funds to buy the good in the spot market, and
selling forward contracts. The carry costs must also account for storing, insuring, and otherwise
maintaining the physical commodity.
The model cannot be used to determine the existence of arbitrage opportunities when the cash
good must be sold short to arbitrage. The reason for this lies in what makes financial commodities
different from all other physical commodities such as agricultural commodities. Financial instru-
ments such as bonds, foreign exchange, and stocks are used for investment purposes. They are not
used as part of any production process. Thus if the forward price was too low, no one would be
inconvenienced by selling, or selling short, the cash good (the debt instruments, stocks, or foreign
exchange) and buying an underpriced forward contract. No one would miss these commodities:
they would be replaced on the delivery date of the forward contract. Indeed, individuals who arbi-
trage would be better off on the delivery date because they had sold these assets short (pure arbi-
trage) or out of their inventory (quasi-arbitrage).
We call goods that ave used for production purposes noncarry commodities. The users of non-
carry commodities will not always be willing to sell their inventory in the spot market and buy for-
ward contracts to replenish their supplies at a later date. Similarly, potential pure arbitrageurs will
not always be able to find supplies of the physical good to borrow and sell short. Producers need
to maintain supplies of the goods that are used in their production processes. Cereal manufacturers
need wheat and corn in inventory; electrical equipment manufacturers need supplies of copper to
manufacture their products. Consequently, the cash prices of these noncarry commodities can even
be above the forward price, and it is possible that no one will be willing and able to arbitrage by
selling the good in the spot market and buying forward contracts.
The cost-of-carry formula can be modified to account for this situation by defining a new
term, convenience yield (also sometimes called the convenience return). A commodity’s conve-
nience yield is the benefit, in dollars, that a user realizes for carrying inventory of the physical
good above his or her immediate near-term needs. An oil refiner receives the convenience yield on
crude oil inventories because without it, the refiner cannot produce any finished products.
Financial assets have no convenience return. In contrast, agricultural commodities frequently
have a high convenience return because producers face losses if they have none of the commodity
in inventory. A commodity’s convenience return can be different for different users, and it can vary
over time.? It will be at its highest when there are spot shortages of the cash good. At these times,
spot prices will lie above forward prices.
Thus, for noncarry commodities, the cost-of-carry formula may be presented as follows;

F =S§+CC-—CR-convenience return (S5)

The problem with this formula is that the convenience return is not easily measured. Some
users may have a low convenience return, and they will arbitrage when the forward price lies
below S+CC—CR-their convenience return. Other users are indifferent between selling their
supplies (or lending them to short sellers) and maintaining their inventory to realize their conve-
nience return. In such cases, the relevant convenience return in Equation 5.5 is the marginal con-
venience return for that marginal producer. Finally, other producers will have a high convenience
return, and they will never wish to sell or lend their supplies of the physical good.
98 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

Whenever the cash price of a deliverable commodity is above the forward price, a spot short-
con-
age (or temporary excess demand) of the good probably exists, and there is a high marginal
venience return.

5.1.7. Do Forward Prices Equal Expected Future

Spot Prices?

5.1.7.1 Financial Assets

The cost-of-carry model determines the theoretical forward prices of financial assets such as
interest rates, currencies, and stocks. Under the appropriate assumptions, actual forward prices
must equal theoretical forward prices, or else arbitrage opportunities will exist. Expectations of
future spot prices are not directly included in the forward prices of these assets. Any expectations
of future spot prices are incorporated into the current spot price of the good, and given that spot
price, as well as carry costs and carry returns, the forward price is found by the cost-of-carry
model.
For example, if all investors expect the stock market to greatly appreciate in value in the near
future, then the spot prices of stocks will rise to reflect those expectations. No matter how bullish
investors are, the forward price of stocks must equal the spot price plus the net carrying costs
(interest on the stocks minus the dividends between today and the delivery date).!9 Whether the
forward price incorporates the market’s expectation of the future spot price of the underlying com-
modity becomes a matter of semantics. The spot price reflects market expectations, and given the
spot price and the cost-of-carry formula, the forward price is determined. The forward price incor-
porates expectations only because they are reflected in spot prices.
Therefore, the forward price of a financial asset or gold will rarely equal the market’s expec-
tation of the future spot price. Suppose that the spot price of gold is $280 and the interest rate is
0%. Then, the forward price must also equal $280, regardless of market expectations about the
future spot price of gold.
Recall that market imperfections allow the forward price to lie in a band, or range, of prices
without allowing for arbitrage opportunities. In these cases, the forward price will provide more
information about market expectations. For example, if the theoretical forward price F is
350
S$F$352 and investors are bullish, we would expect to see F=352. If investors are bearish,
then F will likely equal 350. Now, forward prices reveal market expectations, and futures prices
are theoretically correct.
If F rises above 352, traders will arbitrage by buying the spot good and selling (overvalued)
forward contracts. When the spot good is bought, its price will rise; when it is sold forward, the
forward price will fall. Eventually, equilibrium will be reestablished, and there will be no opportu-
nities to arbitrage. If F declines below 350, forwards will be bought and the spot good will be
sold short.
The situation is different for the forward prices of physical commodities, where the forward
price more likely reflects expected supply and expected demand at the delivery date. As such, the
forward price does reflect the market’s expectation of the future spot price. But it may not equal
the expected spot price. There are theories that predict the possible existence of risk premiums in
forward prices. A risk premium is defined to be the difference between the forward price and mar-
ket’s expectation of what the spot price will be at delivery. The theories give rise to the concepts of
normal backwardation and contango.!!
 5.1 FORWARD COMMODITY PRICES 99

5.1.7.2 Physical Commodities: Normal Backwardation

and Contango
In a world of certainty, determining the forward price of any commodity is easy. It will equal
the future spot price of the good at delivery, which all investors know with certainty. There is
nothing to prevent the spot price from changing in a known, perfectly predictable manner, such
that the forward price lies above or below the current spot price. The spot price will fluctuate
according to supply and demand conditions. However, all investors know what the spot price
will be at every subsequent date, including the delivery date of the forward contract. The spot
price that all investors know will exist on the delivery date equals the forward price, and in a
world of certainty, the forward price will never change. Buyers and sellers of forward contracts
put up no money to assume their positions, and they will realize no subsequent cash flows
from any changes in forward prices. Speculators, hedgers, and arbitrageurs have no reason to
exist because the spot price at delivery is known with certainty and the forward price is
constant.
While the situation is different under conditions of uncertainty, many still believe in the unbi-
ased expectations hypothesis of forward prices. According to this theory, the forward price
equals the market’s expectation of what the spot price will be at delivery:

Fa EAS)
This formulation states that F,, the forward price at any time f¢, equals the time ¢ expectation of
what the spot price of the commodity will be at delivery (time 7). Under this hypothesis, the
expected cash flow to any forward position is zero; today’s forward price equals the expected for-
ward price on the delivery day. And it should be obvious that the expected forward price for deliv-
ery at time 7 equals the expected spot price on day 7.
If the unbiased expectations hypothesis of forward prices is correct, then any forward price is
determined because traders have used all the information available to come to the aggregate expec-
tation that on the delivery date, the spot price for the good will be that forward price. In other
words, F, = E,(S7).
If speculators are risk neutral, the unbiased expectations theory is likely to explain commod-
ity forward prices. Risk neutrality means that all assets are priced to provide the same riskless rate
of return. If any asset was priced to yield an expected return greater than the riskless interest rate,
investors would buy it, regardless of the asset’s riskiness. Similarly, no investor would ever buy an
asset if he thought it would yield a return less than the riskless rate. Forward positions, long and
short, can be entered into with no cash outlay. In a risk-neutral world, therefore, the expected cash
flow to both longs and shorts must be zero.
Others, however, believe that the forward price is a biased predictor of what the future spot
price will be. Keynes (1930) first proposed that forward prices will contain a risk premium. He
hypothesized that hedgers tend to sell forward contracts and futures contracts. If hedgers are net
short, then it must follow that speculators have more long positions than short positions.'* But
speculators will assume long positions only if they expect to earn a higher return, a risk premium.
Therefore, the forward price must be below the spot price that investors expect to prevail at deliv-
ery, F, < EGS): The forward price is expected to rise over the life of the contract, to provide a
positive expected return to speculators. Risk-averse hedgers are willing to lose a little to shed the
price risks they face in an unhedged position.
100 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

Keynes called this situation normal backwardation. According to the normal backwardation
hypothesis, forward prices are below expected future spot prices, and the forward price is expected
to rise as the delivery date approaches. The reason for backwardation is that hedgers are usually
short forward. A hypothetical price process of a forward contract exhibiting normal backwardation
is shown in Figure 5.5.!°
A contango exists whenever the forward price lies above the expected future spot price,
F > E,(S;). Here, the forward price should generally decline as the delivery date nears. This
situation arises because for some commodities and at some times, hedgers will be net long forward
contracts, and speculators will be net sellers of forward contracts. Speculators must expect to
earn a profit if they are to sell forwards. In a contango, forward prices must be expected to fall.
A contango is shown in Figure 5.6.
Cootner’s (1960) theory about the seasonality of hedging activities can be modified to present
a summary statement about the issue of whether forward prices equal expected future spot prices

Forward price

EXS7)

0) ih Time

Figure 5.5 Normal backwardation. The forward price will lie below the existing expectation (as of any time
t prior to the delivery date, time 7) of what the time 7 (delivery date) spot price will be. The forward price
will rise, on average. It is assumed that E,(S;) remains unchanged as the delivery date nears.

Forward price

E(S7)

0 IF Time

Figure 5.6 Contango. The forward price lies above the existing expectation (as of any time fprior
to the
delivery date, time T) of what the time T (delivery date) spot price will be. The forward price will
fall
on average. It is assumed that E,(S,) remains unchanged as the delivery date nears.
 5.1 FORWARD COMMODITY PRICES 101

for noncarry commodities. Basically his model states that the supply and demand varies over time
for short hedges and for long hedges. Any risk premium (the difference between the forward price
and the expected spot price on the delivery date) will be a function of the net hedging activity
occurring at any moment, and it can change in sign (from backwardation to contango) over the life
of the contract.
Thus, if risk-averse hedgers are currently attempting to manage their risk exposures by
actively selling forward contracts, the forward price quoted by dealers will decline. This will occur
in one of two ways. First, if the dealers are playing the role of speculators, we conclude that
they will not be willing to accept the price risk unless there is a risk premium, F < ECS} ),
Alternatively, the dealers will use other derivatives markets to shed themselves of the price risk
they assumed by buying forwards from the hedgers. They will do this by selling futures, or by
using options or swaps. But now, their hedging activities will suppress prices in those markets, and
there will be a resulting secondary impact on forward prices. But either way, we conclude that
active short hedging activity will lead to lower forward prices, which are likely to be less than the
future spot prices expected by market participants.
It seems naive to believe that hedgers are consistently net short. Users of commodities hedge
their planned future purchases of raw materials, too, and they will tend to buy forward contracts
in those situations. Thus, like Cootner, we might expect to observe backwardation and contango
situations at different times for different commodities. The question of whether forward prices
equal expected future spot prices is ultimately an empirical one, and many researchers have exam-
ined forward prices for the existence (if any) of a risk premium that would answer whether the
unbiased expectations hypothesis holds, or whether backwardation or contango exists.
Kamara (1984, p. 70) summarizes the many studies that test whether forward prices are the
unbiased expectation of future spot prices writing about futures markets by stating:
In sum, although it is widely accepted that futures markets are used by risk-averse hedgers, the
evidence suggests that hedgers have been able to purchase the insurance very cheaply. As a
result, forward prices on average do not contain a significant risk premium.

5.1.8 Valuing a Forward Contract After Origination

After a forward contract has been originated, forward prices change. In other words, on March 1,
you might agree to buy an ounce of gold on October 1, at the forward price of $320/0z. One month
later, on April 1, the forward price for delivery of gold on October | might be $330/oz. The value
of your original forward contract (that obligates you to buy gold at $320/oz.) is merely the present
value of the difference between the two forward prices.
Thus, define

F(0,7)=forward price of the original contract, created at time 0, for delivery of the underlying
asset at time T
F(t, T)=forward price at time t, for deliver also at time T

h(t, T)=spot interest rate that exists at time f, for borrowing and lending until time f with A(t, T)=
r(T—1)/365, where r is the annual interest rate for borrowing and lending over (T—?f) days.
Then, the value of the original forward contract, at time f, iS
PGT = tO;T)
1+h(t,T)
102 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

If the forward price has risen [F(t,T)>F(0,7)], the value is positive for the long position
(an asset) and negative for the short position (a liability). If the forward price has declined
[F(t, T)<F(0,T)], the value is positive for the individual who is short the forward contract and
negative for the individual who is long the contract.

5.2 FORWARD EXCHANGE RATES

5.2.1 The Standard Approach to Deriving the Forward

Exchange Rate
The standard cost-of-carry pricing formula, with one small modification, determines foreign
exchange forward prices and forward prices. Define:

N=number of units of foreign exchange in one forward contract

T=number of days until delivery

ras tf=annual domestic and foreign interest rates, respectively

h,O,T)=domestic unannualized interest rate from today until the delivery date =(r,)(T)/365

h,(0, 7) =foreign unannualized interest rate from today until the delivery date =(r)(T)/365

When performing the cash-and-carry arbitrage trades, borrow funds to purchase N/[1+
h,(O,T)] units of foreign exchange and sell a forward contract for the delivery of N units. In other
words, buy the present value of N units of foreign exchange, where the interest rate used in deter-
mining the present value factor is the foreign interest rate. Thus, if the cost-of-carry model
assumes no carry return,'+ the forward exchange pricing model specifies

Ser 2 are [1+h,(0,T)] hg+

= SU O,T)]
1+h;(0,T) 1+h,(0,T) 25.6
Equation (5.6) is the standard cost-of-carry forward pricing model when there is no carry
return, except S/[1+h,(0, T)] is substituted for S.
When performing cash-and-carry arbitrage,'> the arbitrageur borrows funds to purchase
the present value of N units of foreign exchange and invests those units to earn the foreign
riskless interest rate. On the delivery date, the arbitrageur will have N units of the foreign
currency to deliver, thereby allowing the requirements of the short forward position to be
fulfilled.
Equation (5.6) can be rearranged and reexpressed in terms of annual interest rates as
follows:

us [7,(7/365)] +1 _ 365+ rT (5.7)

S [--(7/365)]+1 365+ 7,7
 103

EXAMPLE 5.4 Suppose that the delivery date for forward delivery of euros is 144
days hence. The annualized domestic (U.S.) interest rate is 7% if an individual wishes to
borrow or lend for 144 days. The euro interest rate is 4.5%/year. The spot exchange rate
is $0.95/€. Determine the theoretical forward price.
Use Equation (5.6) to obtain the solution:

F= S[i+h,(0,T :
[1+h,(0,T)] a 0.95[1 + j (0.07)(144)/365] _ 9.95(1.027616)
OSG: = $0,9502/€
1+h,(0,T) 1+(0.045)(144)/365 1.017753

The theoretical forward price is $0.9592/€. By going long one euro forward contract, a
trader locks in the purchase price of $0.9592/€. Figure 5.7 shows how FinancialCAD
uses the function aaFXfwd to solve the problem. The function aaAccrual_days (also
shown in Figure 5.7) is used to verify that there are 144 days between September 24,
1999 and February 15, 2000.

AaFXfwd
FX spot - domestic / foreign
Rate — domestic - annual
Rate — foreign - annual
Value (settlement) date oO
Forward delivery or repurchase 15-Feb-2001
date
Accrual method - domestic rate | A actual/365 (fixed)
Accrual method - foreign rate | A factual/365 (fixed)
Statistic 2\fair value of forward (domestic
/foreign)

fair value of forward (domestic 0.959206418

/foreign)

AaAccryal_days
Effective date 24-Sep-2000
Terminating date 15-Feb-2001
Accrual method ne)

Number of business days from an

effective date to a terminating
date

Figure 5.7 The FinancialCAD function aaFXfwd is used to compute the theoretical forward exchange
price. The time from an effective date to a terminating date is found by using a AaAccrual_days.
104

The FinancialCAD function aaFXfwd_sim allows you to observe how the forward price
interest rate.
varies as a function of either the spot rate, the domestic interest rate, or the foreign
You choose the independent variable on the line titled x-axis. The program’s output table (Figure
5.8a) was plugged into the Excel Chartwizard to produce a graph (Figure 5.8b).
Now, suppose that the actual 144-day forward price is $0.953/€. Because this price is less
than the 144-day theoretical forward price of 0.9592, arbitrageurs will engage in reverse cash-and-
carry arbitrage. Assume that N= €125,000 An arbitrageur would perform the following series of
reverse cash-and-carry trades:

Today

© Borrow 125,000/1.017753 = €122,819.58 at the foreign interest rate of 4.5%/year. Sell the
€ 122,819.50 at the spot price of $0.95/€, and receive $116,678.525.
* Lend the proceeds of $116,678.525 for 144 days at the domestic interest rate of 7%/year.
* Go long one forward contract that requires the purchase of €125,000 at the forward price of
BU .955/S2
Zero cash flow today

At Delivery (144 days hence)

* Receive the loan proceeds of $116,678.525(1.02762) =$119,901.186.
¢ Fulfill the requirements of the forward contract: by purchasing €125,000 at the contracted
price of $0.953/€. The total purchase price is $119,125.
¢ Repay the euros borrowed. With interest, the obligation is €125,000.
Cash inflow at delivery =$119,901.186—$119,125=$776.186
Note two points. First, the arbitrage profit of $776.186 is realized with no initial capital
outlay. Second, if arbitrage opportunities such as this ever emerged, individuals would sell euros
in the spot market and go long forward contracts. The process of arbitrage would lead to a lower
spot euro price and a higher forward euro price. Arbitrageurs’ trades will correct the initial
mispricing.
Data on foreign interest rates can be found at several websites, such as www.bloomberg.com/
markets/iyc.html (Bloomberg’s site). Charts that depict how foreign interest rates have moved in
the past few years can be found at www.yardeni.com/finmkts.html (Ed Yardeni’s site). The Wall
Street Journal gives yields on international government bonds, which are long-term foreign inter-
est rates, in its “Bond Market Data Bank” column; an example is given in Figure 5.9. Barron’s
provides a graph of short-term interest rates for British pounds, euros, and Japanese yen, and a
graph of yields for long-term British, German, and Japanese government bonds in its weekly
“Current Yield” column; an example is presented in Figure 5.10.

5.2.2 An Alternative Derivation of the Theoretical

Forward Price
Assume that you have one dollar to invest for T days. You have two ways to invest the money:

Method I: Invest the dollar in the United States. At the end of the T days, you will have
1[1+h,0, T)]=1+(rgT/365).
 5.2 FORWARD EXCHANGE RATES 105

CV AaFXfwd sim
FX spot - domestic / foreign
Rate - domestic - annual
Rate - foreign - annual 0.045
Value (settlement) date 24-Sep-99
Forward delivery or repurchase -0
15-Feb-00
dale. —
Accrual method - domestic rate | tfactual/ 365 (fixed)
Accrual method - foreign rate [____ tlactual/ 365 (fixed)
Statistic yeas 2c value of forward (domestic/
foreign)
x-axis |
____1|domestie spot price
Simulation range x-axis kr —
Orientation : vertical format

Simulation table - aaFXfwd_sim

Items in X axis simulation range items in Y axis simulation range
[%*)
lee)
a

0/09/00

|
(095|0.959206418)

NIN
0
00}
|
TN
TREN
NJ

| 0.9595] 0.968798482|No

(b) 9.97

0.965

0.96

0.955

0.95
Forward
exchange
rate
0.945
0.935 0.94 0.945 0.95 0.955 0.96 0.965
Spot exchange rate

Figure 5.8 (a) The FinancialCAD function aaFXfwd_sim computes a table of theoretical forward exchange
rate.
prices as a function of either the spot exchange rate, the domestic interest rate, or the foreign interest
(b) Forward exchange rate as a function of the spot exchange rate.
106 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

BOND MARKET DATA BANK 6/4/01

INTERNATIONAL GOVERNMENT BONDS
MATURITY MATURITY
COUPON = (Mo. /YR.) PRICE CHANGE YIELD" COUPON = (Mo. /YR.) PRICE CHANGE YIELD
Japan (3 p.m. Tokyo) Germany (5 p.m. London)
450% 0603 10903 - 0.01 006% 3.25% 0204 723 + 006 434%
3.40 0605 11250 - 003 027 5.00 0505 1016 - 001 4507
10 0611 10053 + 004 124 5.00 O71 945 + O00 5069
19 0321 10007 - 02 190 5.50 0131 o309 + «(002 «(568
United Kingdom (5 p.m. London) Canada (3 p.m. Eastem Time)
—Tox~OSS*=~CS~«sSC*CSCOK C*SCiOKSSC*«it:SC*‘“‘«‘ik
«CO
9.50 0405 11446 - 0.07 5312 5.25 0803 10055 + O07 4386
623 1110 108.19 -— 003 5146 6.00 0608 10205 4+ O29 SB4I
OO
45
Rs alll - Bee
055 408 gas| rel
800 pe Ooo
eb a 1297
etal O61 5939
+ee ees
*Equivalent to semi-annual compounded yields to maturity

Figure 5.9 Yields on government bonds from Japan, the United Kingdom, Germany, and Canada.
(Reprinted with permission of The Wall Street Journal, page C20. © June 4, 2001.)

GLOBAL SHORT-TERM RATES (b) GLOBAL LONG-TERM RATES

Tee
10-Yr. U.S.
T-Note

Figure 5.10 (a) Short-term interest rates for four major currencies. (b) Long-term yields for government
bonds of the same countries. (Reprinted with permission from Barron’s, April 23, 2001, page MW16.)

Method 2:
1. Convert the dollar into fx at the spot exchange rate, S.
2. Invest the 1/S units of fx to earn the foreign interest rate of h,O, T)% over T days.
3. Sell a forward contract that obligates you to deliver the (1/S)[1 +h0,T)] units of fx on the
delivery date at time 7. The forward price is F (expressed as the dollar price of a unit of
foreign exchange fx).
4. At time 7, your foreign investment will be worth (1/S)[1+h,(O, T)] units of fx. Under
the
terms of the forward contract, each fx unit can be converted to dollars at the exchange rate
F. Thus, you will receive (F/S)[1+ h,(O, T)] dollars.
 5.2 FORWARD EXCHANGE RATES 107

The two methods are equivalent because they are both riskless lending transactions for T days.
Therefore, you should have the same wealth at time T either way you invest. This means that

$I[1+h,(0,7)]=$1(F/ S)[1+ h,(0,T)]

which is the same as Equations (5.6) and (5.7).

If one strategy dominated the other, then investors would invest in the better strategy. For
example, if method | provided a higher return than method 2, Americans would keep their dollars
as dollars, and invest in the United States. Also, foreigners would sell their units of fx for dollars,
lend them in the United States, and buy forward contracts on their fx.

5.2.3 The Implied Repo Rate

If the present value (found by using the foreign interest rate) of spot foreign exchange is pur-
chased, and a foreign exchange forward contract is sold, this portfolio creates a long position in a
synthetic T-bill. The rate of return earned on this synthetic T-bill is called the implied repo rate. If
the implied repo rate exceeds your borrowing rate, cash-and-carry arbitrage is possible.
To find the unannualized implied repo rate, solve Equation (5.6) for h0,T). To compute the
annualized implied repo rate when using an actual/365 day count method, solve Equation (5.7) for ry.

FIL hn OD ls
unannualized implied repo rate = h, (0,7) = (5.8)
S

365F —365S + FTr,

annualized implied repo rate = r, = 7 (9)

EXAMPLE 5.5 _ Assume that you can lend British pounds for three months in Great
Britain at the rate of 6%/year. All day count methods are assumed to be 30/360. A long
position in a synthetic (U.S.) T-bill is created by purchasing 62,500/[1 + (0.06/4)]=
£61,576.35 and selling a forward contract requiring the delivery of £62,500 three
months hence. At the spot exchange rate of $1.64/£, the purchase of £61,576.35 will
cost $100,985.22. The pounds are lent in Great Britain, and a forward contract is sold at
the forward price of $1.65/£, which locks in a selling price. Three months later, the
£62,500 is delivered, satisfying the terms of the forward contract, and (62,500)(1.65) =
$103,125 is received. The implied repo rate is ($103,125 — $100,985.22)/$100,985.22 =
2.119% over three months, or 8.476%/year. If an individual can borrow in the United
States for three months at an annual rate of less than 8.476%, and if transactions costs
are ignored, then there is an arbitrage opportunity. Figure 5.11 shows how Financial-
CAD would use the function aaFXfwd_repo_d to solve the problem. Note the use of the
30/360 accrual methods for both interest rates.

re
108 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

AaFXfwd_repo_d
FX spot - domestic / foreign
FX forward price - domestic/
foreign
Rate - foreign - annual
Value (settlement) date
Forward delivery or repurchase
date
Accrual method - domestic rate 30/ 360
Accrual method - foreign rate 30/ 360

Domestic repo rate 0.084756098

Figure 5.11 FinancialCAD function aaFXfwd_repo_d computes the theoretical domestic repo rate
obtained from buying a foreign currency and selling it forward.

In the example just presented, a 30/360 day count method is used, and thus Equation (5.9), the
formula for the annualized implied repo rate, must be modified as follows:

ri,£ 360(1.65) — 360(1.64) + (1.65)(90)(0.06)

= 0.08476
(90)(1.64)

5.3 FORWARD INTEREST RATES

5.3.1 Spot Rates and Forward Rates

A spot rate is an interest rate that exists today. If today is denoted time 0, then r(0, t1) is denoted
today’s spot rate for a debt instrument that matures at time tl. Also, r denotes annual interest rates.
Thus, r(0, 3) is the spot three-year interest rate, expressed as an annual rate.!®
To compute a forward rate, you need two spot rates for two different annual maturities, t1 and 72,
where #2 >t1. Then, the forward rate can be computed by solving for fr(t1, f2) in the following formula:

(1+ r(0,12))? =[1+7(0, tI)" f+ fra, 22))7 (5.10)

In a sense, the forward rate is an interest rate that exists in the future. That is, fr(t1, £2) is the inter-
est rate on a loan beginning at time fl and ending at time f2. Note that fr is an annual forward rate.
Thus, in Equation (5.10), all times such as fl and 12, are expressed in years.

EXAMPLE 5.6 The spot rate for a six-year debt instrument is r(0, 6)= 12%, and the
spot rate for a two-year debt instrument is r(0, 2) = 10%. Find the forward rate for a debt
instrument that begins two years hence and ends six years hence. That is, find the rate
quoted for a 24x72 FRA.
 5.3. FORWARD INTEREST RATES 109

Use Equation (5.10) to solve for the forward rate, fr(2, 6):

- (1.12)° = (1.10)?[1+ fr(2,6)]°

1.9738227 =1.21[1 + fr(2,6)]*

(1.6312584)°?> =[1+ fr(2,6)]

1.130136 =[1 + fr(2,6)]

fr(2,6) = 13.0136%

When working with maturities of less than one year, another method of computing forward
rates often is more useful. Define h(0, t2) and h(0, t1) as today’s unannualized spot interest rates
for debt instruments that mature at times f2 and fl, respectively. Define fh(t1, t2) as the forward
unannualized rate for a debt instrument that begins at time tl and ends at time 72. Then the fol-
lowing formula can be used to solve for the forward rate:

1+ A(0,t2)=14+ h(0, 7) [1+ fh(al, t2)] (5.11)

Note that in Equation (5.11), there are no exponents. Also, note that the spot and forward
rates are unannualized.

EXAMPLE 5.7 A $10,000 face value Treasury bill that matures in 34 days is priced
at $9907.71, while the price of a T-bill that matures in 55 days is $9836.95. Find the
forward rate from day 34 to day 55.
To solve, first, compute the unannualized spot rates. Given P=9907.71, F= 10,000,
and T= 1 period (of 34 days), then 10,000=9907.71 (1 +h), and h(0, 34)=0.9315%. By
the same logic, the unannualized 55-day spot rate is h(0, 55)=1.65753%. Equation
(5.11) is then used to find the unannualized forward rate, fh(34, 55):

1.0165753 = 1.009315[1+ fh(34,55)]

fhB4,55) = 0.71933%

There are two ways to annualize this rate. If 0.0071933 is multiplied by the number
of 21-day periods in a year (there are 21 days from t1=34 to 12=55), then the rate is
annualized assuming simple interest:

0.007 1933 x 365/21 = 12.50256%

 Alternatively, the rate of 0.71933% can be compounded to obtain an annualized rate:

(1.0071933)°>/2! — 1 = 1.0071933)!7780? — 1 =13.26713%

In the case of compounding, interest earns interest every 21 days.

Because the yields on short-term money market instruments are computed in different ways
(e.g., different securities use different day count conventions), and because there are different
ways to annualize the unannualized yield, it is usually safer and less ambiguous to just deal with
prices and unannualized yields, which is what Equation (5.11) does.
Figure 5.12 illustrates how the FinancialCAD function aaFRAi can be used to compute for-
ward rates. It cannot be used to compute rates when they are compounded. Thus, the software can-
not be used to compute fr(2, 6) as was done for the four-year interest rate that will exist in two
years. The figure presents the solution to the Treasury bill problem when the simple interest
approach is used to annualize fh(34, 55). Note that discount factors must be entered, not interest
rates. The entry on the line titled “FRA contract rate” is not used when the desired output statistic
is the implied forward rate.
The FinancialCAD utility function aaConvertR_DFcrv will convert interest rates to discount
factors. The example is shown in Figure 5.13. The October 28, 1999, yield to maturity is computed

Value (settlement) date

Effective date
Terminating date
FRA contract rate
Notional principal amount
Accrual method
Discount factor curve t_43._1
Interpolation method | Aflinear
Statistic | implied forward rate

t_43_1
discount factor curve
grid date discount

(=1/1.009315)
18-Nov-99] 0.983694961 (=1/1.0165753)

implied forward rate 0.125026309

Figure 5.12 FinancialCAD function aaFRAi computes the theoretical forward rate given
two spot rates. To
use the function, the spot rates must be converted to discount factors.
 aaConvertR_DFecrv |
value (settlement)
date 24-Sep-99
rate curve 148 4
tate quotation basis _ | __1annual compounding
accrual method of rate 1|actual/365 (fixed)

t_484
holding cost curve
maturity date ield to maturity
28-Oct-1999} 0.104658291
18-Nov-1999} 0.11527138

discount factor curve - aaConvertR_DFcrv

grid date discount
factor
24-Sep-1999) 1
28-Oct-1999 0.990771
18-Nov-1999 0.983695

Figure 5.13 The FinancialCAD function aaConvertR_DFcrv converts interest rates to a set of discount factors.

by P=9907.71, F=10,000, and T=34/365 =0.093150685 year. Upon entering these values into
your calculator, you should find that the yield solution is 10.4658291%. The November 18, 1999,
yield is computed by P=$9836.95, F= 10,000, and T=55/265 =0.150684932 year.
One last useful method of obtaining forward yields requires the use of prices. Define the price
of a zero-coupon, $1 face value debt instrument that matures at time f1 as P(O, t1). Similarly, the
price of a pure discount debt instrument that matures to be worth $1 at time 2 is P(O, 12). Then, the
forward price of a $1 face value debt instrument from time f1 to time 12, FP(t1, 12), is found by

IA OK) SIA OA VAG) (5.12)

Consider the example in which r(0, 6) = 12% and r(0, 2)= 10%. We know that P= F(1+r(0, Dee
Thus, P(0,6)= 1(1.12)°=0.5066311, and P(0,2)=1/(1. 10)” =0.8264463. Then, by Equation
(5.12), we have

0.506631 1 = 0.8264463F
P(2, 6)

FP(2,6) = 0.6130236

Thus, a debt instrument that will be issued two years hence and will be worth $1 six years from
today, will sell for $0.6130236 two years from today. The annual rate of return on an investment of
P=$0.6130236 that will be worth F=$1 four years later (T=4) is found by solving for the interest
rate x in the equation

F=P(i+x)!

1 = 0.6130236(1 + x)*

and we find that x= 13.0136%. This is exactly what we earlier found for fr(2, 6).'7
WW 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

As another example that uses securities with maturities of less than a year, consider the
problem with $1 face value Treasury bills, where P(0, 34)=0.990771 and P(0,55)=0.983695.
Then the forward price, FP(34, 55) 1s:

(0.983695) = (0.990771) FP(34, 55)

FP(34, 35) = 0.9928581

What unannualized rate of return will an investor earn if $0.9928581 is invested at time 34 and
receives $1 at time 55? The answer is (F —P)/P=(1 —0.9928581)/0.9928581 =0.71933%. This is
exactly what we found earlier for fh(34, 55).
Thus, we have Equations (5.10)-(5.12), given earlier, three equivalent formulas to use when
working with spot and forward annualized yields, unannualized yields, and prices:

[1+ r(0,t2)]? = [1+ r(0,e))][1+ fr(tl, 22)" (5.10)

1+ A(O,t2) = [1+ h(0,

41) [1+ fact, 12)] (SLD)

P(0,t2) = P(0,t1)FP(t1,t2) (5.12)

5.3.2 How to Lock in a Forward Rate

Up until now, the forward rate has been just a number that is implicit in the term structure of (spot)
interest rates. It turns out that an investor can actually lock in the forward rate as a borrowing rate
or a lending rate! First, some assumptions must be made:
There are no transactions costs or bid—asked spreads.
Pure discount debt instruments of $1 face value trade for any maturity.
These securities can be bought or sold short.

Under these assumptions, any investor can lock in the forward rate as a borrowing rate or a lend-
ing rate, from time f1 to time 72.
Consider the following time line:

To lock in a borrowing rate from time f1 to time 12, borrow $X from time 0 to time 72, and lend $X
from time 0 to time 1:

<--------- Borrow--------------------- > = <---Borrow------ >

 5.3. FORWARD INTEREST RATES

To lock in a lending rate from time f1 to time 12, lend $X from time 0 to time #2, and borrow $X
from time 0 to time 11:
<---Borrow------ >
<--------- Lend------------------------ > = <--- Lend------ >
ne [|__| __|
0 tl ie?) 0 tl t2

An investor lends by purchasing debt instruments. An investor borrows by short selling debt
instruments.

EXAMPLE 5.8 In Example 5.6 we specified that r(0,6)=12% and r(0,2)= 10%. We
then computed the forward rate of fr(2,6)=13.0136%. An investor can lock in
13.0136% as an annual borrowing rate from time 2 to time 6 by borrowing $1 (or $X) for
six years at 12%/year and lending $1 (or $X) for two years at 10%/year. The resulting
cash flows are as follows:
Time 0
Borrow $1 for six years at 12%/year +$1
Lend $1 for two years at 10%/year —$1
Net cash flow 0
Time 2
Get repaid on loan +1(1.1)°=+$1.21
Time 6
Repay borrowed funds ~ 1(1.12)°=—$1.9738227
The result of both borrowing and lending today is that the investor has locked in a
cash inflow at time 2 of $1.21 and a cash outflow at time 6 of $1.9738227. Thus, the
investor has borrowed $1.21 for four years at 13.0136%/year. Obviously, by adjusting
the value of $X, investors can borrow any amount from time 2 until time 6 at r(2,6)=
13.0136%/year.

EXAMPLE 5.9 Wecan use the data from Example 5.7 to demonstrate that an investor
can lock in a lending rate for a 21-day period, beginning 34 days hence. The unannual-
ized rates are h(0,34)=0.9315% and h(0,55)=1.65753%. The investor should lend $1
for 55 days and borrow $1 for 34 days. The resulting cash flows are as follows:
Time 0
Borrow $1 for 34 days +$1
Lend $1 for 55 days —$1
Net cash flow 0
 34 days hence
Repay loan — 1.009315

55 days hence
Get repaid on loan + 1.0165753
Thus, suppose a firm knows that 34 days from now, it will receive $750,000 and it
knows that 55 days from now, it will have to make a large payment to a supplier. It would
like to lock in the prevailing unannualized 21-day forward lending rate of 0.71933%
during that time; after compounding, this fh(34, 55) is equal to 13.26713%/year, and the
firm believes this is an attractive rate of return.
The firm would borrow $743,078.23 for 34 days, and lend the same amount for 55
days.!8 Then, in 34 days, it would repay its loan with interest, a cash outflow equaling
$750,000. Twenty-one days after that, it would receive $755,394.97. The net result is
that, at time 0, it has locked in the unannualized forward rate of 0.71933% on a 21-day
loan of $750,000 made 34 days hence.

These illustrations of how to lock in forward borrowing and lending rates also provide
“proofs” of how forward interest rates are derived using the cost-of-carry model. When we found
the forward borrowing rate, what we did was sell short the underlying asset (the six-year debt
instrument) and lend the proceeds for the period of the forward contract (two years). When we
computed the forward lending rate, we borrowed for the period of the forward contract (34 days)
to be able to buy the underlying asset (a debt instrument with 55 days to maturity). Thus, the same
cost-of-carry logic used for finding forward exchange rates and forward commodity prices serves
also in computing forward interest rates.

5.4 SUMMARY

This chapter derived theoretical forward prices for commodities, foreign currencies (forward
exchange rates), and interest rates (forward rates). The standard model for computing theoretical
forward prices is the cost-of-carry model, F=S+CC—CR. Arbitrage ensures that forward prices
conform to this model. If forward prices are too high, traders will borrow, buy the spot good, and
sell the overpriced forward contract; this is called cash-and-carry arbitrage. If the forward price is
too low, traders will sell the good in the spot market, lend the proceeds, and buy the cheap forward
contract; this is called reverse cash-and-carry arbitrage.
The cost-of-carry model works very well for gold and for financial assets such as currencies,
debt instruments, and stocks. However, the model sets only an upper pricing level for theoretical
forward prices of all physical commodities except gold. What this means is that forward prices of
commodities (agricultural goods such as wheat, energy products such as crude oil, etc.) will often
be below their theoretical cost-of-carry values. The reason for this is that physical commodities
offer a convenience yield. Users of these goods do not wish to sell them, or sell them short,
because they need them as part of ongoing production processes.
 5.4 SUMMARY AIS

Forward prices of financial assets, and of gold, do not equal the expected spot prices at deliv-
ery. However, forward prices of other physical commodities may equal expected future spot
prices; the theory that predicts this is the unbiased expectations hypothesis of forward prices.
However if risk-averse hedgers are actively selling forward contracts, the state of prices is called
normal backwardation, and forward prices will be below what investors expect to prevail in the
future. And if hedgers are actively buying forward, we are said to be in contango, and forward
prices lie above expected future spot prices.
Cost-of-carry arbitrage establishes theoretical forward exchange rates. The arbitrageur must
buy the present value of the needed units of foreign exchange, discounted at the foreign interest
rate. Then, a forward contract is sold. Equation (5.6) is the theoretical forward exchange rate model.
Although the cost-of-carry model was not explicitly used to compute theoretical forward
interest rates, the concept is very much present in the derivation of Equations (5.10)-(5.12). This
should be apparent by a careful reading of Section 5.3.2.
Theoretically, forward prices and futures prices will be almost identical. In Chapter 6, we
explain the differences between forward and futures contracts, and in Section 6.5 of that chapter
we address the question of how daily resettlement of futures might create a difference between the
prices of the two types of contract.

References

Cootner, Paul H. 1960. “Returns to Speculators: Telser versus Keynes.” Journal of Political Economy, Vol.
48, No. 4, August, pp. 396-414. Reprinted in A. E. Peck, ed., Selected Writings on Futures Markets.
Chicago: Chicago Board of Trade, 1977, pp. 41-69.
Teweles, Richard J., Edward S. Bradley and Ted M. Teweles. 1992. The Stock Market, 6th ed. New York: John
Wiley & Sons.
Kamara, Avraham. 1984. “The Behavior of Futures Prices: A Review of Theory and Evidence.” Financial
Analysts Journal, Vol. 40, No. 4, July-August, pp. 68-75.
Keynes, John Maynard. 1930. Treatise on Money, Vol. I, London: Macmillan.

Notes

'See Appendix A, at the end of this chapter, for more about short selling.
2n(0,T) is the interest rate that applies to the period beginning at time 0 and ending at delivery, time T. If r is the
- annual interest rate and there are T days until delivery, then we find by using the actual/365 day count method that
B to
h(0, T)=rT/365. We assume that this interest, and the carry return, are both payable at time T. See Appendix
this chapter for additional material on different day count methods.
that can be earned
3} the carry return cash inflows were received prior to time 7, then CR should include the interest
value of the carry return cash flows. See Appendix C
on those cash flows. In other words, CR is actually the future
computing the future value of the carry return cash flows.
to this chapter for more discussion on
in which an individual gets
4Problems 5.1 and 5.2d ask the student to apply the cost-of-carry formula to situations
to use only a fraction of the proceeds from the short sale.
116 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

>See Appendix B to this chapter for a discussion of different day count methods.
©The purchase of a good and the sale of a forward contract on that good creates what is called a synthetic Treasury
bill. In a cash-and-carry arbitrage, the synthetic Treasury bill earns a rate of return in excess of spot Treasury bills.
Hence, one borrows by selling spot Treasury bills and lends by buying synthetic Treasury bills.
7It is not unusual for the loan to be slightly below the securities’ market value.
8In practice, the day count method for annualizing repo rates is the actual/360 approach.
9 In addition, storage and carrying costs will also differ across different market participants, and they often change
over time.
10ft is possible that the supply of arbitrage capital is limited or faces competition from other trading strategies.
If investors are overwhelmingly bullish, they may perceive greater benefits from buying forwards and
futures even when these are overvalued. Similarly, hedgers will buy forward contracts even when their prices
are too high, and sell them even when forward prices are below what the cost-of-carry pricing model
predicts. If these situations do exist, arbitrage opportunities will also exist and may even persist for extended
periods of time.
!1Note that many of the concepts discussed in this chapter, like normal backwardation and contango, were initially
developed in theories of futures pricing. However the theories that lead to these concepts are also applicable for
forward prices.
!2 Arbitrageurs were not explicitly considered in Keynes’s model.
'3Many practitioners use the terms backwardation and contango when viewing the term structure of futures prices,
vs the spot price. If futures prices are lower, the more distant the delivery date, then these individuals say that the
market is in backwardation, or that the futures market is “inverted.”
'4a|ternatively, the foreign interest earned by investing the foreign currency can be thought of as a carry return.
When a currency is the underlying asset, this arbitrage is also known as covered interest rate arbitrage, and
covered interest parity.
'6The spot rates are the yields available on zero-coupon bonds.
'7 Alternatively, enter PV=—0.6130236, FV=1, N=4, and then CPT i=? into your financial calculator.
'8Given that T=34 days, and h(0,34)=0.9315%, the present value of $750,000, is $743,078,23.

PROBLEMS
5.1 Assume that you are an individual who 5.2
gets to use only a fraction, x, of the proceeds
from the short sale of the good underlying a a. Determine the no-arbitrage upper and
forward contract 0< x <1. Otherwise, S is the lower forward price boundaries for a
price of the spot good, r is the annual interest stock that is quoted at $62.50/share
(bid) and $63.00 (asked). The stock
rate, and CR is the future value of any carry
return. What is the cost-of-carry pricing for- does not pay any dividends. The deliv-
mula that determines the range (upper bound ery date of the forward contract is eight
and lower bound) of prices for which you months henee., Your annual lending
cannot arbitrage? (Problem 2d provides an ihe sit apeoe etna Doroyiipinals
Eoplicaionoe thieamodelt is 7%. Use the FinancialCAD function
 PROBLEMS 17

aaCDF to verify your results (for both - Given Fo=313, compute the implied
boundaries). repo rate for the forward contract. Use
. Suppose that S=$62.75, r=6%, and FinancialCAD to check your answer.
the stock will pay a $0.40/share 5.4
dividend next month, and quarterly
thereafter (i.e:, at t=1, t=4, and t=7).
. Spot gold sells for $300/oz. Assume
The interest rate is expected to remain that you can borrow at an annual rate
constant at 6% for all maturities up of 10% and risklessly lend any amount
of money at an annual rate of 9%.
to a year in length. Compute the
What is the lowest forward price for
theoretical forward price for the
that contract that will not allow arbi-
stock. Use aaEqty_fwd to verify your
answer. trage for you? What is the highest for-
ward price? The forward contract calls
. Assume all data from part b to be valid. for the delivery of 100 0z. of gold five
If F=63, then compute the implied months from today.
repo rate for the forward contract. Use
. Now, in addition to the information in
aaCDF_repo to verify your answer.
part a, assume that the bid price of gold
How would you arbitrage if F=63?
is $300/oz. and the asked price is
. Now assume that S=$62.75, r=6%, $301/oz. Compute the range of gold
and there are no dividends, but if you forward prices (the delivery date is still
sell the stock short, you will get to use five months hence) that can exist with-
only 70% of the proceeds. Compute out permitting you the opportunity to
the theoretical upper and lower bound- arbitrage. Use FinancialCAD to check
aries for the forward price for the your answers.
stock. These are the relevant price
. In addition to the data in part b, sup-
boundaries within which you cannot
pose that you face a $50 commission
arbitrage.
on the forward contract that is paid
ahs) upon offsetting your forward position.
What are the lowest and highest for-
. Spot gold sells for $300/oz. You can
ward prices that preclude arbitrage,
risklessly borrow and lend any amount
now?
of money at an annual rate of 10%.
What is the forward price for a contract . Finally, assume that you can short-sell
that calls for the delivery of 100 oz. of gold, but you will receive only 10% of
gold 5 months from today? Use Finan- the proceeds from the short sale; the
cialCAD to check your answer. remainder stays on deposit with the
broker. What is the lowest forward
. Suppose that Fo=313. Explain how
price for that contract that will not
you would arbitrage, given the data
allow arbitrage for you? What is the
in part a. Present all the trades you
highest forward price?
would make today, and the trades that
you would make five months hence. 5.5 What is the definition of a risk premium
Are you performing cash-and-carry for a forward contract? Define it in terms of
arbitrage, or reverse cash-and-carry net hedging and net speculation concepts (nor-
arbitrage? mal backwardation and contango).
118

5.6 State the differences among the follow- b. Suppose that the actual forward price
ing: repo rate, implied repo rate, and implied is ¥85.25/Can$. How would you arbi-
reverse repo rate. trage? Specify all the trades you would
make on March 14 and on June 20.
5.7. On January 2, 1999, the spot price of Compute the implied repo rate (in
West Texas Intermediate crude oil was terms of Japanese interest rate). Use
$12.68/bbl. The crude oil forward prices for FinancialCAD to check your answer.
July 1999 delivery and January 2000 delivery
were $12.57 and $10.43/bbl, respectively. 5.10 You have £4 million to invest. If you
What explains this “inverted market,” in which invest the money in Great Britain for two
the cash price exceeds the forward price and years, you can earn 5.8%/year. Alternatively,
nearby forward price exceeds forward prices you can invest in France and earn 8%/year.
for even more distant delivery dates? What is The spot exchange rate is £0.10/FFR. The for-
the likely reason for arbitrageurs’ failure to sell ward exchange rate for delivery two years
spot oil and buy forward contracts? If you hence is £0.098/FFR. Which method of invest-
expected the spot price of crude oil to be ing do you prefer? Show your results.
$12/bbl in January 2000, would you believe
5.11 The unannualized spot interest rates for
that the market was exhibiting normal back-
different holding periods are as follows:
wardation or contango?
Unannualized
5.8
Period Interest Rate
a. A stock sells for $125/share. It will
1 month A(0, 1) 0.01
trade ex-dividend two months hence,
and the dividend amount will be 2 months A(0, 2) 0.0205
$0.50/share. The interest rate is 5%. 3 months h(0, 3) 0.0305
Compute the theoretical forward price 4 months /A(0, 4) 0.041
for delivery four months from today.
5 months A(0, 5) 0.052
Use FinancialCAD to check your
solution. 6 months h(0, 6) 0.063

b. If the forward price was $125.40/share, Compute the unannualized forward rate from
explain how you would arbitrage. month 4 to month 6, h(4, 6). What is the annu-
What is the implied repo rate of the alized forward rate from month 4 to month 6?
forward contract? Use FinancialCAD Use FinancialCAD to check your answer.
to check your answer. Demonstrate how, by trading pure discount
5.2. spot debt securities today, an investor can bor-
row $132,000 from month 4 until month 6 at
a. Today is March 14. The annual interest
the forward rate you computed.
rate in Japan is 1%. The annual interest
rate in Canada is 5%. The spot price of 5.12 If 10-year pure discount bonds are priced
a Canadian dollar, expressed in terms to yield 10%/year, and 14-year pure discount
of Japanese yen, is ¥86.25/Can$. Com- bonds are priced to yield 11%/year, at what
pute the theoretical forward price for interest rate can an investor borrow $100,000
Canadian currency for delivery on June from time 10 to time 14? Demonstrate how
20 of the same year. Use Financial- this can be done, showing the transactions
CAD to check your answer. and dollar amounts at all relevant dates.
 PROBLEMS Wie

Assume that all securities are infinitely divisi- borrowers had borrowed enormous amounts of
ble, that no transactions costs exist, and that dollars, the article pointed out that the Indone-
investors get full use of the proceeds from sian government managed the dollar/rupiah
short sales. 7 exchange rate so that it declined at a rate of
about 4-5% per year. “Indonesian borrowers
5.13 An investor wants to invest $10 million in
faced a simple choice. They could borrow rupiah
zero-coupon debt instruments maturing 10 years
at 18 or 20% and not worry about the exchange
hence. She can invest in the United States and
rate. Or they could borrow dollars at 9% or 10%
earn a 6.6% annual rate of return. Or, she can
a year and then convert the proceeds to rupiah. A
convert her $10 million into Japanese yen and
year later, they figured, it would take 4% or 5%
buy 10-year, zero-coupon, yen-denominated
more rupiah to buy the dollars needed to repay
notes that are currently priced to yield 2.6%.
the loan, but the cost was less.”
The spot exchange rate is ¥120/$.
a. Explain why it was such a “simple
a. At what forward exchange rate (for
choice” for Indonesians to borrow dol-
delivery 10 years hence) will the
lars. In particular, focus on the discus-
investor be indifferent between invest-
sion in Section 5.2.2 of this chapter.
ing in the United States and in Japan?
(Equivalently, consider if she chooses b. Explain what happened to _ the
not to hedge. Then at what spot unhedged Indonesian borrowers of
exchange rate that will exist 10 years dollars when the dollar rose from about
hence will she “break even” in terms of 2300 rupiah in July 1997 to about 5800
an ex-post rate of return?) rupiah in December 1997.

b. What will be the investor’s terminal c. How could have forward contracts
wealth 10 years hence if she invests in been used to hedge Indonesian borrow-
the United States? Show that this ers of dollars?
equals her terminal dollar wealth if she 5.18
invests in Japan instead.
a. Today, S=48, where S is the price of
5.14 Use current spot interest rate data to the spot asset. If today’s one-year
compute the forward interest rate for a five- interest rate, r(0,1), is 6%, compute
month period commencing four months hence. the theoretical forward price for deliv-
ery one year hence.
5.15 Use current spot interest rate data to
b. Three months later, S=42. The term
compute the forward interest rate for a five-
structure of spot interest rates is as
year period commencing four years hence.
follows:
5.16 Use current spot interest rate data and
spot foreign exchange rate data to compute the r(0, 1/4) = 6%
theoretical forward price of a Canadian dollar
r(0, 1/2) = 6.5%
for delivery one year hence.
r(0, 3/4) = 7%
5.17. On December 30, 1997, an interesting
front page Wall Street Journal article analyzed r(0, 1) = 7.5%
why the Indonesian rupiah fell by 50% in
value versus the U.S. dollar in the fall and What is the value of the original forward con-
winter of 1997. In discussing why Indonesian tract (described in part a)? For which party is
120 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

the forward contract an asset, and for which 5.21 On January | (today), a firm sells a 9x
party is it a liability? 12 FRA. The notional principal is $50 million.
The contract rate is 8%. There are 365 days in
5.19 Suppose that on September 15, 1999, a year. The following spot interest rates exist
you sell €250,000 forward, for delivery on
today (as shown on the first line of the accom-
January 15, 2000. On September 15, 1999, the panying table), and subsequently occur in the
spot price of a euro is $1.05 (i.e., the spot
future (as shown on lines 2-5):
exchange rate is $1.05/€), and the forward
price for delivery four months later is $1.02/€. Spot Interest Rates That Occur
in the Future
On October 15, 1999, the following prices
3-Month 6-Month 9-Month
are observed:
Date LIBOR LIBOR LIBOR
Spot price $1.03/€
January 1
Forward price for delivery (today) TAG 7.8% 7.9%
three months hence $1.04/€ April | 7.5% 8% 8.3%
Forward price for delivery July 1 8.2% 8.8% 9.1%
four months hence $1.06/€ October | 8.6% 9.4% 9.5%
January |
Also, on October 15, 1999, the following
(next year) 9.2% 9.6% 9.8%
interest rates are observed (in the United
States):
a. If today’s 9x12 FRA contract rate of
For securities maturing one 8% is theoretically correct, compute
month later (i.e., on 11/15/99): 4% today’s spot 12-month LIBOR. Use
For securities maturing three FinancialCAD to solve the problem.
months later (on 1/15/00): 5% b. When will the FRA be settled? (1.e.,
For securities maturing four when will money be exchanged?)
months later (on 2/15/00): 6% c. Will the firm receive money (a profit)
or have to pay money (a loss) on the
a. Compute the value of your position as settlement day? Why?
of October 15, 1999. This is equivalent
d. How much will be received or paid at
to asking how much is exposed to
settlement?
default risk.
b. Is your position an asset or a liability? 5.22 Use the FinancialCAD function aaCDF
Explain why. to compute the theoretical value of a futures
c. Are you more likely to want to default,
contract on gold. The spot price of gold is
$295/oz. The delivery day for the futures con-
or is your counterparty? Why?
tract is five months from today. The interest
5.20 Compute the forward exchange rate for rate is 6%. Assume no storage cost or conve-
delivery of euros 13 months hence. The spot nience value. What happens to the theoretical
exchange rate is ¥113.42/€. The interest rate on fair value of the futures price if there is a small
13-month riskless debt instruments in Euroland storage cost of 0.1? Explain why the theoreti-
is 5.25%. The interest rate on 13-month riskless cal futures price changes in that direction
debt instruments in Japan is 0.8%. Use Finan- when there is a cost for storing the physical
cialCAD to check your solution. commodity.
 APPENDIX A 121

5.23 Get arecent Wall Street Journal and find 5.24 You areaU.S. citizen. The spot exchange
the column titled “Currency Trading” (its often rate with Swiss Francs is $0.6495/SFR. The
on the foreign exchange page of Section C). futures price of 1 SFR for delivery six months
Find and record the spot price of a dollar for hence is $0.6624/SFR. The interest rate in
Japanese citizens. Also find and record the Switzerland is 3%. Use aaFXfwd_repo_d to
forward price of a dollar for delivery six find the repo rate for the futures contract. How
months hence. Then use aaFXfwd to compare does the domestic repo rate you computed
the theoretical forward price of the dollar to compare with the interest rate that exists in the
the actual forward price of the dollar. Remem- United States for six-month debt instruments?
ber that domestic = Japanese interest rates (you 5.25 Suppose that the spot interest rate for
are Japanese, after all), and foreign is U.S.
four-month debt instruments is 5%, and the spot
interest rates. Go to www.bloomberg.com. interest rate for one-year debt instruments is 6%.
Click on currencies. Click on International First find the unannualized interest rate for a
Bonds. Record the yield that exists for six- four-month holding period. Use the Financial-
month U.S. treasuries and for 6-month Japan- CAD function aaFRAi to compute the implied
ese governments. Use these interest rates in forward rate. Note that the numbers to be entered
aaFXfwd to compute the fair forward price of into the discount factor cells are 1/(1+h), where
a dollar. his the unannualized interest rate.

APPENDIX A _ Selling Short

It is simple to conceive of a long position in an asset, whether it be a physical or a financial asset.
An investor first buys the asset. While he owns it, he has a long, or bullish position. He will sell it
at a later date, hopefully at a higher price. Investors always like to buy low and sell high.
A short seller also likes to buy low and sell high. However, short sellers sell the asset first and
later buy it back. They hope the price will decline during the time that they are short the asset.
They are called “bears.”
How can a short seller sell something he doesn’t own? His broker borrows the asset from
someone else. Thus, suppose A owns 100 shares of XYZ Corp., B wishes to sell 100 shares short,
and individual C will buy these 100 shares. B’s broker will borrow the shares from A and lend
them to B, who then sells these shares to C, who in turn pays investor B for these shares. B hopes
that at a subsequent date, XYZ will sell at a lower price. At that time B can buy the shares (at a
price lower than the price at which they were sold short). B’s broker takes the shares and returns
them to A’s account. All this is frequently done without A’s knowledge, though when A opened his
account, he must have consented to allow his shares to be borrowed in this manner.
What if A decided to take possession of the asset, or to sell it? The broker would then have to
find another investor who owns the shares of XYZ, and borrow them from that person. It is possi-
ble, though unlikely, that no shares of a stock would be available for selling short. It is also possi-
ble that B would sell short, and some time after, a// investors would want their shares; then the loan
would be called, forcing B to buy the shares to close his short position. For example, suppose that
B sells short and afterward there is a tender offer for the shares of XYZ Corp. In a tender offer, an
individual or corporation makes an offer to acquire the existing shares of a company. If enough
122 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

shares are tendered (including the shares of A, the original owner of the shares that B borrowed),
there may be no shares available to be borrowed for short selling, and B will be forced to somehow
buy the shares back to “cover” the short position. Another event that would force the short to cover
is a proxy fight. Short selling creates more shares owned than the firm originally issued. In our
simple example, both A and C own 100 shares. If (a contrived case) the firm has issued only the
100 shares that investor A bought, how can the shares be voted? Both investors A and C own
shares, hence own voting rights.
For large corporations and normal voting events, there will be sufficient proxies to satisfy all
long positions because many investors do not vote. The brokerage firm will find enough proxies to
permit all to vote. But if there is an important vote, and there are no proxies available, the short
seller will be squeezed (i.e., forced to buy the stock).
The broker of short seller B will not worry about investor B’s ability to buy back the shares
she sold short. That is because the proceeds of the short sale must be kept in investor B’s account
as collateral for the shares he has borrowed.
Moreover, not only does investor B not get to use the proceeds of the short sale, he also must
meet margin requirements. Recently this was 50% of the value of the stock. For example, if 100
shares are sold short at $40/share, the short seller must keep the $4000 proceeds in the account as
collateral and also deposit another $2000 to meet margin requirements (the $2000 can be in the
form of securities, e.g., $2000 worth of another company’s stock).
If the stock price starts to rise (to the short seller’s dismay), the broker will demand that the
short seller deposit more cash or securities.
Dividends offer a complication similar to voting rights. If the firm pays a dividend, who gets
it: investor A or investor C? Both get it. The firm pays the dividend to investor C, and also, all short
sellers must also pay dividends to the owners of the shares they have borrowed.
Short sales of common stock are subject to an “uptick rule.” In the 1920s and earlier, ruthless
speculators often sold short stock at prices below the last trade, driving quoted prices down.
Shortly thereafter, they would disclose false negative information about the stock, which would
cause others to sell their shares, perhaps even creating a selling panic. Then they would close their
short positions at a profit.
To eliminate this type of abuse, and also to minimize the price-depressing effects of short sell-
ing, the Securities and Exchange Commission outlawed short sales of stock at prices below the last
previous trade. An investor can sell short at the same price as the last trade only if the last previous
change was an uptick. It is always permissible to sell short a price above the last trade. Thus if the
last trade was at $40, you can sell short at $40.10, regardless of the trend in stock prices (assuming
that there is a buyer at $40.10). You would be able to short sell at $40 only if the last prior trade
was at a price less than $40.
Individuals sell short for many reasons. Bearish investors will sell short, though it is probably
wiser to buy a put option. Losses are limited with a put; they are theoretically unlimited with a
short sale.’ Other investors sell short for tax reasons, as part of hedging strategies or for arbitrage
purposes.
Note that in many of the valuation models of this book, we will assume that the short seller
has full use of the proceeds of a short sale. In some cases, we can relax this assumption, and we
will demonstrate the effect of doing so. Also, some large traders are able to negotiate with their
brokers, hence can indeed make full use of the proceeds from selling short.
Teweles, Bradley, and Teweles (1992, pp. 162-180) contains a great deal of useful material on
short selling.
 APPENDIX B 123

Reference

Teweles, Richard J., Edward S. Bradley and Ted M. Teweles. 1992. The Stock Market, 6th ed. New York: John
Wiley & Sons.

Note

‘Consider an investor who sold short 100 shares of Diana Corp. on May 6, 1996, at a price of $46 per share. After
all, the company had reported a loss of $0.18/share in its fiscal year ending March 31, 1995, and a loss of
$0.80/share in its fiscal year ending March 31, 1996. But during this time, its stock price actually rose by 700%,
from $5 3/4 on August 9, 1995, to $14 1/4 on February 21, 1996, to $46 on May 6, 1996. Obviously, some value-
oriented investors might have considered it to be overvalued. Well, less than three weeks later, on May 24, 1996, the
stock proceeded to rise to an intraday high of $120/share! Our hypothetical investor who sold short at $46 lost
$74/share, or $7400 on the 100 original shares, if he covered his short position at $120! As a postscript, our
investor’s bearishness on Diana was not totally unwarranted: it plummeted to $39 1/4 on June 26, 1996, and $20 5/8
on August 19, 1996. By June 1997, it had been delisted from the NYSE and was selling for $3.125/share.

APPENDIX B-Day Count Methods

There are several day count methods that are used to compute interest payments over different
intervals of time. Thus, if an annual interest rate is quoted, the issue is how to compute interest
over holding periods of less than a year.
* 30/360: Generally assumes that there are 12 months of 30 days each in a year. If a month has
31 days, no interest is earned on the 31st day. Since there are 28 days in February, two extra
days of interest are earned on the 28th day; in leap years, one extra day of interest is earned
on February 29. One year equals 360 days. In this convention, three months is always one-
quarter of a year; six months is always a half-a-year. For example, the period of time between
January 28 and July 28 is half a year. Exceptions occur when the last day of the period is on
the 31st of the month and the first day of the period is not the 30th or 31st. That is, the num-
ber of days between January 28 and March 31 is 63 (2 days in January, 30 days in February,
and 31 days in March), and there is 0.175 of a year between those two dates (63/360). Oddly,
there are also 63 days between January 28 and April 1 (2 days in January, 30 days in both
February and March, and | day in April). Corporate bonds, municipal bonds, and agency
securities generally use the 30/360 day count method when accruing interest.
Actual/360: Count the actual number of days between two dates and divide by 360 to find
the fraction of the year. In the United States this is called the “money market basis.” Note
that there is 1.0138889 year between two dates one year apart in this method (365/360); an
annual money market rate of 4% on $100 would produce $4.05556 in interest.
Actual/365 (fixed): Count the actual number of days between two dates and divide by 365
to find the fraction of the year.
124 5 DETERMINING FORWARD PRICES AND FUTURES PRICES

the actual
¢ Actual/365 (actual)=U.S. government actual/actual =actual/actual: Count
number of days between two dates and divide by 365 to find the fraction of the year in non-
leap years. In a leap year, divide by 366. U.S governmen t bonds accrue interest using the
actual/actual method.
Euro 30E/360: Always assumes that every month has 30 days and that there are 360 days in
a year. No exceptions are made when the last day of the period is on the 31st day of the
month. Thus, there are 62 days between January 28 and March 31 (2 days in January, and 30
in both February and March).

APPENDIX C Computing the Future Value of

Carry Return Cash Flows
The theoretical forward price was derived in this chapter to be

f= SencG = Gk

If today is time 0, a carry return cash flow will be paid at time 1, and the delivery date is at time
T, then this model may be expressed as follows:

F(O, T) =S[1+A(0, T)]— div[1+ fra, T)]

where

F(0, T)=time 0 theoretical forward price for delivery at time T

S=spot price of the underlying asset

h(O, T)=unannualized interest rate for the period from today until time T
div =cash flow that is received by the owner of the underlying asset

fh(tl, T)=unannualized interest rate that will exist at time t1; the cash flow carry return is
received at time fl, and it will earn this rate of interest until time T

The careful reader might ask how we can derive the theoretical forward price when we don’t
really know what fh(t1, 7) will be. In other words, at time 0, we don’t know what amount of inter-
est the cash flow carry return (the dividend) will be able to earn.
The answer comes from Equation (5.11):

1+A(0, T)=[1+ A(O,t1))[1 + fa(tl, T)] (5.11)

Solve Equation (5.11) for 1+fh(t1, 7):

1+h(0,T)
1 tg 9 je
GD 1+ A(0,t1)
 APPENDIX C 12S

Thus, the theoretical forward pricing equation becomes

F=S(1+h(0,T))- dj awe) =[1+h(0, nys= vata

Baad div
Pr aree) an]1+h(0,11) 1+ 10,11) |a VS EY (diy )]
where FV is the future value operator and PV is the present value operator;
PV(div) is the
present value of the carry return cash flow.
This equation is operational at time 0 (today) because both A(0,t1) and h(0,T) are spot
interest rates.