MFIN6003 Derivative Securities

Lecture Note Three

HKU Business School

University of Hong Kong

Dr. Huiyan Qiu

3-1
 Outline
Forward pricing formula
Synthetic forward: hedge a forward position
Futures contracts: margins and marking to market
Uses of forward and futures: asset allocation; cross
hedging

Reading: Chapter 5

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 Forward and Futures
Forward contract: a binding agreement
(obligation) to buy/sell an underlying asset in the
future, at a price set today

Futures contracts are the same as forwards in

principle except for some institutional and pricing
differences.

In this note, stock or stock index is used as the

underlying asset of the contract.
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 Alternative Ways to Buy a Stock
A share of stock has price S0 at time 0. The continuously
compounding interest rate is r.
At time 0 you agree to a price, which is paid either today or at
time T. The shares are received either today or at time T. 
Four combinations.

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 Alternative Ways to Buy a Stock
Four different ways to buy a stock:

Outright purchase: ordinary transaction

Fully leveraged purchase: investor borrows the full

amount

Prepaid forward contract: pay today, receive the share

later

Forward contract: agree on price now, pay/receive

later
3-5
 Pricing Prepaid Forwards
If we can price the prepaid forward (FP), then we can
calculate the price for a forward contract
F = future value of FP
Pricing by no arbitrage principle
For now, assume that there are no dividends
• In the absence of dividends, the timing of delivery is
irrelevant
• Price of the prepaid forward contract should be the same
as current stock price

3-6
Pricing Prepaid Forwards (cont’d)
 Arbitrage: any trading strategy requiring no cash input
that has some probability of making profits, without any
risk of a loss  free money!!!
If at time t = 0, the prepaid forward price somehow
exceeded the stock price, i.e.,

an arbitrageur could: buy stock and sell prepaid forward

3-7
 Pricing Prepaid Forwards (cont’d)
Cash flows of arbitrage strategies when the prepaid
forward price exceeds the stock price:

 Since, this sort of arbitrage profits are traded away quickly, and
cannot persist, in equilibrium we can expect:

3-8
Pricing Prepaid Forwards (cont’d)
 What if there are dividends? Is still valid?
• NO, because the holder of the prepaid forward will not
receive dividends that will be paid to the holder of the
stock  .
• The price difference should reflect exactly the dividends
from time 0 to time T.
• If the stock pays discrete dividends Dti at times ti, i = 1,
…., n, the prepaid forward price:

 S 0  i 1 PV0,ti ( Dti )
P n
F 0 ,T

3-9
Pricing Prepaid Forwards (cont’d)
Example: XYZ stock costs $100 today and is expected
to pay a quarterly dividend of $1.25. If the risk-free rate
is 10% compounded continuously, how much does a 1-
year prepaid forward cost?
Solution: the buyer of the prepaid forward will not
receive the quarterly dividend of $1.25.

F  $100  i 1 $1.25e
4 0.025i
P
0 ,1  $95.30

3-10
 Pricing Prepaid Forwards (cont’d)
 Instead of discrete dividend in cash, many underlying assets
have dividend yield rate.
For example, for stock indexes containing many stocks, it is
common to model the dividend as being paid continuously at
a constant annual rate of δ.
What should be the prepaid forward price then?
• One share at time T is equivalent to shares at time 0 if the
stock is paying continuous dividend with an annualized
yield rate δ. (Appendix.)
• The prepaid forward price: T
F0,T  S 0 e
P

3-11
Pricing Prepaid Forwards (cont’d)
 
Example: The current index level is 1250 and the
dividend yield is 3% continuously compounding. How
much does a 1-year prepaid forward on the index cost?
Solution: given the index is yielding 3%, buying share
of the index now will result in exactly one share of the
index 1 year later. Thus, the 1-year prepaid forward
should pay the same price as buying share of the index
now.

F0P,1  1250e 0.03  1213.06

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 Pricing Forwards
 Forward price is the future value of the prepaid forward.
• No dividends

• Discrete dividends

• Continuous dividends

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 Forward Price
Forward / futures price converges to spot price as the
expiration date is approached.
• When the delivery time is reached, the forward price
equal – or is very close to – the spot price.
( r  )(T t )
Ft ,T  St e  ST if t  T
If the forward price is higher, arbitrage:
• Short the forward contract
• Buy the asset
• Make delivery
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 Synthetic Forward
Synthetic contract (also called replicating portfolio) is a
portfolio which duplicates the cash flows and value of
the contract under consideration.
How to create a synthetic forward?
• Note that long forward has zero cost and payoff at
expiration: ST – F0,T
• Synthetic forward using stocks (underlying asset) and
bonds: borrow to buy  same zero cost and the same
final payoff.

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 Creating a Synthetic Forward
The following cash flow table demonstrates that
borrowing S0e-T to buy e-T shares of the underlying
replicates the cash flows to a forward contract: 0 at time
0 and ST – F0,T at time T.

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Creating a Synthetic Forward (cont’d)
No-arbitrage  the forward price is F0,T  S0e( r  )T

The idea of creating synthetic forward leads to following

(LHS is the actual contract and RHS is the synthetic
contract)
• Forward = Stock – Zero-coupon bond
• Stock = Forward + Zero-coupon bond
• Zero-coupon bond = Stock – Forward

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 Use of Synthetic Forward Contract
 
Synthetic forward can be used to hedge a position in the
actual forward contract.
• For example, a short forward position faces the risk of
future price being high. Taking a long position in the
synthetic forward (borrow to buy) can offset the risk.
Synthetic forward can also be used to arbitrage mis-
priced forward contract. For example, if the forward
price is higher than , then cash-and-carry arbitrage:
short the forward and long the synthetic forward

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 Cash-and-Carry Arbitrage
Transactions and cash flows for a cash-and-carry
arbitrage:

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 In-Class Exercise
A $50 per share stock pays a 4% continuous dividend.
The continuously compounding risk-free rate is 6%.
a) What is the price of a forward contract that expires 1 year
from today?
b) Suppose you observe a one-year forward price of $52. What
arbitrage would you undertake?
c) Suppose you observe a one-year forward price of $50. What
arbitrage would you undertake?

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 In-Class Exercise
Solution:

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 Arbitrage with Transaction Cost
Cash-and-carry arbitrage with transaction costs
(arbitrage is harder)
• trading fees
• bid-ask spreads
• different borrowing/lending rates
• the price effect of trading in large quantities

No-arbitrage bounds: F + > F0, T > F –

3-22
Arbitrage with Transaction Cost (cont’d)
Suppose
• Bid-ask spreads: for stock Sb < Sa, and for forward Fb < Fa
• Cost k of transacting forward or stock
• Interest rates for borrowing and lending are rb > rl
• No dividends and no time T transaction costs for
simplicity
Arbitrage possible if
 r bT
F b
0 ,T  F  ( S  2 k )e
a
0

 r lT
F a
0 ,T  F  ( S  2 k )e
b
0
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Arbitrage with Transaction Cost (cont’d)
 r bT
If F0,T  F  ( S, then
 2kcash
a
0 )e and carry strategy: borrow
 2k the forward. At time T, net
S0a short
to buy the stock and
payoff is
r bT
F0,T  ( S  2k )e
a
0 0
 r lT
If F0,T  F  ( S, then
b
0 2kreversed
)e cash and carry strategy:
buy the forward and short the stock, and lend the net
proceeds at the lending rate. At time
S0b T,2net
k payoff is

r lT
( S  2k ) e
b
0  F0,T  0
3-24
 Futures Contracts
Exchange-traded “forward contracts”: with specified
delivery dates, locations, procedures
Compare with forward contracts, futures
• Highly standardized structure  harder to customize
• Settled daily through the mark-to-market process  low
credit risk
• Highly liquid  easier to offset an existing position
• Typically daily price limits  trigger a temporary halt in
trading

3-25
 Futures Prices vs. Forward Prices
Futures prices versus forward prices: different because
of institutional difference

For short-lived contracts, the difference are in most

circumstances sufficiently small to be ignored.

The difference can be significant for long-lived contracts

and/or when interest rates are highly correlated with the
price of the underlying asset

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 Futures Trading
For each futures contract, there is at least one clearing house
• Matches buy and sell orders
• Becomes counterparty after matching the trades
• Keeps track of members’ obligations and payments
• Guarantor of contract performance
• collect margin
• settle margin account daily
The clearing house reduces its risk exposure by using
margin accounts and daily settlements

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 Margin Account
Margin account has to be set up for any futures trading.
Initial margin (IM: initial amount to establish a futures
position) and maintenance margin (MM: minimum
amount that must be kept in a margin account). MM is
usually 70-80% of IM
• Excess equity above the IM can be withdrawn
• Margin call will be issued if account balance is below
MM
• Margin call must be met promptly and in full (to IM level)

3-28
 Example: Futures on Juice
An investor enters a long futures contract on frozen orange
juice
• Contract size 15,000 pounds
• F0,T US$1.60 / lb
• IM US$6,000
• MM US$4,500

(Q1) What price change would lead to a margin call?

(Q2) Under what circumstances could US$2,000 be withdrawn

from the margin account?
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 Example (cont’d)
Suppose the next day’s future price is F1,T , then the margin
account balance is

X = 6,000 + 15,000(F1,T – F0,T)

(Q1) What price change would lead to a margin call?

X < 4,500  F1,T < 1.5

(Q2) Under what circumstances could US$2,000 be withdrawn

from the margin account?

X ≥ 8,000  F1,T ≥ 1.74

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 S&P 500 Futures
Specifications for the S&P 500 index futures contract:

3-31
 Example: S&P 500 Futures
Consider an S&P 500 futures which will expire in 10
weeks. For simplicity, assume weekly settlement. The
futures price is 3200.
The notional value of one futures contract is $250 ×
3200 = $800,000: the amount long is agreeing to pay at
expiration per futures contract.
Take a long position in 8 futures contract. The
corresponding future investment in S&P 500
$800,000 × 8 = $6.4 million

3-32
 Example: S&P 500 Futures
The continuously compounding annual interest rate is
2%.
Assume 10% IM. The initial margin level is then $0.64
million.
Suppose one week later, the futures price drops to
3027.99. On a mark-to-market basis, the profit / loss on
the futures position
8 × $250 × (3,027.99 – 3,200) = – $344,020
The margin balance is then
$640,000e0.02×1/52 – $344,020 = $296,226.20
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 Example: S&P 500 Futures
Mark-to-market proceeds and margin balance over 10 weeks
from long position in 8 S&P 500 futures contracts.

Week Multiplier ($) Futures Price Price Change Margin Balance ($)
0 2,000 3,200.00 640,000.00
1 2,000 3,027.99 -172.01 296,226.20
2 2,000 3,067.88 39.89 376,120.16
3 2,000 3,103.23 35.35 446,964.85
4 2,000 3,148.78 45.55 538,236.79
5 2,000 3,290.32 141.54 821,523.84
6 2,000 3,106.94 -183.38 455,079.87
7 2,000 3,180.98 74.04 603,334.94
8 2,000 3,094.74 -86.24 431,087.03
9 2,000 3,107.30 12.56 456,372.87
10 2,000 3,151.65 44.35 545,248.43
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 Example: S&P 500 Futures
For S&P 500 futures contracts, the week-10 profit on the
position is obtained by subtracting from the final margin
balance the future value of the original margin investment:
___________________________________
  , 248.43− $ 64 0,000 e 0.02× 10/52=− $ 97,217.85
$If545
the position had been a forward rather than a futures
position, but with prices the same, the week-10 profit would
have been

________________________
(3151.65 − 3200)×$2000=−$
  is earned
Interest 9 6,700
on the mark-to-market proceeds with the
futures contract.
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 Quanto Index Contracts
There exists index futures with settlement of the contract
in a different currency than the currency of
denomination for the index.
Example: Nikkei 225 Futures

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 Nikkei 225 Futures
Anything special about Nikkei 225 Futures?
• The currency of denomination for the index: Yen
• The currency for settlement: US dollar
Purpose of such futures
• Dollar-based investor to speculate on the change of
Nikkei 225 index
• Currency risk (exchange risk, the risk that the yen/dollar
exchange rate will change) is avoided
Quanto index contracts allow investors in one country
to invest in a different country without exchange rate
risk
3-37
Forward to Reallocate Investment
Forward can be used to switch investment among
different asset categories – asset reallocation – by
creating synthetic security.
Example: Effect of owning the stock and selling
forward, assuming that S0 = $100 and F0,1= $110.

← Risky Investment

← Riskfree Investment
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Forward to Reallocate Investment
Asset A – Forward on Asset A = Risk-free Asset
Forward / Futures overlay: the use of multiple
forward/futures to convert a position from one asset
category to another
Asset A Asset A
– Forward on Asset A
+ Forward on Asset B
– Forward on Asset A = Asset B

+ Forward on Asset B
T-bill Asset B 3-39
 Futures to Cross-Hedge
Forward and futures are often used for hedging risk.
• Problem: may not be able to find a contract based on the
same asset that you wish to hedge.
• Solution: use a contract on another asset which is highly
correlated with the asset concerned  cross-hedging.
E.g.: hedge jet fuel with crude oil futures
Index futures can be used to cross-hedge stock portfolio
that are not exactly the index but correlated with the
index

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 Cross-Hedging: Example
Example: Cross-hedging with perfect correlation
• we own $100 million of stocks with a beta relative to the
S&P 500 of 1.3, our portfolio is perfectly correlated with
S&P 500 index.
• With perfect correlation and beta of 1.3, $100 million
investment in stock portfolio is equivalent to $130 million
investment in S&P 500 index.
• Suppose S&P 500 is 3,100 with 0 dividend yield;
effective risk-free interest rate is 3%  the price of one-
year futures is 3,193
How can we hedge risk?
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 Cross-Hedging (cont’d)
By contract specification, one S&P 500 futures contract
covers $250 x 3,100 = $0.775 million investment in
S&P.
The number of S&P 500 futures to short in order to
cross-hedge:

• Note: For illustration purpose, we assume that taking fractional

number of contracts is feasible.

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 Cross-Hedging (cont’d)
 Two positions:
• $100 million invested in stock portfolio
• Shorting 167.74 index futures
Suppose the index value one year later is 2,950:
• Profit on shorting 167.74 futures:

• What is the value of stock portfolio?

• The stock portfolio is perfectly correlated with S&P 500
index with beta 1.3
• CAPM:
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 Cross-Hedging (cont’d)
 The return on S&P 500 index over the year is

By CAPM, the return on the portfolio (perfect correlated

with index) with beta 1.3 is

Portfolio value is thus

$100m × (1 – 7.19% ) = $92.81 million
Combined: $103 million
3-44
 Cross-Hedging (cont’d)
Table Results from shorting 167.47 S&P 500 index futures
against a $100 million portfolio with a beta of 1.3.
S&P 500 Index Gain on Futures Portfolio Value Total
2,950 10,190,323 92,809,677 103,000,000
3,000 8,093,548 94,906,452 103,000,000
3,050 5,996,774 97,003,226 103,000,000
3,100 3,900,000 99,100,000 103,000,000
3,150 1,803,226 101,196,774 103,000,000
3,200 -293,548 103,293,548 103,000,000
3,250 -2,390,323 105,390,323 103,000,000
3,300 -4,487,097 107,487,097 103,000,000

Cross-hedging with imperfect correlation

Risk management for stock-pickers 3-45
End of the Notes!

3-46
 Appendix

on Continuous Dividends

3-47
 Continuous Dividends
What does it mean by “continuous dividends with an
annualized yield rate d”?
• Instead of receiving cash dividend, number of shares is
accumulated at the rate δ.
• For stock indexes containing many stocks, it is common
to model the dividend as being paid continuously at a
constant rate δ.
Beginning with one share, how many shares are there at
time 1?
• Similarly, what is the future value of $1 at time 1 if the
continuously compounding interest rate is d?
3-48
 Continuous Dividends (cont’d)
To
  understand how shares are compounded, consider daily
dividend payout with annual rate .
• At day t, the daily dividend payment (in cash per share)
depends on that day’s share price and the daily dividend
payout rate /365  .
• Daily dividend payment is changing in cash, using the
money, you can buy exactly shares.
• Therefore, 1 share at the beginning of day t become
shares at the end of day t.
• Accumulating for 365T days, one share at time 0 becomes
shares at time T.
3-49
 Continuous Dividends (cont’d)
  dividend is continuously compounded, one share at
If
time 0 becomes shares at time T.
In other words, one share at time 0 is equivalent to
shares at time T. Or 1 share at time T is equivalent to
shares at time 0.
Buying prepaid forward is paying now for 1 share at
time T. Thus, the price should be the same as the price
for shares now, that is .

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