Options, Futures, and Other Derivatives
Tenth Edition
Chapter 5
Determination of
Forward and
Futures Prices
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Consumption vs Investment Assets
• Investment assets are assets held by significant numbers of people
purely for investment purposes (Examples: stocks, bonds)
• Consumption assets are assets held primarily for consumption
(Examples: copper, oil)
Short Selling
• Short selling involves selling securities you do not own
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Assumptions and Notation
Assumptions
– No transaction costs
– Same tax rate on all net trading profits
– Market participants can borrow and/or lend money at the same
risk free rate
– Market participants take advantage of any existing arbitrage
opportunity
S0: Spot price today
F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for maturity T
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An Arbitrage Opportunity?
• Suppose that:
– The spot price of a non-dividend-paying stock is $40
– The 3-month forward price is $43
– The 3-month US$ interest rate is 5% per annum
• Is there an arbitrage opportunity?
If Short Sales Are Not Possible…
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Another Arbitrage Opportunity?
• Suppose that:
– The spot price of nondividend-paying stock is $40
– The 3-month forward price is US$39
– The 1-year US$ interest rate is 5% per annum (continuously
compounded)
• Is there an arbitrage opportunity?
If Short Sales Are Not Possible…
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When an Investment Asset Provides a
Known Income
F0 = (S0 – I )erT
where I is the present value of the income during life of forward
contract
When an Investment Asset Provides a
Known Yield
F0 = S0 e(r–q )T
where q is the average yield during the life of the contract (expressed
with continuous compounding)
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Valuing a Forward Contract
• By considering the difference between a contract with delivery price
K and a contract with delivery price F0 we can deduce that:
– the value of a long forward contract is
(F0 – K )e–rT
– the value of a short forward contract is
(K – F0 )e–rT
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Stock Indices
• Dow Jones Industrial Average
• Standard & Poor’s 500
• Nasdaq - 100
Stock Indices Futures
• A futures contract to buy or sell a broad stock market index at a
predetermined price and for “delivery” to be made at a
predetermined date.
• Settlement is cash only. Contracts does not pay any dividends.
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Calculating Hedge Ratio
• To hedge stock portfolio, sell futures according to the hedge ratio
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Hedging with Stock Index Futures:
Example (Section 3.5, page 62)
• Portfolio Description:
– Current portfolio value : $5,050,000
– Beta of the portfolio: 1.5
– Index level = 1,000
– Index Future price = 1,010
– S&P 500 futures price = $250 *index future price= 250*1010=
$252,500
– HR=?
• Scenarios in 3 months
– Suppose market fall to index level 900, future price on index to
902
– Suppose market rises to index level 1050, future price on index
to 1053
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Stock Index
• Can be viewed as an investment asset paying a dividend yield
• The futures price and spot price relationship is therefore
F0 = S0 e(r–q )T
where q is the average dividend yield on the portfolio represented by
the index during life of contract
Index Arbitrage
• When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index
and sells futures
• When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the
stocks underlying the index
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Futures and Forwards on Currencies
• A foreign currency is analogous to a security providing a yield
• The yield is the foreign risk-free interest rate
• It follows that if rf is the foreign risk-free interest rate
1000 units of
foreign currency
(time zero)
( r r f )T
1000e
rf T
units of
1000S0 dollars
F0 S 0 e
foreign currency at time zero
at time T
rf T 1000S0erT
1000 F0 e
dollars at time T
dollars at time T
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Futures on Commodities
• Investment Commodities
F0 = (S0+U )erT
• Consumption Commodities
F0 ≤ (S0+U )erT
where U is the present value of the storage costs.
F0 ≤ S0 e(r+u )T
where u is the storage cost per unit time as a percent of the asset’s spot
price
Convenience Yield
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The Cost of Carry
• The cost of carry, c, is the storage cost plus the interest costs less the
income earned
– For non-dividend paying stock c=r
– For stock index c=r-q
– For currency c=r-r_f
– For commodity which provides income c=r-q+u
• For an investment asset F0 = S0ecT
• For a consumption asset F0 ≤ S0ecT
• The convenience yield on the consumption asset, y, is defined so that
F0 = S0 e(c–y )T
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