Chapter 5

Determination of Forward and

Futures Prices

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Copyright © John C. Hull 2014 1
Consumption vs Investment Assets
Investment assets are assets held by
significant numbers of people purely for
investment purposes (Examples: stocks,
bonds, gold, silver)
Consumption assets are assets held
primarily for consumption (Examples:
copper, oil)

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Short Selling (Page 105-106)
Short selling involves selling securities
you do not own
Your broker borrows the securities
from another client and sells them in
the market in the usual way

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Short Selling (continued)
At some stage you must buy the securities
so they can be replaced in the account of
the client
You must pay dividends and other benefits
the owner of the securities receives
There may be a small fee for borrowing
the securities
The investor is required to maintain a
margin account
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Example
You short 100 shares when the price is $100
and close out the short position three months
later when the price is $90
During the three months a dividend of $3 per
share is paid
What is your profit?
What would be your loss if you had bought
100 shares?
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Example
Purchase of shares Short Sale of share
T=0 (now) T=0 (now)
buy 100 shares @$100 -$10000 Borrow 100 shares and sell @$100
Earn dividends of $3 $300 So, the CF will be $10000
Pay dividends -$300
T=1 (in three months)
sell 100 shares @$90 $9000 T=1 (in three months)
Buyback 100 share @$90 -$9000
Net Profit/loss -$700 Net profit/loss $700

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Assumptions for Valuing Futures
and Forward Contracts
No transaction costs when market
participants trade
The market participants are subject to the
same tax rate on all net trading profits
The market participants can borrow money @
the same risk free rate as they can lend
The market participants take arbitrage
opportunies as they arise
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Notation for Valuing Futures and
Forward Contracts
S0: Spot price today
F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T

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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?

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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?

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 The Forward Price
If the spot price of an investment asset is S0 and the futures price
for a contract deliverable in T years is F0, then
F0 = S0erT
This equation holds because of arbitragers. If F0 ≠ S0erT
Then, an arbitrage opportunity will arise. Such opportunities will
be instantaneously exploited by arbitragers
the futures and spot prices will revert back to equilibrium

where r is the T-year risk-free rate of interest.

In our examples, S0 =40, T=3/12=0.25, and r=0.05 so that
F0 = 40e0.05×0.25 = 40.50

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The Forward Price
Fo=$43 Fo=$39
F0> S0erT F0 < S0erT
T=0 (now) T=0 (now)
Borrow +$40 @5% for 3 months Short the asset @+$40
Buy asset @ -$40 Invest $40 @5% for 3 months
Sell foreword @$43 Take a long position in the forward
to buy the asset @$39
T=1 (in three months)
Proceeds from selling the asset @+ T=1 (in three months)
$43 Buy the asset @-$39
Repay the loan -$40.50 Close the short position
Profit realized $2.5 Receive +$40.50 from the
investment
Profits realized $1.50

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If Short Sales Are Not Possible..
Formula still works for an investment asset
because investors who hold the asset will sell
it and buy forward contracts when the forward
price is too low F0 < S0erT
The investors already own the investment
assets. So, if the F0 < S0erT
Then, they will sell the asset and buy the
forward contract such that equilibrium relation
is restored.
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When an Investment Asset
Provides a Known Income (page 110,
equation 5.2)
If the underlying asset has a known cash flow
in the form of or coupon payment. If you
own the forward contract, do you get this
payment? No
So the equation is reformulated as follows
F0 = (S0 – I )erT
where I is the present value of the income
during life of forward contract
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Example
Compute the price of a 6 months forward
on a coupon bond worth $1000 that pays a
5% per annum coupon semiannually. A
coupon to be paid in three months assume
that the risk-free rate is 4%
F0 = (S0 – I )erT
First, we need to calculate the coupon payment
Second, we to calculate its present value
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Example
The coupon payment is (1000*(0.05/2))=$25
I=25 e-0.04*(3/12)
I=25(0.99005)=24.75
F0 = (1000 – 24.75 )e0.04*(6/12)
=(975.25)*1.020201= $ 994.95

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When an Investment Asset Provides
a Known Yield (Page 112, equation 5.3)
If an asset pays a dividend, we assume that it
is paid continuously. Letting q represents
dividend yield, the equation becomes
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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Example
Compute the price of a 6 months forward for
which the underlying a stock index with a
value of $1000 and a continuous dividend yield
of 1% per annum. The risk-free rate is 4% per
annum.
F0 = 1000 e(0.04–0.01 )6/12
= 1000*1.01511=$1015.11

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Valuing a Forward Contract
A forward contract is worth zero (except for
bid-offer spread effects) when it is first
negotiated
Later it may have a positive or negative value
Suppose that K is the delivery price and F0 is
the forward price for a contract that would be
negotiated today

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 Valuing a Forward Contract
(pages 112-114)
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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Forward vs Futures Prices
When the maturity and asset price are the same, forward
and futures prices are usually assumed to be equal.
(Eurodollar futures are an exception)
In theory, when interest rates are uncertain, they are
slightly different:
A strong positive correlation between interest rates and the asset
price implies the futures price is slightly higher than the forward
price
A strong negative correlation implies the reverse

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Stock Index (Page 115-117)
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

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Stock Index (continued)
For the formula to be true it is important that
the index represent an investment asset
In other words, changes in the index must
correspond to changes in the value of a
tradable portfolio
The Nikkei index viewed as a dollar number
does not represent an investment asset (See
Business Snapshot 5.3, page 116)

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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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Index Arbitrage
(continued)
Index arbitrage involves simultaneous trades in
futures and many different stocks
Very often a computer is used to generate the
trades
Occasionally simultaneous trades are not
possible and the theoretical no-arbitrage
relationship between F0 and S0 does not hold
(see Business Snapshot 5.4 on page 117)

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Futures and Forwards on
Currencies (Page 117-120)
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

( r  r f )T
F0  S 0 e
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Explanation of the Relationship
Between Spot and Forward (Figure 5.1)

r T
1000e f units of
foreign currency
at time T

r T
1000 F0 e f
dollars at time T

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Consumption Assets: Storage is
Negative Income
F0  S0 e(r+u )T
where u is the storage cost per unit time as a
percent of the asset value.
Alternatively,
F0  (S0+U )erT
where U is the present value of the storage
costs.

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The Cost of Carry (Page 123)
The cost of carry, c, is the storage cost plus
the interest costs less the income earned
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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Futures Prices & Expected Future
Spot Prices (Page 124-126)
Suppose k is the expected return required by
investors in an asset
We can invest F0e–r T at the risk-free rate and enter
into a long futures contract to create a cash inflow of
ST at maturity
This shows that
F0 e rT kT
e  E ( ST )
or
F0  E ( ST )e ( r  k )T
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Futures Prices & Future Spot
Prices (continued)

No Systematic Risk k=r F0 = E(ST)

Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic Risk k<r F0 > E(ST)

Positive systematic risk: stock indices

Negative systematic risk: gold (at least for some periods)

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