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: gold,
silver)
Consumption assets are assets held
primarily for consumption (Examples:
copper, oil)

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Short Selling
Short selling involves selling securities
you do not own.
Suppose an investor instructs a
broker to short 500 shares
Your broker borrows the securities
from another client and sells them in
the market in the usual way

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Short Selling

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Short Squeeze
A short squeeze results if the
broker runs out of securities
to borrow.
A short squeeze is a
phenomenon that occurs in
financial markets when short
sellers of a security are forced
out of their positions by a
sharp increase in the
security’s price.
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Example
Consider the position of an investor who shorts 500 shares in
April when the price per share is $120 and closes out the
position by buying them back in July when the price per share is
$100. Suppose that a dividend of $1 per share is paid in May.
The investor receives 500 x $120 = $60,000 in April when the
short position is initiated.
The dividend leads to a payment by the investor of 500 x $1 =
$500 in May. The investor also pays 500 x $100 = $50,000 for
shares when the position is closed out in July. The net gain,
therefore, is

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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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Cash flow of short and long are
mirror image

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Assumptions
1. The market participants are subject to no
transaction costs when they trade.
2. The market participants are subject to the same
tax rate on all net trading profits.
3. The market participants can borrow money at the
same risk-free rate of interest as they can lend
money.
4. The market participants take advantage of
arbitrage opportunities as they occur.

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What drives the market
It is the trading activities of these key market
participants and their eagerness to take advantage of
arbitrage opportunities as they occur that determine
the relationship between forward and spot prices.

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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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 Part I
An Arbitrage Opportunity – No Income

Formula (Forward Price)

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Example 1 – Arbitrage – No
Income
Consider a long forward contract to purchase a
non-dividend-paying stock in 3 months.1
Assume the current stock price is $40 and the
3-month risk-free interest rate is 5% per annum.
Suppose first that the forward price is relatively
high at $43.
Discuss the possibility of arbitrage.

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Arbitrage – No Income…
Can he borrow ?
Yes, Borrow $40 at the risk-free interest rate of 5% per
annum.

buy one share, and short a forward contract to sell one

share in 3 months. At the end of the 3 months, the
arbitrageur delivers the share and receives $43.
Payoff by this strategy
By following this strategy, the arbitrageur locks in a profit
of $43:00 - $40:50 = $2:50 at the end of the 3-month
period.

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What if the forward price relatively low i.e.
$39, Discuss
An arbitrageur can short one share, invest the
proceeds of the short sale at 5% per annum for 3
months, and take a long position in a 3-month
forward contract.
The proceeds of the short sale grow to,

At the end of the 3 months, the arbitrageur pays $39,

takes delivery of the share under the terms of the
forward contract, and uses it to close out the short
position. Net Gain

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Therefore If
arbitrageurs can buy the asset and short forward
contracts on the asset. (“Going long for short”)

Arbitrageurs can short the asset and enter into long

forward contracts on it (Going Short for long)

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Part II – Known Income
Determination of forward
price with known income

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Known Income
A forward contract on an investment asset
that will provide a perfectly predictable cash
income to the holder
Examples are stocks paying known dividends
and coupon-bearing bonds.

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Example 2 – Known Income
Consider a long forward contract to purchase a
coupon-bearing bond whose current price is $900.
We will suppose that the forward contract matures in
9 months. We will also suppose that a coupon
payment of $40 is expected after 4 months. We
assume that the 4-month and 9-month risk-free
interest rates (continuously compounded) are,
respectively, 3% and 4% per annum. Suppose first
that the forward price is relatively high at $910.

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Strategy 1 - Short forward contract (When Forward
Price is $910)
Of the $900, $39.60 is therefore borrowed at
3% per annum for 4 months so that it can be repaid with
the coupon payment. The

remaining $860.40 is borrowed at 4% per annum for 9

months.
The amount owing at the end of the 9-month period is

A sum of $910 is received for the bond under the terms of

the forward contract. The arbitrageur therefore makes a
net profit of

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Summarized

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When forward price is low say $870

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Therefore arbitrage is possible
if,
an arbitrageur can lock in a profit by
buying the asset and shorting a
forward contract on the asset.

an arbitrageur can lock in a profit by

shorting the asset and taking a long
position in a forward contract.

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PART III – 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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Known Yield
where the asset underlying a forward contract
provides a known yield rather than a known
cash income.
This means that the income is known when
expressed as a percentage of the asset’s
price at the time the income is paid.

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Known Yield
Consider a 6-month forward contract on an asset that
is expected to provide income equal to 2% of the asset
price once during a 6-month period. The risk free rate
of interest (with continuous compounding) is 10% per
annum. The asset price is $25.

F0 = S0 e(r–q )T

F0 = 25 e(0.10 – 0.0396 )0.5

= $25.77

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27
 Part IV
Valuing Forward Contracts

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Valuing a Forward Contract
The value of a forward contract at the time it
is first entered into is close to zero.
At a later stage, it may prove to have a
positive or negative value. It is important for
banks and other financial institutions to value
the contract each day.

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K, Fo & f
It is important to be clear about the meaning of
the variables F0, K, and f.
At the beginning of the life of the forward
contract, the delivery price, K, is set equal to
the forward price at that time and the value of
the contract, f, is 0.
As time passes, K stays the same (because it is
part of the definition of the contract), but the
forward price changes and the value of the
contract becomes either positive or negative.
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Valuing 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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Example
A long forward contract on a non-dividend-paying stock was entered into
some time ago. It currently has 6 months to maturity. The risk-free rate of
interest (with continuous compounding) is 10% per annum, the stock price
is $25, and the delivery price is $24.

In this case, S0 = 25, r = 0:10, T = 0:5, and K = 24.

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PART V – Future Price of Stock
Indices
A stock index can usually be regarded as the
price of an investment asset that pays
dividends.
It is usually assumed that the dividends
provide a known yield rather than a known
cash income.
F0 = S0 e(r–q )T

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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

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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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Example -
Consider a 3-month futures contract on an index.
Suppose that the stocks underlying the index provide
a dividend yield of 1% per annum, that the current
value of the index is 1,300, and that the continuously
compounded risk-free interest rate is 5% per annum.
In this case, r = 0.05, S0 = 1,300, T = 0.25, and q =
0.01, Calculate Future price of the contract.

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PART VI – Forwards and
Futures contract on Currencies
( r rf ) T
F0  S0e
• rf as the value of the foreign • S0 as the current spot
price in US dollars of
risk-free interest rate when one unit of the foreign
money is invested for time T. currency.
• The variable r is the risk-free • F0 as the forward or
rate when money is invested futures price in US
for this period of time in US dollars of one unit of
the foreign currency
dollars

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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

( r rf ) T
F0  S0e

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Example
Suppose that the 2-year interest rates in
Australia and the United States are 3% and
1%, respectively, and the spot exchange rate
is 0.9800 USD per AUD. From equation the
2-year forward exchange rate should be
( r rf ) T
F0  S0e F0  0.9800e ( 0.010.03) 2

0.9416 (arbitrage possible ?)

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PART VII – Convenience Yield
The benefits from holding the physical asset are
sometimes referred to as the convenience yield
provided by the commodity. If the dollar amount
of storage costs is known and has a present
value U, then the convenience yield y is defined
such that

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Convenience Yield
The convenience yield reflects the market’s expectations
concerning the future availability of the commodity.
The greater the possibility that shortages will occur, the
higher the convenience yield. If users of the commodity
have high inventories, there is very little chance of
shortages in the near future and the convenience yield
tends to below.
If inventories are low, shortages are more likely and the
convenience yield is usually higher.

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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 an investment asset F0 = S0ecT
For a consumption asset F0 = S0e(c-y)T

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