FINANCIAL DERIVATIVES AND RISK

MANAGEMENT
2-Credit Elective Course for MBA(IB) 2023-25

Course Coordinator:
Dr. Niti Nandini Chatnani
Professor (Finance)
IIFT, New Delhi

07/29/24 1
 Session 6:

Pricing of Futures

Calculation of Forward/Futures prices

•For Stocks/Bonds
•For Currencies
•For Commodities

Valuation of Forward/Futures Contracts

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•The primary difference between forward and futures valuation is the daily settlement of
futures gains and losses via a margin account. Daily settlement resets the futures contract
value to zero at the current futures price Ft(T). This process continues until contract maturity
and the futures price converge to the spot price, ST.

•The cumulative realized mark-to-market (MTM) gain or loss on a futures contract is

approximately the same as for a comparable forward contract.

•Daily settlement and margin requirements give rise to different cash flow patterns between
futures and forwards, resulting in a pricing difference between the two contract types. The
difference depends on both interest rate volatility and the correlation between interest rates
and futures prices.

•The emergence of derivatives central clearing has introduced futures-like margining

requirements for over-the-counter (OTC) derivatives, such as forwards. This arrangement has
reduced the difference in the cash flow impact of ETDs and OTC derivatives and the price
difference in futures versus forwards.
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Are forward (OTC) and futures (ETD) prices equal?

Theoretically, yes. When the short-term risk-free interest rate is constant, the forward price
for a contract with a fixed delivery date will be same as the price for a futures contract with
the same delivery date. This is also true when the interest rate is a known function of time.

Practically, there may be some differences due to:

1.Interest rate fluctuations and unpredictability

2.Margin requirements in futures; profit and losses are realized immediately
3.Liquidity of futures contracts
4.Factors like taxes, transactions costs etc. not reflected in the theoretical models of pricing

In our discussions, we assume that forward and futures prices are the same

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Case 1: Forward/Futures Price for an Investment Asset that provides no income
F0=S0.erT

If spot price is 250, r is 6% per annum and T is 3 months, then the forward/futures price
today will be 250*EXP((6%*3/12)) = 253.78

A.If F0 > 253.78, say 260, then an arbitrageur can borrow Rs. 250 at the risk-free rate of 6%
per annum for 3 months, and short a forward contract to sell one share in 3 months. The cost
of borrowing is 253.78, and the arbitrageur locks-in a profit of Rs. 6.22 at the end of 3
months. (Cash-and-Carry Arbitrage)
B.If F0 < 253.78, say 251, then an arbitrageur can short one share, invest the proceeds at the
risk-free rate of 6% per annum for 3 months, and take a long position in a forward contract to
buy one share in 3 months. The proceeds of the short sale become 250*EXP((6%*3/12)) =
253.78, of which the arbitrageur pays 251 to take delivery of the share and uses it to close
out the short position, locking-in a profit of Rs. 2.78. (Reverse Cash-and-Carry Arbitrage)
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Example:

The spot price of a stock is Rs. 400 and the forward price for a contract with delivery date
in 3 months is Rs. 422. The 3-month risk-free rate is 5%, and no dividends are expected
during the life of the contract. Is an arbitrage possible?

The forward price, given the above details should be:

400e0.05X(3/12)= 405

With forward price of 422, an arbitrageur can do a cash-and-carry arbitrage

1.Borrow Rs. 400 to buy one share,
2.Enter a forward contract to sell one share in 3 months at 422
3.At the end of 3 months, deliver the share and repay the loan.

The profits to the arbitrageur will be

422 - 405 = Rs.17
July 29, 2024 6
Case 2: Forward/Futures Price for an Investment Asset with a known income (I)
When the cash flow to be earned from an investment asset during the life of the forward contract is
predictable (as interest income in bonds), then F0=(S0- I).erT (PV of I will be used)

The spot price of a coupon paying bond is 900. What should be the forward price to purchase this
bond after 9 months with a coupon of Rs. 40 due after 4 months. Continuously compounded risk-
free rates are: 4 month: 3% and 9 month: 4%.
Then, F0= (900-40*EXP((-3%*4/12)))*EXP((4%*9/12)) = 886.60

A.If F0>886.60, say 910, the arbitrageur can borrow 900 to buy the bond and short a forward
contract. Of the 900, 39.60 (PV of the coupon of 40) is only borrowed for 4 months and can be
repaid when it is received, and the remaining amount of 860.40 can be repaid after 9 months as
886.60. (Cash-and-Carry)
B.If F0<886.60, say 870, the arbitrageur can short the bond and enter into a long forward contract.
Of the 900, 39.60 is invested for 4 months at 3% to make it 40, and the remaining 860.40 is
invested for 9 months at 4%. 870 is paid to buy the bond and the short position is closed out.
July 29, 2024 7
(Reverse Cash-and-Carry)
Example:

Current price of a bond is 900. A one-year forward contract is priced at 905. The bond pays a coupon of
40 after 6 months, and another coupon of 40 after 1 year, just before the time of contract expiry. The
continuously compounded interest rate for 6-months is 9% and for 12-months is 10%. Is an arbitrage
possible?

The forward price, given the above details should be:

(900 – (40e-0.09*(6/12) +40e-0.10))e0.10= 912.40

With a forward price of 905, the arbitrageur who holds a bond can do a reverse cash-and-carry arbitrage
1.Sell one bond for 900
2.Enter a long forward contract to buy the bond in one year

900 is realized from selling the bonds. Of this, 38.23 is invested at 9% for 6 months. This becomes 40
and replaces the coupon that would be received on the bond after 6 months. The balance of 861.77 is
invested at 10% for 1 year. This becomes 952.40. Of this, 40 replaces the coupon that would be received
on the bond after 1 year. This leaves the seller with 912.40, of which 905 is paid to buy back the bond as
per the terms of the forward contract. This leaves the seller with a profit of 7.40.
July 29, 2024 8
Question:

What should be the 10-month forward price of a stock with a current price of Rs. 500, given
the following information? The continuously compounded risk-free rate is 8% and the term
structure of interest rates is flat. Dividends of Rs. 7.50 are expected after 3 months, 6 months
and 9 months.

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Case 3: Forward/Futures Price for an Investment Asset with a known yield (q)
When the cash flow to be earned from an investment asset during the life of the forward contract
is predictable as a continuously compounded yield (not as an absolute income) then F0=S0.e(r-q)T

If a 6-month forward contract on an investment asset is expected to provide an income of 2%**

of the asset price once during the 6-month period, the risk-free rate with continuous
compounding is 10%. The asset price is Rs. 250.

**The yield on the asset will be 4% per annum with semi-annual compounding. The continuous
compounding rate will be 3.922%

F0=250*EXP((0.10-0.03922)*6/12)=257.7

July 29, 2024 10

Valuing Forwards and Futures:

Futures have zero initial value and a futures price F0(T) established at inception. The futures
price, F0(T), equals the spot price compounded at the risk-free rate as in the case of a forward
contract. When a contract is first entered, its value is 0. At later stages, the value may be positive
or negative.

Valuing the contract each day is called marking-to-market.

F0 is the forward price applicable if the contract is negotiated today, with a spot price of S0
K is the contracted price of this forward contract
The value of a forward contract today will be f

f = (F0 – K).e-rT or f = S0 - Ke-rT

For a security that provides no income, f = S0 - Ke-rT

For a security that provides a known income with a PV of I, f = S0 – I - Ke-rT
For
July a
29,security
2024 that provides a known dividend yield at rate q, f = S0e-qT - Ke-rT 11
Example:

A long forward contract on a non-dividend-paying stock was entered 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 250, and the negotiated delivery price is
240. What is the value of this forward contract?

Value of the forward contract will be f = (F0 – K).e-rT or f = S0 - Ke-rT

F0 = 250.e(0.10*6/12) = 262.8
f = (262.8 - 240).e(-0.10*6/12) = 21.68 (This is the PV of profit at today’s forward price)

Or

f = 250 – 240.e(-0.10*6/12)
July 29, 2024 12
Case 4: Futures Prices of Stock Indices

A stock index tracks the changes in the value of a hypothetical portfolio of stocks.

The dividends paid by the stocks are the dividends that would be received by the holder of this
portfolio.

It is usually assumed that the stocks provide a known yield rather than a known cash income. The
chosen value of q should represent the average annualized dividend yield during the life of the
contract. The dividends used for estimating q should be those for which the ex-dividend date is
during the life of the futures contract.

If q is the dividend yield rate, F0=S0.e(r-q)T

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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 18,000, and that the continuously compounded risk-free interest rate is 5% per
annum. What should the futures price of the index be?
(Note: NIFTY DY is usually in the range of 1 to 1.5)

Futures price of the index will be

F0 = 18000.e((0.05-0.01)*(3/12))

F0 = 18180.90

https://trendlyne.com/equity/DIV/NIFTY50/1887/nifty-50-dividend-yield/
July 29, 2024 14
Case 5: Forwards/Futures Price for Currencies

The holder of a foreign currency can earn interest at the risk-free rate prevailing in the foreign
country.

R is the domestic risk-free interest rate with continuous compounding

rf is the foreign risk-free interest rate with continuous compounding.

S.e-rfT = F.e-rT

F= S.e(r-rf)T (Since a foreign currency is analogous to a dividend paying stock)

This is the interest rate parity relationship.

When rf>r, F is less than S and F decreases as T increases.
When rf<r, F is more than S and F increases as T increases.
July 29, 2024 15
Once again, it is assumed that F is a reasonable approximation of the futures price.
 Interest rate parity theory suggests a strong
relationship between interest rates and a
currency's spot exchange rate and its forward
exchange rate.

It implies that no arbitrage is possible if one

invests money in Country A and then converts
those earnings to another the currency of
Country B or converts the money first and
invests the money overseas. The investor
should make the same amount of money either
way.
Example: If the spot exchange rate for USD-INR is 84, the USD interest rate of 5%, and the
INR interest rate is 7%, what will be the forward USD-INR exchange rate after a year?
F = 84.e(0.07-0.05) = 85.69
July 29, 2024 16
Case 6: Forward/Futures Price for a Commodity (Consumption Asset)
Carrying Costs:
•Sum total of the costs involved in possessing or holding a commodity is known as the carrying cost (or
carrying charges or cost of carry or carry)
•Expressed as a cost per quantity per period and depends on the commodity concerned
•Most important determinant of the trading relationship between spot and futures prices

If C is the PV of all carrying costs that will be incurred over the life of the futures contract, then

F 0 = (S0 + C)erT
If carrying costs can be expressed as a proportional to the price of the commodity, then

F0= S0.e(r+c)T

F0 - the current futures price for delivery of the commodity at time T,

S0 - the current spot price; r is the risk-free interest rate, c is the storage cost per unit per year and
T July- 29,
time2024forward in years 17
Convenience Yield:

•Premium/benefit earned by sellers who hold a physical commodity when it is in short-supply

•Reflects the near-term scarcity of the commodity or underlying asset
•Calls for an adjustment to the theoretical future price of a commodity or the future contract delivery price
F0= S0.e(r+c-y)T

Factors determining Carrying Cost: Storage

Costs
Risk-Free
Interest Rate Futures Price

Spot Price Convenience

Yield

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Example:

The spot price of wheat (at Kanpur mandi) is Rs. 2200/quintal.

The annual risk free rate is 6%.
The cost of storage per quintal per year is 1%.
What is the theoretical futures price of wheat after 2 months? After 3 months? After 6 months?

Solution:

Spot Price 2200

RF Rate (annual) 6%
Storage Cost (annual) 1%
Time 2 months 3 months 6 months
Futures Price 2225.817 2238.839 2278.363

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 Price Inversion

July 29, 2024 20

Question:

For a 1-year futures contract on gold, assume it costs Rs. 100 per 10g to carry gold for 1 year. The
carrying cost must be paid at the end of the year. The spot price of gold is Rs. 60,000 per 10g. The
risk-free rate for 1-year is 7%.
What should the futures price of the 1-year futures contract on gold be?

PV of C= 100e-.07 = 93.24
F = (60000 + 93.24)e.07
= 64450

Alternatively,
c= 93.24/60000 = 0.001554

F = 60000e(.07+.001554)
= 64450

July 29, 2024 21

Futures Pricing in the case of Normal Markets:
• The established price structure in a normal market will have prices ascending from lowest in the
spot month to highest in the furthest futures deferred month
• Normal markets are also known as “contango” markets or premium markets

Price

Spot Price Near Futures Deferred Futures

Price Structure in Normal Markets

July 29, 2024 22
Futures Pricing in the case of Inverted Markets:
• The established price structure in an inverted market is one where prices descend progressively from
the spot to the furthest futures delivery month
• Inverted markets are also called “backwardation” markets or discount markets

Price

Spot Price Near Futures Deferred Futures

July 29, 2024 Price Structure in Inverted Markets 23

Futures-Spot Convergence:

• The process of shrinking of the difference between spot and futures prices continues till the near futures
month becomes the spot month, and then there is no difference between the spot price and the futures
price, because no carrying charges apply
• In normal markets as well as in inverted markets, the prices of spot and futures will converge and tend
to zero when the near futures month coincides with the spot month

(a) In Normal Markets (b) In Inverted Markets

Price Price

Futures Spot

Futures
Spot
Time Time
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Expected Future Spot Price E(ST)

Is the futures price of an asset the same as its expected future spot price?
Is the futures price an unbiased estimate of the likely price of an asset in the future?

Generally,
1.If more speculators are long than short, it is because the futures price is less than the expected
future spot price. Since the futures price converges to the spot price at maturity, speculators can
expect to make a gain.
2.If more speculators are short than long, it is because the futures price is higher than the
expected future spot price. Since the futures price converges to the spot price at maturity,
speculators can expect to make a gain.

The speculator takes a futures position by comparing E(ST) with F, and if the two are not equal, the
speculator takes a long or short futures position expecting to earn a rate determined by the asset’s
systematic risk (CAPM). Over a long period of time, the market revises its expectations about
future spot prices upward as well as downward, and ultimately, the futures and spot price become
equal at the maturity of the futures contract.
July 29, 2024 25
 This implies that:

1.If F = E(ST), the futures price will drift up or down only if the market changes its views about
the expected futures spot price.
2.If F < E(ST), the speculator will take benefit from long positions, as the futures price will drift
up to converge with the expected future spot price.
3.If F > E(ST), the futures price will come down to the level of the expected future spot price,
and the speculator will benefit from short positions.

However, changes in E(ST) can also result in losses for the speculator with a long or a short
futures position.

July 29, 2024 26