Goal

Determination of Forward and Futures Prices

Chapter 5

Examine the relation between forward/futures prices and spot prices

forward contracts are easier since there is no daily settlement settlement.

Use the results to determine the forward and futures prices of an investment asset from its spot price.

we cannot do this for consumption assets.

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Consumption vs Investment Assets

Short Selling (Page 104-105)

Investment assets are assets held by significant numbers of people purely for investment purposes

Short selling involves selling securities you do not own Reason: Expect that prices will fall in the future. How does it work?

Examples: gold, silver E l ld il

Consumption assets are assets held primarily for consumption

Examples: copper, oil

shorting instruction to y g your broker broker borrows relevant shares from other clients account and sell the shares you receive the proceeds at certain time in the future, you buy the same number of shares from open market at spot price and return the shares to brokers
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Short Selling
(continued)

Short Selling example

You must pay dividends and other benefits the owner of the securities receives even though you a e bo o g t e are borrowing them. Sometimes (rarely), broker will require you to return shares before you are ready to do so.

You call the broker and tell him to short sell 100 shares of AT&T (T) Broker borrows shares of T from another customer and sells them in the open market at say $50/share You deposit the cash in your account ($5,000) 10 days later you instruct the broker to close the position Broker buys back the shares and returns them to original owner

If the price is $48, get $200 profit If the price is $51, lose $100 on this transaction

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Notation
S0: Spot price today F0: Futures or forward price today p y T: Time until delivery date r: Risk-free interest rate for maturity T

Simple vs Continuous Compounding

(1 APR n ) 1 EAR n

Lim(1
n

APR n ) ? n

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

No Income Securities

1. Gold: An Arbitrage Opportunity?

We can determine todays forward price by using a no-arbitrage argument This is very simple for securities that do not provide interim cash payments (dividends or interest payments)

Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is i US$1100 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

2. Gold: Another Arbitrage Opportunity?

(work at home)

The Futures Price of Gold

(Simple Compounding)
If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S=1000, T=1, and r=0.05 so that F = 1000(1+0.05) = 1050
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is US$990 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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When Interest Rates are Measured with Continuous Compounding

What if

F0 = S0erT
This equation relates the forward price and the spot price for any investment asset that provides no income and has no storage costs
Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

F>SterT , then you can earn an arbitrage profit by taking the following positions

Borrow St at rate r for T owe SterT Buy 1 unit of the asset in the spot market @ St y p Take a short position in the forward market @ F At time T:

Sell asset for F Pay back the loan at SterT Realize a profit of F SterT > 0

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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What if

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 p price is too low

F<SterT , then you can earn an arbitrage profit by taking the following positions

Sell short in spot market @ St Invest proceeds St @ at rate r for T so g p grows to SterT Long position in forward market @ F At time T:

Buy asset for F Close short position Realize a profit of SterT F > 0

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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When an Investment Asset Provides a Known Dollar Income

(page 110, equation 5.2)

When an Investment Asset Provides a Known Yield

(Page 111, equation 5.3)

Consider a forward contract on an investment asset that will provide a perfectly predictable cash income to the holder. F0 = (S0 I )erT where I is the present value of the income during life of forward contract
Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

( q) F0 = S0 e(rq )T

where q is the average yield during the life of the contract (expressed with continuous compounding)

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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Valuing a Forward Contract

Page 112

Forward vs Futures Prices

Suppose that K is delivery price in a forward contract & F0 is forward price that would apply to the contract today The l Th value of a long f f l forward contract, i d t t , is = (F0 K )erT Similarly, the value of a short forward contract is =(K F0 )erT
Note: F0 is the forward price today, while is the value of the forward contract today.
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Forward and futures prices are usually assumed to be the same. When interest rates are uncertain they are, in theory, slightly different: A strong p g 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 The difference between forward and futures prices can be relatively large for Eurodollar futures (see Chapter 6)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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Stock Index (Page 115)

Stock Index
(continued)

Can be viewed as an investment asset paying a dividend yield The futures price and spot price relationship is therefore

F0 = S0 e(rq )T
where q is the dividend yield on the portfolio represented by the index during life of contract
Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

For the formula to be true it is important that the index represent an investment asset In other words changes in the index words, 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
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Index Arbitrage

Index Arbitrage
(continued)

When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures (r-q)T When Wh F0 < S0e( )T an arbitrageur b bi buys futures and shorts or sells the stocks underlying the index

Index arbitrage involves simultaneous trades in futures and many different stocks Very often a computer is used to generate the trades

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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Futures and Forwards on Currencies (Page 116-120)

A foreign currency is analogous to a security providing a dividend yield The continuous dividend yield is the foreign risk-free interest rate It follows that if rf is the foreign risk-free interest rate

F0 S 0 e

( r rf ) T

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

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