Pricing of Forward and Futures

Lorenzo Bretscher

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Pricing of Forward and Futures

Lorenzo Bretscher

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Spot vs Forward - A Comparison
at T
Spot Payoff
Forward

D
" "

ii
If we buy the stock today it costs us S0 . The value of the position at T
equals ST
If we enter the forward it costs us 0. The value of the position at T equals
ST F
With both positions, we own the stock at T . However, the two positions
require different initial investments

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Spot vs Forward - A Comparison

We refer to a position that has been paid in full as funded (Spot), and one
for which payment is deferred as unfunded (Forward)
We can only compare them fairly if we equate the amounts initially invested
and take into account the interest earned between today and time T
Two ways to do so:
I Invest S0 in zero-coupon bond along with the forward contract ! funded
I Borrow S0 to buy the stock ! initial cost are 0, unfunded

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Pricing of Forwards and Futures

Pricing of forwards and futures is based on no-arbitrage:

I Two portfolios with the same cash flows must have the same market value

Reminder: Definition of an arbitrage

① I An asset with price equal to zero and (PV of) E[future CF] > 0!
→
Buy !
An asset with a price different from zero and all future CF are equal to zero.
② I

↳ sell !
To apply no-arbitrage, we will construct a portfolio that synthetically
replicates the payoff of a forward/futures contract

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Forwards on Non-Dividend-Paying Stocks

Consider a forward contract on a stock that

I pays no dividends until the maturity of the contract
I has a delivery price F and the risk-free rate equals r
I has time to maturity equal to T
Fact: Forward price is

D F = S (1 + r )
or, with continuously compounded interest rate
T

F = Se rT
Example:
S = $100, T = 1-year, r = 5% (discretely compounded, annual)
T
Forward price is: S ( etr )

F = 100(1 + 0.05) = 105

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Replicating Portfolio

Replicating portfolio for the forward contract:

I buy one share of the stock
F
I borrow (1+r )T
dollars, i.e. sell F T -year zero-coupon bonds
Cash flows are:
Cash Flows
Transactions GOTime 0 Time T (expiration)

Forward Contract 0 ST F

F
Replicating Portfolio S0 + (1+r )T
ST F

The forward contract does not entail any cash flows today. Therefore, its
“market value” is 0.
Absence of arbitrage implies that the market value of the replicating portfolio
has also to be 0.
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 l

Replicating Portfolio: Payoff Diagrams

F - - -

•
pi i r

- it
.

- Fe

(a) Buy Stock (b) Sell Bond (c) Portfolio

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Forward on (Discrete) Dividend Paying Stocks

Consider a forward contract on a stock that pays dividends before the

maturity of the contract t '
Assume that the dividends are known today
wit
Fact: Forward price is
① ① ③
F = (S g
PV (D)) (1 + r )
T

where PV (D) is the PV (at the riskless rate) of the dividends to be received
until maturity

If dividends are unknown, we replace them by expected dividends, and the

formula becomes an approximation

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Forward on (Discrete) Dividend Paying Stocks

So
Example: 1 year forward contract on XYZ - suppose XYZ stock costs $100
today and is expected to pay a $1.25 quarterly dividend, with the first coming
3 months from today and the last just prior to the delivery of the stock.

Suppose the annual continuously compounded risk-free rate is 10%. (The

quarterly continuously compounded rate is therefore 2.5%)
Then
4
X
0.025i
(S PV (D)) = $100 $1.25e = $95.30
i=1

Caveat: We implicitly assumed that the dividends are certain. Over a short
horizon this might be reasonable. Over a long horizon we would expect
dividend risk to be greater, and we would need to adjust the discount rate in
computing the present value of expected dividends.

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Forward on (Continuous) Dividend Paying Stocks

For stock indexes containing many stocks, it is common to model the

dividend as being paid continuously at a rate proportional to the level of the
index. Suppose that the annualized daily compounded dividend yield is .
The dollar dividend over 1 day is

Daily dividend = ⇥ S0
365
Now suppose that we reinvest the dividends in the index ! after T years we
will have more shares than we started with. Hence, at the end of T years we
hold approximately
✓ ◆365T
# shares = 1 + ⇡e T
365
for every share invested.
An investment of Se T will give us exactly one share at time T , hence,
T
(S PV (D)) = Se
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Forward on (Continuous) Dividend Paying Stocks

Example: 1 year forward contract on the index - suppose that the index is $100
and the annualized daily compounded dividend yield is 5%. Then
0.05
(S PV (D)) = $100e = $95.12

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Forward on Bonds yield
iii. ÷ °

We use the same formula as for stocks, replacing “dividends” by “coupons”

Example: Suppose the 1-year spot rate is 5%, the 1.5-year spot rate is 5.5%,
and the 2-year spot rate is 6%. Determine the forward price for a bond with
annual coupon rate 8% and maturity two years. The delivery date is T = 1.5
year.
-

We have
① S0 =
8
+
108
1 + 5% (1 + 6%)2
= 103.74
-

⑦ PV (C ) =
8
1 + 5%
= 7.62

③ r1.5 = 5.5%
Therefore,
1.5
F0 = (S0 PV (C )) ⇥ (1 +O
r1.5 )
1.5
= (103.74 7.62) ⇥ (1 + 5.5%) = 104.16
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Creating a Synthetic Forward Contract

We now demonstrate that borrowing S0 e T to buy e T

shares of the index
replicates the payoff to a forward contract, ST F0,T

Cash Flows
Transactions Time 0 Time T (expiration)

Buy e T
units of the index S0 e T
ST

Borrow S0 e T
at risk-free rate +S0 e T
S0 e (r )T

Total O
0 ST S0 e (r )T

IIsoe"
To summarize, we have shown that si

Forward = Stock Zero-Coupon Bond

1-
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Forward and Arbitrage
B)
tooo eco
2=11221.45
-
25 - O -

A
IN =

Suppose that the current price of a dividend-paying stock equals $1,000. Let
r = 0.25 and = 0.15. You notice that a forward price for delivery of this stock in
two-years equals F = $1, 200. You suspect that this forward price creates an
arbitrage opportunity. The reason for this suspicion is that the forward price based
on no-arbitrage (FNA ) equals
0.15)⇥2
FNA = S0 e (r )T
= 1000e (0.25 = 1, 221.4 > F = 1, 200

Cash Flows
Transactions Time 0 Time T (expiration)
because it
→
Long forward is too 0 ST F
cheap
Short e T units of the index +S0 e T
ST
Invest S0 e T at risk-free rate S0 e T
S0 e (r )T
Total 0 S0 e (r )T
F
"
The payoff is: S0 e (r )T
F = 21.4 > 0 FNA > F
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Synthetic Forwards and Market-Making

Suppose a customer wishes to enter into a long forward position.

The market-maker, as the counterparty, is left holding a short forward
position.

Cash Flows
Transactions Time 0 Time T (expiration)

Buy e T units of the index S0 e T

+ST
Borrow S0 e T at risk-free rate +S0 e T
S0 e (r )T
Short forward 0 O
F0,T S0,T
Total 0 F0,T S0 e (r )T
FNA

The market-maker offsets this risk with a cash-and-carry which entails

creating a synthetic long forward position.
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Synthetic Forwards and Market-Making

Similarly, suppose the market-maker wishes to hedge a long forward position.

Cash Flows
Transactions Time 0 Time T (expiration)

Short e T units of the index +S0 e T

ST
Lend S0 e T at risk-free rate S0 e T
+S0 e (r )T
Long forward 0 ST F0,T
Total 0 S0 e (r )T
F0,T

The market-maker offsets this risk with a reverse cash-and-carry that entails
short-selling the index and entering into a long forward position.

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No-Arbitrage Bounds

IT IN
A
ft

me
This analysis ignores
I transaction costs, k
I bid-ask spreads, (S0b , S0a )
I different interest rates for borrowing and lending (r B , r L ) , and
I the possibility that buying or selling in large quantities will cause prices to
change. →
price impact

The effect of such costs will be that, rather than there being a single
no-arbitrage price, there will be no-arbitrage bounds

B
F + = (S0a + 2k)e r T

L
F = (S0b 2k)e r T

such that F 2 [F , F + ] =) no arbitrage is profitable

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No-Arbitrage Bounds

Suppose an arbitrageur believes that that the current bid future price, F b is too
high!?
S b < S a , F b < F a , transaction costs are denoted by k, and r B > r L
stock pays no dividends
Strategy:
short forward: k
buy share: (S0a + k)
borrow: (S0a + 2k)
Payoff at maturity T :
B
(S0a + 2k)e r T
+ F0,T ST + ST
rBT
! If F > F
b +
= (S0a + 2k)e , then there is an arbitrage

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Interpretation of the Forward Pricing Formula

The forward pricing formula for a stock index depends on r , the

difference between the risk-free rate and the dividend yield.
This difference is called the cost of carry.
I Suppose you buy a unit of the index that costs S and fund the position by
borrowing at the risk-free rate.
I You will pay rS on the borrowed amount, but the dividend yield will provide
offsetting income of S.
I You will have to pay the difference, (r ) S, on an ongoing basis.
I This difference is the net cash flow if you carry a long position in the asset;
hence, it is called the cost of carry.

So we have
Forward price = Stock price + Cost of Carry

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Forwards vs. Futures

Forwards and futures prices can differ because of the different settlement of
gains and losses
Fact: If the riskless rate is deterministic, forwards and futures prices coincide
If the riskless rate is not deterministic, the forward price formula can be used
as an approximation of the futures price

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Are Forward Prices Unbiased Estimates of Future Spot
Els't
Prices? ?

)
fo
-
-

f. =
South

No, not necessarily. Let’s consider a forward contract on a non-dividend paying

stock.
•

From the spot-futures parity relation: S0 = F0

(1+r )T ①
From asset-pricing, where k is the required rate of return on the stock,
E [ST ]
S0 = (1+k) T
②
1
typically
-

/]
⇣ ⌘T
1+r
Hence, it must be the case that F0 = E [ST ] 1+k

F0 will be less than the expectation of ST whenever k is greater than r which

will be the case for any positive beta asset in a CAPM world
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Commodity Futures

When will the forward curve be upward/downward sloping?

I Forward curve is the graphical representation of the relationship between the
forward price and the time to maturity

An upward-sloping forward curve is said to be in contango

A downward-sloping forward curve is said to be in backwardation

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Normal Backwardation vs. Contango

O
If E (ST ) > F we say that the market is in normal backwardation (first
termed by Keynes)
I Future markets are primarily driven by hedgers who hold short positions, e.g.
producers of commodities such as ExxonMobil
I Speculators who take long positions are paid a premium to assume the price
risk

O
If E (ST ) < F we say that the market is in contango
I Future markets are primarily driven by hedgers who hold long positions, e.g.
consumers of commodities such as Boeing
I Speculators who take short positions are paid a premium to assume the price
risk

Backwardation vs. Contango markets depend upon global supply and demand
of the underlying security
I Commodity markets are backwarded most of the time
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Normal Backwardation - Example

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Future Curve

8
•

short horizon
long horizon

to
Time
maturity
→

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What Determines Forward and Futures Prices?

Forward/futures prices ultimately linked to future spot prices

Notation

Contract Spot at t Forward Futures

Price St Ft,T Ht,T

Ignore differences between forward and futures price for now

Ft,T ⇡ Ht,T

Two ways to buy the underlying asset for date-T delivery

1. Buy a forward or futures contract with maturity date T
2. Buy the underlying asset and store it until T

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What Determines Forward and Futures Prices?

T
F0,T ⇡ H0,T = (1 + r ) S0 + FVT (net storage costs)

F0,T H0,T
T
⇡ T
= S0 + PV0 (net storage costs)
(1 + r ) (1 + r )
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Example - Gold

Gold is durable, nonreactive, noncorrosive, relatively inexpensive to store

compared to its value () negligible costs of storage).

Lease rate for gold: Short-sales and loans of gold are common in the gold market.
On the lending side, large gold holders (e.g., central banks) put gold on
deposit with brokers, in order that it may be loaned to short-sellers.
The gold lenders earn the lease rate.
No-arbitrage requires that
T
F0,T = S0 (1 + r y)

or, using continuously compounded rate,

F0,T = S0 e (r y )⇥T

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Example - Gold

Suppose the gold spot price is $300/oz, the 1-year forward price is 310.686, and
the continuously compounded risk-free rate is 5%.

What is the lease rate?

What is the return on a cash-and-carry in which gold is loaned, earning the

lease rate?

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Example - Gold

We can calculate the lease rate according to the formula:

✓ ◆ ✓ ◆
F0,T 310.686
y = r ln = 0.05 ln = 0.015
S0 300

If gold can be loaned, we engage in the following cash and carry arbitrage
Cash Flows
Transactions Time 0 Time T (expiration)

Short forward 0 310.686 ST

0.015
Buy tailed gold 300e = 295.534 ST
and lend @ 0.015
Borrow at risk-free +295.534 310.686
Total 0 0
This shows that the forward is fairly priced, after taking the implicit lease
rate into account.
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Foreign Exchange Futures

Consider a forward contract to buy pounds in T years

I Let S denote the pound / dollar spot exchange rate
I Let F denote the forward price of pounds
I Let rUK and rUS denote the annualized T -year risk-free rates in the UK and
the US

The cash flows for this contract are as follows

I No money changes hands at inception
I ST F at maturity

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The covered interest-rate parity: Derivation

Consider the following two portfolios

Portfolio A
I short the pound forward contract
I buy (1+r1 )T (in pounds) of T -year UK bonds
UK
Portfolio B
F0
I buy (1+rUS )T
(in dollars) of T -year US bonds
At time T , both portfolios will be worth F0 dollars.
By no abritrage, two portfolios with identical payoffs must have the same price.
Therefore,
F0 1 1
T
= T
S0 (1 + rUS ) (1 + rUK )
Solving for the forward price we get:
✓ ◆T
1 + rUS
F0 = S0
1 + rUK
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The covered interest-rate parity

The currency futures pricing equation

✓ ◆T
1 + rUS
F0 = S 0
1 + rUK

is also know as covered interest-rate parity (CIP)

I When interest rates differ across countries, investors have an incentive to
borrow in the low-interest rate country and invest in the high-interest rate
country
I There is always the risk that the high-interest rate currency could depreciate
I If you avoid this risk by locking in the future exchange rate, the forward
exchange rate F must exactly offset any benefit from the higher interest rate,
eliminating any arbitrage opportunity ) CIP

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The uncovered interest-rate parity

What about uncovered interest-rate parity (UIP)?

✓ ◆T
1 + rUS
E [ST ] = S0
1 + rUK

I Conceptually, UIP holds only if the aforementioned risk is unpriced

I Empirically, UIP does not hold: high interest-rate countries tend to appreciate
rather than depreciate
I The carry trade “exploits” this “failure” of UIP

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Carry trade relies on “Forward rate bias”

Excerpt from [Link]

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Conclusions

We have priced forward contracts using no arbitrage

Since two portfolios with the same cash flows must have the same price, we
can synthetically replicate a forward to determine the fair forward price

This logic allows us to price a variety of forward contracts

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