Determination of Forward and
Futures Prices and their
relation with Spot Prices
Readings:
Chapter 5: 5.1 - 5.6, 5.8, 5.9-5.14
Pricing Forwards & Futures
We will determine forward/futures price in
relation to the spot price by using a no-arbitrage
argument
We start by looking at underlying assets that do
not provide interim cash payments (dividends or
interest payments) and require no storage costs
Extensions (conceptually small) to cash
payments, yields, storage costs will follow
We will first consider forward prices (i.e., prices
of forward contracts), as they are a bit simpler.
Then, we will make the extension to futures
prices
Assumptions for Pricing
No or negligible transaction costs
Same tax rates for all market participants
Market participants can borrow or lend at
risk-free rate (Libor…)
Investors rationally take advantage of
arbitrage opportunities
All above assumptions need not apply to
all investors: only a few large players
suffice
Arbitrage
Arbitrage - arises if an investor can
construct a zero investment portfolio with
a sure (i.e., no risk) profit.
Since no investment is required, an
investor can create large positions to
secure large levels of profit.
In efficient markets, profitable arbitrage
opportunities will quickly disappear.
One of the most important concepts in
finance (and in this subject!)
Also referred to as free lunch.
Notation
• T: Time to maturity
• S0: Initial spot price
• ST: Spot price at maturity of the contract
• F0: Initial Forward or Futures Price
• r: risk free rate continuously compounded p.a.
• q: Continuous p.a. yield
• I: Discrete payments (dividends, income)
• U: Discrete storage costs (gold, commodities)
• u: continuous p.a. storage costs (like a
negative dividend yield)
No Arbitrage Argument
Action Cash Flow Cash Flow at T
at t=0
Buy 1 unit of -S0 ST
asset at t=0
Short 1 0 F0 – ST
forward at t=0
Borrow $S0 at S0 -S0erT
rate r at t=0
Overall 0 ST+F0-ST-S0erT
Position
No Arbitrage Argument
If it does not cost anything to enter into
the position at time t, then riskless
profits (CF>0) should not be earned at
time T
Therefore, the forward price at t=0 must
be:
F0 = S0erT
Example 1
A forward contract is written on a
stock (no dividend). The maturity of
the contract is 6 months. The stock
price is $50 today and the risk free
rate is 10% per year. What is the
no-arbitrage forward price?
F0 = S0erT = 50e0.10(0.5) = $52.56
What if F0 is NOT $52.56?
Arbitrage
Suppose F0=$53, and all other values
are those on the previous slide
you can earn a riskless profit by
• At t=0 (no cash outlay):
Borrow $50 at the 10% p.a. rate for 6 months
Buy 1 share of stock at $50
Take a short position in the forward expiring at
T for delivery at $53:
• At t=T
Sell asset for 53
Pay back loan 50*e(0.1*6/12)=52.56
Realize a profit of $(53-52.56)=$0.44
Arbitrage
If F0 > S0erT, arbitrageurs buy the
asset spot and short forward
contracts
If F0 < S0erT, arbitrageurs short the
asset spot and buy (long) forward
contracts.
What Happens if the
Security Pays Income?
Dividend paying stocks with a known
(discrete) dividend
Coupon bonds
Let ‘I’ be present value of all known
cash income
Still determine today’s forward price
using no-arbitrage argument
Pricing a Forward with Income
It can be shown that the price of a
forward contract at time t=0 is:
F0=(S0-I)erT
• where S0-I is the dividend adjusted
underlying asset price and arbitrage
activities force the relation to hold
Known Yield
For some securities, like stock
indices, it is easier and more
common to denote with a yield the
income they pay.
Assume that the yield is paid at an
annual rate of q, continuously
compounded (q is a proportion of S0)
Thus, we can use the same no-
arbitrage arguments to find the
forward price.
No Arbitrage… with Known Yield
Instead of subtracting the income
from S0, we reduce S0 by adjusting
it for the dividend yield
S0e- q T
It can be shown that, if there is
no arbitrage, for assets paying a
dividend yield of q
F0 = S0e- q T*erT =
S0e(r- q)T
Stock Index Futures/Forwards
Pricing
The previous formula applies to, for
instance, forwards written on stock
indices as a they are dividend-paying
assets
• Dividend is paid continuously with a
dividend yield rate of q p.a.
Currency Forwards Pricing
Notation:
• S0: price in local currency of one unit of
foreign currency. EX: 1.4 AUD per USD
• r: domestic interest rate with continuous
compounding
• rf: foreign interest rate with continuous
compounding
A foreign currency is analogous to a stock paying
a known dividend yield
The “yield” is rf
Currency Forwards Pricing
Recall that
F0=S0e(r- q)T
Replacing q by rf we can obtain the
forward/futures price on a foreign currency
F0 =S0e(r-rf)T
Also called Covered Interest Parity (CIP) in
International Finance
When r – rf < 0
• Futures price is less than the spot price, S0
When r – rf > 0
• Futures price is greater than the spot price, S0
Commodity Forward/Futures
Unlike financial instruments which
are designed for investment,
commodities can be held for either
immediate consumption or for
investment.
• Examples: pork bellies, gold, sugar,
crude oil, beef, wheat, corn, etc.
Let’s consider investment
commodities first
Gold Forward/Futures (and, more generally,
on investment commodities)
If there are no storage costs (SC),
then gold could be seen as an asset
paying no income.
Thus, the futures price is F0 = S0erT
If there are storage costs, they can be
regarded as negative income. If U is
the PV(SC) incurred during the life of
the contract and we replace I by –U in
the previous expressions, then:
F0 = (S0+U)erT
(Investment) Commodity Futures
Example
A futures contract is written on gold.
The maturity of the contract is one
year and the storage cost is $2/oz
per year. The payment will be made
at the end of the year. The spot
price is $1500 and the risk free rate
is 1% per annum.
What is the no-arbitrage futures
price?
(Investment) Commodity Futures
Example (cont’d)
First we need to find U
• U = 2e-0.01(1) = 1.980
Then the (theoretical?) futures price
is:
• F0 = (S0+U)erT = (1500+1.980)e0.01(1)
• F0 = 1517.08
Notice that U is a known dollar cost
Gold Forward/Futures (and, more generally,
on investment commodities)
Storage costs can also be seen as a
negative dividend yield.
Denote storage costs with ‘u’
Conceptually, we can replace q with
–u
Then
F0= S0e(r+u)T
Notice tha t u is a known cost,
expressed as a proportion of S0
Futures/Forwards on Consumption
Commodities
If F0>(S0+U)erT
Borrow S0 + U, buy commodity spot, short
futures ….equality
If F0<(S0+U)erT
Sell commodity spot (to save storage cost),
invest at risk-free rate, long futures
But market participants holding commodity
for consumption are reluctant to sell
F0<=(S0+U)erT (limited arbitrage)
Convenience Yield
The previous concept is related to the
convenience yield: i.e., the benefit from
holding the physical asset
In formulas, c.y. is defined as the rate y
such that
F0eyT = (S0+U)erT
or
F0eyT=S0e(r+u)T
The greater the expectation of shortage
the higher y (check level of inventories)
y=0 for investment assets
Note: y is generally not directly observable in the
market but it is implied in the formulae above
Cost of Carry
We can simplify and summarize our
discussion using the cost of carry
concept
Cost of carry is equal to:
The storage cost
Plus any interest paid to finance the asset
Less any income earned on the asset
Cost of Carry
For a non-dividend paying stock, c = r
For a dividend-paying stock, c = r- q
For a currency, c = r – rf
For a commodity, c = r + u
Thus, for any investment asset, the forward
price is:
F0 = S0ecT
For any consumption asset
F0 = S0e(c-y)T
Time 0 and Time t
All previous arbitrage examples assumed
that actions were taken at time t=0
But everything conceptually holds at any
time t during the life of the contract
All previous pricing formulas hold at
each time t between contact inception
(t=0) and contract expiration (t=T)
General formula: Ft = Ste(c-y)(T-t)
Forward vs. Futures Prices
Thus far we have looked at the pricing of
forward contract by no arbitrage and
ignored daily settlements
At first glance, futures prices ought to
differ from forward prices as the cash flow
stream differs between the two
More specifically, with futures gains earn
interest and losses need to be financed
However, it turns out that forward and
futures price may not differ by any
appreciable amount
Relation between Forwards &
Futures Prices
Specifically, when interest rates are constant, or
change in a deterministic way, or are
uncorrelated with spot / forward / futures prices
forward and futures prices are the same
It can be shown mathematically, assuming (quite
realistically…) that on a daily basis futures prices
are unpredictable (random walk)
At the intuitive level, accrued interest (on gains)
and financing costs (on losses) tend to offset
each other the more they offset each other,
the more a futures looks like a forward
As interest rates change over time in an
unpredictable (random, stochastic) way, there
may be a divergence between forward and
futures prices
Relation between Forwards &
Futures Prices
If the underlying asset price is positively correlated
with interest rates, futures prices tend to be higher
than forward prices (long position is ‘better off’ with
futures).
If the underlying asset price is negatively correlated
with interest rates, futures prices tend to be lower
than forward prices (long position is better off with
forwards).
If the underlying asset price is uncorrelated with
interest rates (like, e.g., when interest rates are
constant) futures and forward prices tend to be very
close
If the maturity is only a few months, the difference
between the two prices is very small even if interest
rates are correlated with spot prices.
Relation between Forwards &
Futures Prices
Other factors such as taxes,
transaction costs and default risk
may create a divergence between
forward and futures prices.
In general, we will continue to
assume that forward and futures
prices are, in most situations, equal
or almost so.
Futures (Forward) Curves
Curve is the relation between time-to-maturity (x –
axis) and futures price (y-axis)
Upward sloping (or, normal)
Downward sloping (or, inverted)
In the industry (and financial press), slope of curve
often “confused” with contango/backwardation
Contango and Backwardation (again)
Normal Backwardation: F below expected S.
Normal Contango: F above expected S
In the industry, the two concepts (‘Bw’ & ‘Cn’) define
the relation between F and current S. So:
• F<S (i.e., positive basis) ‘Backwardation’
• F>S ‘Contango’
With the “industry” definition
• ‘Cn’ corresponds to an upward sloping (or, normal) futures
curve (futures prices above the current spot price S0)
• ‘Bw’ corresponds to a downward sloping (or, inverted) futures
curve (futures prices below the current spot price S0)
Contango and Backwardation (again)
Just terminology….
https://www.youtube.com/watch?v=o2X_XNdmWws
To summarize:
• Contango: S0 < F0(T)
• Normal Contango: E(ST) < F0(T)
• Backwardation: F0(T) < S0
• Normal Backwardation: F0(T)<E(ST)
Contango and Backwardation
Commodities can be in “industry” contango
(negative basis), yet be in normal backwardation
• EX: S0 = $30, E(ST) = 34, F0 = 32.
• Market is in “N.B.” but curve is upward sloping, i.e.,
basis is <0 [ since S0 < F0(T)]
Similarly, we can have a commodity in “industry”
backwardation (positive basis) and, at the same
time, in normal contango
Part of the reason for the industry shortcut (or,
for the confusion) is that E(ST) is unobservable
(not on traders’ screen) but S0 is observable.
Less confusing to use “basis” or “slope of curve”
for observed prices
Contango and Backwardation
Once we are clear about the terminology, the
more substantial issues are:
1. What affects the slope of the curve (and,
hence, the basis)?
2. Does the slope of the curve contain relevant
information for (i.e., predict) future prices (S
and F)? - i.e., is it useful to investors (hedgers
and/or speculators) ?
Slope of Curve and Future Returns
An upward- or downward-sloping term
structure of futures prices creates the
possibility of roll return (or, roll yield)
on futures positions.
Beware: those return are not
guaranteed
Slope of Curve and Roll Yield
EX:WTI Futures as of May 2004
FJuly 2004 =$40.95 FJuly 2005= $36.65
You could, in May 2004, go long the July 2005 contract
and hold the position for one year, then roll it over
IF the term structure of oil remained unchanged
between May 2004 and May 2005….
The roll return (“rolling down the curve”) would have
been $40.95/$36.65 – 1= 11.7%
Similar examples can be constructed for shorting
futures on normal curve
In actuality, the curve may shift
Total Return on futures may differ from hypothetical
roll return
Beware of paper roll returns!
Slope of Curve and Future Returns
For investment assets slope of curve
simply reflects cost of carry
• if c>0 upward sloping
Slope does not necessarily predict
future prices or returns (spot or
futures).
Slope of Curve and Future Returns
For consumption assets (and gold…), curve is
inverted if c<y (as seen earlier)
Economically, y should decline as inventory
increases
Curve may have predictive power as it tells us
about conv. yield and, hence, about
probability of shortages through the inventory
channel
More generally, (slope of ) curve may tell us
about fundamentals (demand and supply)
Conv. yield and/or basis (slope of curve) are,
indeed, used as trading signals by some
But remember: it’s like predicting stock returns!
