1

Chapter 3. Pricing Forwards and Futures I:

The Basic Theory
• Outline
2

1. Introduction
2. Pricing Forwards by Replication
3. Numerical Examples
4. Currency Forwards
5. Stock Index Forwards
6. Valuing Forwards
7. Forward Pricing: Summary
8. Futures Pricing
• Objectives
3

This chapter introduces students to the pricing of

derivatives using no-arbitrage considerations.
Key points:
[Link] cost-of-carry method of pricing
forward contracts.
[Link] role of interest rates and holding
costs / benefits in this process.
[Link] valuation of existing forward contracts.
• The Forward Price
4

Forward price: The delivery price that makes the

forward contract have "zero value" to both parties.
How do we identify this zero-value price?
Combine
The Key Assumption: No arbitrage
with
The Guiding Principle: Replication.
5

Pricing Forwards by Replication

• The Key Assumption: No Arbitrage
6

Maintained Assumption: Market does not permit

arbitrage.
What is "arbitrage?"
A profit opportunity which guarantees net cash
inflows with no net cash outflows.
Such an opportunity represents an extreme form of
market inefficiency where two identical securities (or
baskets of securities) trade at different prices.
Assumption is not that arbitrage opportunities can
never arise, but that they cannot persist.
• The Guiding Principle: Replication
7
Replication: Fundamental idea underlying the pricing of all
derivative securities.
The argument:
 Derivative's payoff is determined by price of the underlying
asset.
 So, it "should" be possible to recreate (or replicate) the
derivative's pay offs by directly using the spot asset and,
perhaps, cash.
 By definition, the derivative and its replicating portfolio
(should one exist) are equivalent.
 So, by no-arbitrage, they must have the same cost.
 Thus, the cost of the derivative (its so-called "fair price") is
just the cost of its replicating portfolio, i.e., the cost of
manufacturing its outcomes synthetically.
• Replicating Forward Contracts
8

Forward contracts are relatively easy to price by

replication.
Consider an investor who wants to take a long forward
position.
Notation:
S : current spot price of asset.
T : maturity of forward contract (in years).
F : forward price for this contract (to be determined).
We will let 0 denote the current date, so T is also the
maturity date of forward contract.
• Replicating Forwards
9

At maturity of the contract, the investor pays $F and

receives one unit of the underlying.
To replicate this final holding:
Buy one unit of the asset today and hold it to
date T.
Both strategies result in the same final holding of
one unit of the underlying at T.
So, viewed from today, they must have the same
cost.
What are these costs?
• Cost of Forward Strategy
10

The forward strategy involves a single cash outflow

of the delivery price F at time T
So, cost of forward strategy: PV (F ).
• Cost of Replicating Strategy
11

To replicate, we must

Buy the asset today at its current spot price S.
"Carry" the asset to date T. This involves:
Possible holding/carrying costs (storage,
insurance).
Possible holding benefits (dividends,
convenience yield).
Let
M = PV (Holding Costs) — PV (Holding
Benefits).
Net cost of replicating strategy: S + M.
• The Forward Pricing Condition
12

By no-arbitrage, we obtain the fundamental forward

pricing condition:

Solving this condition for F, we obtain the unique forward price

consistent with no-arbitrage.
• Violation of this Condition  Arbitrage
13

 If PV (F ) > S + M, the forward is overvalued relative to spot.

Arbitrage profits may be made by selling forward and
buying spot.
"Cash and carry" arbitrage.
Forward contract has positive value to the short, negative
value to the long.
 If PV (F ) < S + M, the forward is undervalued relative to spot.
Arbitrage profits can be made by buying forward and
selling spot.
"Reverse Cash and carry" arbitrage.
The contract has positive value to the long and negative value
to the short.
• Determinants of the Forward Price
14

The forward price is completely determined by three

inputs:
Current price S of the spot asset.
The cost M of "carrying" the spot asset to date T.
The level of interest rates which determine present
values.
This is commonly referred to as the cost-of-carry method
of pricing forwards.
Two comments:
Forward and spot prices are tied together by arbitrage:
they must move in "lockstep."
To what extent then do (or can) forward prices embody
expectations of future spot prices?
• Pricing Formulae I: Continuous Compounding
15

 Fundamental pricing equation: PV (F) = S + M.

 Let r be the continuously-compounded interest rate for horizon
T.
 So PV (F ) = e —rT F.
 Therefore, e —rT F = S + M, so

 When there are no holding costs or benefits (M = 0),

• Pricing Formulae II: Money-Market Convention
16

Let ℓ denote the T -year rate of interest in the money-

market convention (Actual/360).
If d is the actual number of days in the horizon, then

 Therefore,
• Numirical Example 1
17
Consider a forward contract on gold. Suppose that:
Spot price: S = $1, 140/ oz.
Contract length: T = 1 month = 1/12 years.
Interest rate: r = 2.80% (continuously compounded).
No holding costs or benefits.

 Then, from the forward pricing formula, we have

Any other forward price leads to arbitrage.

If 1160 > 1, 142.66, sell forward and buy spot.
If F < 1, 142.66, buy forward and sell spot.
• Arbitrage with an Overpriced Forward
18
 Suppose that F = 1, 160, i.e., it is overpriced by 17.34.
 Arbitrage strategy:
1. Enter into short forward contract.
2. Buy one oz. of gold spot for $1,140.
3. Borrow $1,140 for 3 month at 2.80%.
• Arbitrage with an Underpriced Forward

•
19
Suppose that F = 1, 125, i.e., it is underpriced by $17.66.
 Arbitrage strategy:
1. Enter into long forward contract.
2. Short 1 oz. of gold.
3. Invest $1,140 for one month at 2.80%.
• Holding Costs and/or Benefits
20

 Holding costs are often non-zero.

 With equities or bonds, there are often holding benefits
such as dividends or coupons.
 With commodities, there are often holding costs such as
storage and insurance.
 Such interim cash flows affect the total cost of the replication
strategy and should be taken into account in pricing.
 Our second example deals with such a situation.
• Numerical Example 2
21

 Consider a forward contract on a bond.

 Suppose that:
 Spot price of bond: S = 95.
 Contract length: T = 6 months.
 Interest rate: r = 10% (continuously compounded)
for all maturities.
 Coupon of $5 will be paid to bond holders in 3
months.
 What is the forward price of the bond?
• Example 2: The Forward Price
22

 The coupon is a holding benefit.

 So M is minus the present value of $5 receivable in 3 months:

 Thus, the arbitrage-free forward price F must satisfy

so 95 – 4.877 = 90.123

 Any other forward price leads to arbitrage.

=e-^(0.1 x .25) = 0.975x5= 4.877

95 - 4.877 = 90.123 x e ^(0.1 x 0.5) = 94.74

e^(0.1 x .25) = 1.025 x 4.877 = 5

• Arbitrage with an Overvalued Forward
23

 For example, suppose F = 98 – 94.74 = 3.26

 Then, the forward is overvalued relative to spot, so we want
to sell forward, buy spot, and borrow.
 Buying and holding the spot asset leads to a cash outflow of
95 today, but we receive a coupon of 5 in 3 months.
 There are may ways to structure the arbitrage strategy. Here
is one. We split the initial borrowing of 95 into two parts,
with
 one part repaid in 3 months with the $5 coupon, and
 the balance repaid in six months with the delivery price
received on the forward contract.
• The Arbitrage Strategy
24

 So the full arbitrage strategy is:

 Enter into short forward with the delivery price of 98.
 Buy the bond for 95 and hold for 6 months.
 Finance spot purchase by
 borrowing 4.877 for 3 months at 10% = 5
 borrowing 90.123 for 6 months at 10%. = 94.74
 In 3 months:
 receive coupon $5
 repay the 3-month borrowing.
 In 6 months:
 deliver bond on forward contract and receive $98
 repay 6-month borrowing.
• Cash Flows from the Aribtrage
25

 Question: What is the arbitrage strategy if F = 91.50?

26

Currency Forwards
• Forwards on Currencies & Related Assets
27
Forwards on currencies need a slightly modified argument.
For example, suppose you want to be long £1 on date T.
Two strategies:
Forward contract: Pay $F at time T, receive £1.
Replicating strategy: Buy £x today and invest it to T, where
x = PV (£1).
PV(£1) is the amount that when invested at the sterling
interest rate will grow to £1 by time T. (4%, T = 3 months)
PV = e ^- (0.04 x .25) = 0.99 FV = e^(0.04 x 0.25) = 1
The "£" inside the PV expression is to emphasize that
present values are being taken with respect to the £
interest rate.
• Currency Forwards: Replication Costs
28

Cost of the forward strategy in USD:

PV ($ F ) = F x PV ($1).
Cost of the spot (or replicating) strategy in USD:
S x PV (£1)
As usual, S denotes the spot price of the
underlying in USD.
Here, the underlying is GBP, so S is the spot
exchange rate ( $ per £).
• Currency Forwards: The General Pricing Expression
29

By no-arbitrage, we must have

S x PV (£1) = F x PV ($1).

Solving we obtain the fundamental forward pricing

expression for currencies:
• Currency Forwards with Continuous Compounding
30

Let r represent the T-year USD interest rate and d the T-year
GBP
interest rate, both expressed in continuously-compounded
terms.
Then, PV ($ 1) = e—rT and PV (£1) = e—dT .
Using these in the general currency forward pricing expression
and simplifying, we obtain
• Currency Forwards in the Money-Market Conventions
31

ℓ ($): T-year USD interest rate (ACT/360).

ℓ (£): T-year GBP interest rate (ACT/365).
Then:
• Example 3
32 Data:
Foreign currency: GBP
Spot exchange rate S (USD per GBP): 1.63146
Contract length T : 3 months = 90 days.
3-month USD Libor rate: ℓ ($) = 0.251%
3-month GBP Libor rate: ℓ (£) = 0.610%
Therefore, the unique arbitrage-free forward price is:
• Undervalued Forward
33

 Suppose we had F = $1.60/£. Comparing to $1.63146 / £

 Then, the forward is undervalued relative to spot, so we
want to buy forward, sell spot, and invest.
 Long forward contract to buy £1 for $1.60 in 3 months.
 Short PV(£1). That is:
 Borrow PV(£1) = £0.9985 for 3 months at 0.61%.
FV 0.9985 x e^0.0061 x 0.25 = 1
 Sell £0.9985 for $ at the spot rate of $1.63146/£.
 Invest the proceeds for 3 months at 0.251%.
 In 3 months:
 Pay USD 1.6000 and receive GBP 1 from the forward.
 Repay GBP borrowing. 1.63146 – 1.6 = 0.03146
• Currency Forwards: Exercise
34

 Suppose you are given the following data (from 15-Jan-2010):

 Spot USD/GBP exchange rate = $1.6347/£.
 Spot USD/EUR exchange rate = $1.4380/€.
 1-month Libor rates:
USD: 0.2331% (Actual/360)
GBP: 0.5175% (Actual/365)
EUR: 0.3975% (Actual/360)
 What are the 1-month USD/GBP and USD/EUR forward rates?
 Actual 1-month forward rates on 15-Jan-2010:
 USD/GBP: $1.62438/£.
 USD/EUR: $1.43786/€.
Question:
35

•Suppose that the three-month interest rates in Norway and

the US are, respectively, 8% and 4%. Suppose that the spot
price of the Norwegian Kroner is $0.155.
•Calculate the forward price for delivery in three months.

F = e ^ (0.04 – 0.08) x .25 = 0.99 x 0.155 = 0.153

36

Stock Index Forwards

• Stock Index Forwards
37

 We can also price forwards on stock indices using this approach.

 A stock index is essentially a basket of a number of stocks.
 If the stocks pay dividends at different times, we can
approximate the dividend payments well by assuming they
are continuously paid.
 Dividend yield on the index plays the role of the variable d in
the formula.
 Literally speaking, the idea of continuous dividends is an
unrealistic one, but, in general, the approximation works very
well.
 Computationally, much simpler than calculating cash value of
dividend payments expected over contract life and using the
known-cash-payouts formula.
• Example 4: Index Forwards
38

 Data:
 Current level of S&P index: 1,343
 One-month interest rate (continuously-compounded):
2.80%
 Dividend yield on the S&P 500: 1.30%
 What is the price of a one-month (= 1/12 year) futures
contract?
 In our notation: S = 1343, r = 2.80%, d = 1.30%, and T =
1/12.
 So the theoretical futures price is
39

Valuing Forwards
• Valuing Existing Forwards
40

Consider a forward contract with delivery price K that was

entered into earlier and now has T years left to maturity.
What is the current value of such a contract?
We answer this question for the long position.
The value of the contract to the short position is just the
negative of the value to the long position.
So suppose we are long the existing contract.
Suppose also that the current forward price for the same
contract (same underlying, same maturity date) is F.
• Offsetting the Existing Forward
41

 Consider offsetting the existing long forward position with a

short forward position in a new forward contract.
 Original portfolio:
 Long forward contract with delivery price K and
maturity T.
 New portfolio:
 Long forward contract with delivery price K and
maturity T.
 Short forward contract with delivery price F and
maturity T.
 Value of original portfolio = Value of new portfolio (why?).
• Valuation by Offset
42

 What happens to the new portfolio at maturity?

Physical obligations in the underlying offset.
Net cash flow: F — K.
 So new portfolio - certainty cash flow of F — K at time T.
 This means: Value of New Portfolio = PV (F — K ).
 Therefore:
Value of Long Forward = PV (F — K ).
and
Value of Corresponding Short Forward = PV (K — F ).
• Valuing Forwards: Summary
43

 Data:
 Given forward contract: delivery price K, maturity date T.
 Current forward price for same contract: F.
 Valuations:
 Value of long forward: PV (F — K ).
 Value of short forward: PV (K — F ).
 Intuition?
• Example 5: Valuing Existing Forwards
44

You enter into a forward contract to sell 10,000 shares of

Dell stock in 3months' time at a delivery price of $25.25.
A month later:
The price of Dell is $25.40. The two-month rate of
interest at this point is 4.80% (money-market
convention). There are 61 days in the two-month
period.
Dell is not expected to pay any dividends over the next
two months.
What is the value of the contract you hold?
• Example 5: The Steps Involved
45

 To answer this question, we proceed in two steps:

1. Identify the forward price F today for delivery in two
months.
2. Use F together with the locked-in price K = 25.25 to
identify the value of the forward contract.
• Example 5: The Forward Price
46

Since there are no dividends, the forward price must satisfy PV (F

) = S.
This means

• or
• Example 5: The Contract Value
• 47

 Since you are short the forward, the value of the forward contract is

PV (K − F ) = PV (−0.36) = −PV (0.36).

 Using the 2-month interest rate of 4.80%, this present value is

 Over 10,000 shares, therefore, the value of the contract is

10,000 × −0.3571 = −3,571

48

Forward Pricing: Summary

• Forward Pricing: Summary
49

 A forward contract is a commitment by buyer and seller to take part in a

fully specified future trade.
 The commitment to the trade makes forward payoffs linear.
 The forward price is that delivery price that would make the contract
have zero value to both parties at inception.
 The forward price can be determined by replication, and depends on the
cost of buying and "carrying" spot.
 The value of a forward contract is the present value of the difference
between the locked-in delivery price on a contract and the current forward
price for that maturity.
50

Futures Pricing
• Pricing Futures: Considerations
51

 Analytical valuation of futures contracts difficult for two reasons:

1. Delivery options provided to the short position.
2. Margining which creates uncertain interim cash flows.
 These features will have an impact on futures prices compared to another
wise identical forward contract.
 The question is: how much of an effect? Is it quantitatively significant?
• Delivery Options
52

 Consider delivery options.

 Such options make the futures contract
more attractive to the seller (the short position)
less attractive to the buyer (the long position).
 Thus, other things being equal the futures price must be lower than the
forward price on this account.
 How much lower? That is, how economically valuable is the delivery option?
• Delivery Options
53

 The delivery option is provided primarily to guard against squeezes.

 However, provision of the delivery option degrades the quality of the hedge.
 Intuitively, the more valuable this option, the greater this uncertainty, and
the more the hedge is degraded.
 Thus, we would expect that in a successful futures contract, the delivery
option does not have much economic value.
 Empirical studies support this position: One study of the T-Bond futures
contract, for example, found that the option was worth around $430 even
with 6 months left to maturity.
• Margin Accounts
54

 What about margin accounts?

 These create interim cash flows which earn interest at possibly uncertain
rates.
 Thus, the quantitative impact will depend on
how cash flows into the margin account occur (i.e., how futures prices
change)
how interest rates change when futures prices change (i.e., the
correlation between interest rate changes and futures price changes).
 Once again, in a successful futures contract, our expectation would be that
this impact would be quantitatively small.
• Margin Accounts
55

 Best "laboratory" for testing the effect: currency contracts, where no

delivery options exist.
 One study reported that difference in forward and futures prices were
smaller than the bid-ask spread in the currency market.
• Futures Pricing: Summary
56

 Identifying futures prices analytically is complicated by

delivery options
margin accounts
 It is possible to take these factors into account and develop a full pricing
theory for futures.
 However, both theory and empirical evidence point to only a small effect
especially for short-dated contracts.
 Given this, we treat futures and forward prices in the sequel as if they were
the same.