Forward

Risk management applications of
forward strategies
Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
Email: maithuhien712@yahoo.com
Web: http://web.ftu.edu.vn/maithuhien/
Outline
• Introduction to forward
• Forward pricing and valuing
• Risk management using forward strategies
INTRODUCTION TO FORWARD
1
Forward contract
• A forward contract is an agreement between two parties in
which one party, the buyer, agrees to buy from the other
party, the seller, an underlying asset at a future date at a
price established at the start of contract.
• The parties to the transaction specify the forward
contract‘s terms and conditions. In this sense, the contract
is said to be customized. Each party is subject to the
possibility that the other party will default.
• The holder of a long forward contract (the long) is
obligated to take delivery of the underlying asset and pay
the forward price at expiration. The holder of a short
forward contract is obligated to deliver the underlying asset
and accept payment of the forward price at expiration.
4
Forward contract
• The forward contract hedge locks in a price

• Neither party pays any money at the start
Delivery and settlement of

a forward contract
• When a forward contract expires, two possible
arrangements that can be used to settle the obligations of
the parties:
 Delivery (the participants engage in delivery of the asset): the long
will pay the agreed-upon price to the short, who in turn will deliver
the underlying asset to the long (a deliverable forward contract).
 Cash settlement (the participants settle the cash equivalent):
permits the long and the short to pay the net cash value of the
position (F-St) on the delivery date (a cash-settled forward contract
or nondeliverable forwards NDFs).
F
Buyer (the long) Seller (the short)
6
Underlying
2
Termination of a forward contract
• Until the contract expires
• Prior to expiration: Assume that the contract calls for delivery rather
than cash settlement at expiration
‒ Enter another forward contract at opposite position expiring at the same time as
the original forward contract (because of price changes in the market during the
period since the original contract was created, this new contract would likely have
a different price). The company may have credit risk if the counterparty on the
long or the short contract fails to pay.
‒ To avoid credit risk, the company contacts the same counterparty with whom
they engaged the original contract. They could agree to cancel both contracts,
the company receives $2. This termination is desirable for both parties because it
eliminates the credit risk. If the initial counterparty is a bank, the company
requests, at the start, that its initial contract be offset and the bank will charge a
fee (= F0 - F1). Note that it is possible that the company might receive a better
price from another counterparty. If that price is sufficiently attractive and the
companty does not perceive the credit risk to be too high, it may choose to deal
with the other counter party. Long 3 months (40$)
F0 F1 Short 2 months (42$) 7
Payoff of forward contract

P↑→ the buyer wins P↑→ the seller looses
Profit (Payoff) Profit
Price of Price of
underlying underlying
at maturity ST at maturity ST
Long Position Short Position

Payoff = ST - F Payoff = F - ST
FORWARD PRICING AND

VALUING
3
Measuring interest rate
When we compound m times per year at rate r an
amount A grows to A(1+r/m)m in one year
Compounding frequency Value of $100 in one year at 10%

Annual (m=1) 110.00(= 100x1.1)
Semiannual (m=2) 110.25(= 100x1.05x1.05 = 100x1.052)
Quarterly (m=4) 110.38(= 100x1.0254)
Monthly (m=12) 110.47
Weekly (m=52) 110.51
Daily (m=365) 110.52
Options, Futures, and Other

Derivatives 8th Edition, Copyright 10
© John C. Hull 2012
Measuring interest rate

m: compounding frequency
A: an amount invested for T years
V: an amount at expiration
r: interest rate per annum
T: years
• Discrete interest formula
 Annually compounded: V = A(1+r)T
 m times per annum compounded (annually m=1, semiannually m=2,
quarterly m=4, monthly m= 12, weekly m = 52, daily m = 360 if
LIBOR-style rate or m=365 if non-LIBOR-style rate): V = A(1+r/m)mT
• Continuous compounding interestm formula: m→∞
 r 
 V = AerT because e r  lim 1  
m 
 m
Continuous Compounding
(Page 79)
• In the limit as we compound more and more

frequently we obtain continuously compounded
interest rates
• $100 grows to $100erT when invested at a
continuously compounded rate r for time T
• $100 received at time T discounts to $100e-rT at time
zero when the continuously compounded discount
rate is r

4
Conversion Formulas (Page 79)
Define
rc : continuously compounded rate
rm: same rate with compounding m times per year
mT
 r 
Ae rcT  A1  m 
 m
 rm 
rc  m ln 1  
 m

rm  m e rc / m  1 
Note: y = lnx  ey =x
Derivatives 8th Edition, Copyright
13
Examples
• 10% with semiannual compounding is equivalent to

2ln(1 + 10%/2) = 9.758% with continuous compounding
• 8% with continuous compounding is equivalent to
4(e0.08/4 -1) = 8.08% with quarterly compounding
• Rates used in option pricing are nearly always
expressed with continuous compounding

Conversion Formulas
• Yield calculation
y = (cash flow from investment/amount invested) 1/n – 1
Where n: number of periods until the cash flow will be received
y: the yield on investment
• Annualizing yield:
Effective annual yield = (1 + periodic interest rate) m – 1
Where m is frequency of payment per year
Periodic interest rate = (1 + Effective annual yield) 1/m – 1
5
Example
• Yield: 6,805.82(1+y)5 = 10,000
 (1+y)5 = 10,000/6,805.82 = 1.46933
 1+y = 1.469331/5
 y = 8% that is the interest rate that will make
USD6,805.82 grow to USD10,000 in 5 years
• Annual interest is 8%
 Periodic yield is 4% (interest is paid semiannually)
 effective annual yield = (1.04) 2 – 1 = 8.16%
Consumption vs Investment Assets
• Investment assets are assets held by significant

numbers of people purely for investment purposes
(Examples: gold, silver)
• Consumption assets are assets held primarily for
consumption (Examples: copper, oil)

Derivatives, 8th Edition, 17
Copyright © John C. Hull 2012
Short Selling
• Short selling involves selling securities you do not own

• Your broker borrows the securities from another client
and sells them in the market in the usual way

6
Short Selling
• At some stage you must buy the securities so

they can be replaced in the account of the client
• You must pay dividends and other benefits the
owner of the securities receives
• There may be a small fee for borrowing the
securities
Options, Futures, and Other 19

Derivatives, 8th Edition,
Example
• You short 100 shares when the price is $100 and close
out the short position three months later when the price
is $90
• During the three months a dividend of $3 per share is
paid
• What is your profit?
• What would be your loss if you had bought 100 shares?

Forward pricing and valuing

• A forward contract is priced by assuming that the underlying assets is
purchased, a forward contract is sold, and the position is held to
expiration. Because the sale price of the asset is locked in as the
forward price, the transaction is risk free and should earn the risk-free
rate. The forward price is then obtained as the price that guarantees
a return of the risk-free rate.
• If the forward price is too high or too low, an arbitrage profit in the
form of a return in excess of the risk-free rate can be earned. The
combined effects of all investors executing arbitrage transactions will
force the forward price to converge to its arbitrage-free level.
• The value of a forward contract is determined by the fact that a long
forward contract is a claim on the underlying asset and a commitment
to pay the forward price at expiration. The value of a forward contract
is, therefore, the current price of the asset less the present value of
the forward price at expiration. Because no money changes hands at
the starts, the value of the forward contract today is zero. The value
of a forward contract at expiration is the price of the underlying asset
minus the forward price.
7
Forward pricing
Forward price: Example
• Suppose that the spot price of gold is $1000 per ounce

and the risk-free interest rate for investments lasting one
year is 5% per annum. What is a reasonable value for
the one-year forward price of gold?
• Suppose first that the one-year forward price is $1300
per ounce. A trader can immediately take the following
actions:
1. Borrow $1000 at 5% for one year.
2. Buy one ounce of gold.
3. Enter into a short forward contract to sell the gold for
$1300 in one year
Example
• Like in time value of money concept, when continuous
compounding is the assumption, the interest rate formula
becomes: i  e rT
Where e = 2.71828
• Forward price for a non-dividend paying asset is
F  So e rT
8
An Arbitrage Opportunity?
• Suppose that:
– The spot price of a non-dividend-paying stock is $40
– The 3-month forward price is $43
– The 3-month US$ interest rate is 5% per annum
• Is there an arbitrage opportunity?

Another Arbitrage Opportunity?

• Suppose that:
– The spot price of nondividend-paying stock is $40
– The 3-month forward price is US$39
– The 3-month US$ interest rate is 5% per annum
• Is there an arbitrage opportunity?

Forward price
(generalization, continuous compounding)
An asset with no income has spot price S0 today, T is time to

maturity, r is risk-free rate for time T, F0 is forward price:
F0 = S0erT
or S0 is the current value of F0, where S0 = F0e-rT
Exp: S0 = 40, T = 0.25, r = 0.05  F0 = 40e0.05×0.25 = 40.50
• F0 > S0erT , arbitrageur can buy the asset and short forward
contracts on the asset (borrows S0 dollars at r for T years,
buys 1 unit of asset, shorts a forward contract in 1 unit of
asset at F0).
• F0 < S0erT , arbitrageur can short the asset and enter into
long forward contracts on the asset (sell short the asset for
S0 dollars, invest S0 at r for T years, longs a forward
contract to buy the asset for F0). 27
9
Example
• Consider a four-month forward contract to buy a zero-

coupon bond that will mature one year from today. The
current price of the bond is USD930 (This means that
the bond will have eight months to go when the forward
contract matures.) Assume that the rate of interest
(continuously compounded, month/12) is 6% per annum.
When an Investment Asset Provides

a Known Income
F0 = (S0 – I )erT
where I is the present value of the income during
life of forward contract

Example
• Consider a 10-month forward contract on Nishat Mills Ltd

(NML) stock with a price of USD50. Assume that the
risk-free rate of interest (continuously compounded,
month/12) is 8% per annum for all maturities. Also
assume that dividends of is USD0.75 per share are
expected after three months, six months, and nine
months.
10
When an Investment Asset
Provides a Known Yield
• We consider the asset underlying a forward contract
provides a known yield rather than a known cash. This
means that the income is known when expressed as a
percentage of the asset price at the time the income is
paid.
F0 = S0 e(r–q )T
where q is the average yield during the life of the
contract (expressed with continuous compounding)

Example
• Consider a 6-month forward contract on an asset that is

expected to provide income equal to 2% of the asset
price once during a 6-month period. The risk-free rate of
interest is 10% per annum (continuously compounded).
The asset price is $25.
Stock Index
• A stock index can be viewed as an investment asset
paying a dividend yield.
• The investment asset is the portfolio of stocks underlying
the index. The dividend paid by the investment asset are
the dividends that would be received by the holder of this
portfolio.
• The dividends provide a known yield rather than a
known cash income.
• The futures price and spot price relationship is therefore
F0 = S0 e(r–q )T
where q is the average dividend yield on the portfolio
represented by the index during life of contract

11
Stock Index
• For the formula to be true it is important that the index

represent an investment asset
• In other words, changes in the index 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 (See Business
Snapshot 5.3, page 113)

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 1,300, and that the continuously
compounded risk-free interest rate is 5% per annum.
Index Arbitrage
• When F0 > S0e(r-q)T an arbitrageur buys the stocks

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

12
Index Arbitrage
• Index arbitrage involves simultaneous trades in futures

and many different stocks
• Very often a computer is used to generate the trades
• Occasionally simultaneous trades are not possible and
the theoretical no-arbitrage relationship between F0
and S0 does not hold (see Business Snapshot 5.4 on
page 114)

Futures and Forwards on Currencies
• A foreign currency is analogous to a security providing

a yield
• The yield is the foreign risk-free interest rate
• It follows that if rf is the foreign risk-free interest rate
( r rf ) T
F0  S0e

Explanation of the Relationship

Between Spot and Forward
1000 units of
foreign currency
(time zero)
r T
1000 e f units of
foreign currency 1000S0 dollars
at time zero
at time T
r T
1000 F0 e f 1000S0erT
dollars at time T dollars at time T
1000erfT F0 = 1000S0erT
F0 = S0e(r - rf)T
Options, Futures, and Other Derivatives, 8th Edition, 39
13
Pricing forward rate using IRP
(discrete compounded)
1 i
JPY0 JPYn 1 + i   F  1 S  1  i : CIA
*

1 + i  = F  1 S  1  i : IP*
1S F
F 1 i 1 i
 F S
S 1  i* 1  i*

 F  S i  i* F S
 1  i * 
USD0 USDn
1  i*   i  i* 
S 1  i* S
i  i *  F  S  S
F S  S  i  i * 
Forward price for foreign currency

(discrete compounding)
F 1 r 1 r
 F S r, rf interest rate per annum
S 1  rf 1  rf
T
 1 r 
If F is T-year forward rate F  S  
1 r 
 f 
1 r
If F is one-year forward rate F S
1  rf
Example
Suppose that the 2-year interest rates in Australia and
the US are 5% and 7%, respectively, and the spot
exchange rate is USD0.62/AUD. What is arbitrage
opportunity if:
• The 2-year forward rate is 0.63
• The 2-year forward rate is 0.66
and the initial investment is AUD1000 or USD1000.
14
Forward price for investment commodities
Storage is Negative Income
• Commodities such as gold and silver, that are

investment assets, also have storage costs, which
can be treated as negative income.
F0 = S0 e(r+u )T
where u is the storage cost per annum as a percent
of the asset value.
Alternatively,
F0  (S0+U )erT
where U is the present value of the storage costs.

Example
• Consider a one-year futures contract on gold. Suppose

that it costs $2 per ounce per year to store gold, with the
payment being made at the end of the year. Assume that
the spot price is $450 and the risk-free rate is 7% per
annum for all maturities.
Forward price for investment commodities

• If F0 > (S0+U )erT : an arbitrageur can borrow S0+U at

the risk-free rate and use it to purchase one unit of
commodity and to pay storage cost; short a futures
contract on one unit of commodity; and make a profit of
F0 - (S0+U )erT at time T
• If F0 < (S0+U )erT : an arbitrageur can sell the
commodity, save the storage cost, and invest the
proceeds at the risk-free rate; long a futures contract;
and make a profit of (S0+U )erT - F0 at time T
• As arbitrageurs do so, the abovementioned equations
cannot hold for long time, we must have F0 = (S0+U )erT

15
Forward price for consumption commodities
• Commodities that are consumption assets usually provide

no income, but can be subject to significant storage costs.
• The argument of arbitrage cannot be used for a commodity
that is a consumption asset because individuals and
companies who own a consumption commodity usually
plan to use it in some way. They are reluctant to sell the
commodity in the spot market and buy forward or futures
contracts because these contracts cannot be used in
manufacturing process or consumed in some other way.
Thus the equation F0 = (S0+U )erT cannot hold.
• For a consumption commodity:
F0  (S0+U )erT
F0  S0e(r+u )T
Forward price for consumption commodities

• We do not necessarily have equality in F0  (S0+U )erT and

F0  S0e(r+u )T because users of a consumption commodity
may feel that ownership of the physical commodity provides
benefits that are not obtained by holders of a futures
contract
• The benefits from holding the physical asset are sometimes
referred to as convenience yield y provided by the
commodity.
• If the dollar amount of storage costs is known and has a
present value U, then the convenience yield on the
consumption asset, y, is defined so that: F0eyT (S0+U )erT
or the storage costs per unit are a constant proportion of the
spot price u, then F0eyT  S0e(r+u )T  F0 = S0e(r+u–y )T
Forward price
(cost of carry)
• The relationship between futures and spot prices can be

summarized in terms of the cost of carry, which measures
the storage cost plus the interest that is paid to finance the
asset less the income earned on the asset
F = S0 . (1+ carrying cost)T or F = S0 . e(carrying cost x T)
• Carrying cost c:
 For non-dividend-paying stock: cost of carry is r because there are no
storage cost and no income
 For a stock index: cost of carry is r – q because income is earned at
rate q on the asset
 For a currency: : cost of carry is r – rf because currency is treated as
an asset has earned income at rate q = rf
 For a commodity: cost of carry is r – q + u because a commodity
provides income at rate q and requires storage costs at rate u
 For consumption asset: cost of carry must subtract convenience yield
y (-): F = S0e(c – y) x T
16
Forward vs Futures Prices
• When the maturity and asset price are the same, and the
short-term risk-free interest rate is constant, forward and
futures prices are, in theory, usually assumed to be equal.
(Eurodollar futures are an exception)
• When interest rates are uncertain, they are, in theory, slightly
different:
– A strong positive correlation between interest rates and the asset
price S implies the futures price is slightly higher than the forward
price: S↑→ i↑ (because of positive correlation) and the long of futures
contract makes an immediate gain. This gain will tend to be invested
at a higher average of interest rate. S↓→i↓ and the long of futures
contract incurs an immediate loss. This loss will tend to be financed at
a lower than average rate of interest rate. The holder of a forward
contract is not affected in this way. Hence a long futures contract will
be slightly more attractive than a similar forward contract.
– A strong negative correlation implies the reverse (the forward price is
49
slightly higher than the futures price)
Forward valuing
Valuing a Forward Contract

• A forward contract is worth zero (except for bid-offer
spread effects) when it is first negotiated
• Later it may have a positive or negative value
• Suppose that K is the delivery price for a contract that
was negotiated some time ago, F0 is the forward price
for a contract that would be negotiated today, and f is the
value of forward contract today
• At the beginning of the forward contract, K is set equal to
F0 and f is 0.
• As time passes, K stays the same because it is part of
the definition of the contract, F0 changes and f becomes
either positive or negative.
17
Valuing a Forward Contract
• By comparing the long forward contract with delivery
price F0 with an identical long forward contract with
delivery price of K, the difference between two contracts
is the amount that will be paid for the underlying asset at
time T (at expiration), which is F0 – K.
• F0 – K at time T is (F0 – K)e-rT today
• Thus we can deduce that:
– the value of a long forward contract, ƒ, is
(F0 – K )e–rT = S0 - Ke–rT
– the value of a short forward contract is
(K – F0 )e–rT = Ke–rT - S0

Forward price and forward value

(continuous compounding)
Forward value Forward price

No income f = S0 – Ke-rT F0 = S0erT
Known income
f = (S0 – I) – Ke-rT F0 = (S0 – I)erT
I = PV (present value)
Known yield q f = S0e-qT – Ke-rT F0 = S0e(r-q)T
Commodity f = S0e(u-y)T- Ke-rT F0 = S0e(r+u-y)T
K is delivery price for a contract that was negotiated some time ago.
f is the value of contract today.
F0 is forward price that would be applicable if we negotiated the contract today.
For commodity, storage costs u can be treated as negative income (storage costs
are all storage costs per annum as a proportion of the spot price on the asset).
y: convenience yield is the benefits from holding the physical asset.
The holder of crude oil must pay storage costs but receives convenience yield
deriving from the crude oil in inventory can be an input to the refining process.
Example
• A long forward contract on a non-dividend-paying stock

was entered into sometime ago. It currently has 6 moths
to maturity. The risk-free rate (continuous compounding)
is 10%/year, the stock price is 25USD, the delivery price
is 24USD.
18
Futures Prices & Expected Future Spot Prices
(Page 121-123)
• Suppose k is the expected return required by investors in

an asset (k depends on the systematic risk)
• We can invest F0e–r T at the risk-free rate and enter into a
long futures contract to create a cash inflow of ST at
maturity. The present value of this investment is:
- F0e–r T + E(ST)e–kT
• We assume that all investment in securities market are
priced so that they have zero net present value. This
shows that
F0e rT ekT  E (ST ) or F0  E (ST )e( r k )T

Futures Prices & Expected Future Spot Prices
No Systematic Risk: the returns k = r F0 = E(ST): the futures

from the asset are uncorrelated price is an unbiased
with the stock market, the discount estimate of the expected
rate k is the risk-free rate r future spot price
Positive Systematic Risk (stock k > r F0 < E(ST): the futures
indices) price is expected to
understate the expected
future spot price
Negative Systematic Risk (gold at k < r F0 > E(ST): the futures
least for some periods) price is expected to
overstate the expected
future spot price

Convergence of Futures to Spot

Contango: The futures price is above the expected future spot price.
Backwardation: The futures price is below the expected future spot price.
In normal backwardation, the futures prices are increasing
If hedgers tend to go long and If hedgers tend to go short and
speculators tend to go short, the speculators tend to go long, the
futures price will be above the futures price will be below the
expected spot price expected spot price
Futures
Spot Price
Price
Spot Price Futures
Price
Time Time
Arbitrage: Sell (short) a futures Arbitrage: Buy a futures

Buy the asset Sell (short) the asset
Make delivery Make delivery
 Futures price will fall  Futures price will rise
19
Forward pricing and valuing
(extra)
Generic pricing and valuation of

forward contracts
0 t T
today expiration
• S0: The price of underlying asset in the spot market at time 0
• St: The price of underlying asset in the spot market at time t
• ST: The price of underlying asset in the spot market at time T
• F0,T: The forward contract price initiated at time 0 and expiring at time T
• V0,(0,T): The value of the forward contract at time 0 when the contract is
initiated and expiring at time T.
• Vt,(0,T): The value of the forward contract at a point during the life of the
contract
• VT,(0,T): The value of the forward contract at expiration
59
Generic pricing a forward contract

0 T
Buy asset at S0 Hold asset and Deliver asset
Sell forward at F0,T lose interest on Receive F0,T
Outlay S0 outlay
• This transaction is risk free and should be equivalent to investing S 0

dollars in a risk-free asset that pays F0,T at time T. Thus, the amount
received at T must be the future value of the initial outlay invested at
the risk-free rate. For this equality to hold, the forward price must be
given as:
F0,T = S0(1+r)T (discrete compounding)
60
20
Generic valuation of a forward contract
0 T
Buy asset at S0 Hold asset and
Deliver asset
Sell forward at F0,T lose interest on
Receive F0,T
Outlay S0 outlay
• We will have to pay F0,T USD at T
• We will receive the underlying asset, which will be worth S T at T
• The present value of the payment of F0,T is F0,T/(1+r)T-t
• We have the claim on the asset’s value at T and we only know the
market value of the asset St, the current asset price. Thus we have
value of forward contract at time t during the life of the contract is the
asset price minus the present value of the exercise price:
Vt,(0,T) = St - F0,T/(1+r)T-t
• If t = 0, Vt,(0,T) = V0,(0,T) = S0 - F0,T /(1+r)T = 0 because F0,T = S0(1+r)T
• If t = T, Vt,(0,T) = VT,(0,T) = ST - F0,T /(1+r)0 = ST - F0,T
• We set the price such that the value of the contract is zero at the start.
• A zero-value contract means that the present value of the payments
promised by each party to the other is the same, a result in keeping 61
with the fact that neither party pays the other any money at the start.
Example
• An investor holds title an asset worth EUR125.72. To raise money for unrelated
purpose, the investor plans to sell the asset in nine months. The investor is
concerned about uncertainty in the price of the asset at that time and enters into
a forward contract to sell asset in nine months. The risk-free rate is 5.625%
(discrete compounding, months/12).
A. Determine the appropriate price the investor could receive in nine months by
means of the forward contract.
B. Suppose the counterparty to the forward contract is willing to engage in such a
contract at a forward price of EUR140. Explain what type of transaction the
investor could execute to take advantage of the situation. Calculate the rate of
return (annualized) and explain why the transaction is attractive.
C. Suppose the forward contract is entered into at the price you computed in Part
A. Two months later, the price of the asset is EUR118.875, the investor would
like to evaluate her position with respect to any gain or loss accrued on the
forward contract. Determine the market value of the forward contract at this
point in time from the perspective of the investor in Part A.
D. Determine the value of the forward contract at expiration assuming the contract
is entered onto at the price you computed in Part A and the price of the
underlying asset is EUR123.50 at expiration. Explain how the investor did on
the overall position of both asset and the forward contract in terms of the rate
of return.
Pricing and valuation of equity forward

contracts
• The present and future value of a stream of dividends over the life
of the forward contract:
PV0,T(D) = ∑i=1nDi/(1+r)ti
FV0,T(D) = ∑i=1nDi(1+r)ti
• The forward price including dividends:
F0,T = [S0 - PV0,T(D)](1+r)T or F0,T = S0(1+r)T - FV0,T(D)
or F0,T = (S0e-qT)erT
• The value of forward contract:
Vt,(0,T) = St – PVt,T(D) - F0,T/(1+r)T-t
or Vt,(0,T) = St e-q(T-t) - F0,Te-r(T-t) (continuous compounding)
• At expiration t = T and no dividends remains, VT,(0,T) = ST - F0,T
• At the contract initiation date, t = 0, V0,(0,T) = S0 – PV0,T(D) -
F0,T/(1+r)T = 0 because F0,T = [S0 - PV0,T(D)](1+r)T
63
21
Example
An asset manager anticipates the receipt of funds in 200 days,
which he will use to purchase a particular stock. The stock he has in
mind is currently selling for USD62.50 and will pay a USD0.75
dividend in 50 days and another USD0.75 dividend in 140 days. The
risk-free rate is 4.2% (discrete compounding, days/365). The
manager decides to commit a future purchase of the stock by going
long a forward contract on the stock.
A. At what price would the manager commit to purchase the stock in
200 days through a forward contract?
B. Suppose the manager enters into the contract at the price you
found in part A. Now, 75 days later, the stock price is USD55.75.
Determine the value of the forward contract at this point.
C. It is now the expiration day, and the stock price is USD58.50.
Determine the value of the forward contract at this time.
Pricing and valuation of fixed-income

forward contracts
• Bc: a coupon bond
• Bct,(T+Y): the bond price at time t
• T: expiration date
• Y: the remaining maturity of the bond on the forward contract
expiration
• T+Y: the time to maturity of the bond at the time the forward
contract is initiated.
• Consider a bond with n coupon to occur before its maturity date.
65
Pricing and valuation of fixed-income

forward contracts
• Converting the formula for a forward contract on a stock into that for a
forward contract on a bond and let CI be coupon interest over a specific
period of time, we have:
• The forward price including dividends:
F0,T = [Bc0,(T+Y) - PV0,T(CI)](1+r)T or F0,T = [Bc0,(T+Y)](1+r)T - FV0,T(CI)
where PV0,T(CI) and FV0,T(CI) is the present value and the future value of
the coupon interest over the life of the forward contract.
• The value of forward contract at time t would be:
Vt,(0,T) = Bct,(T+Y) – PVt,T(CI) - F0,T/(1+r)T-t
• At expiration, no coupons would remain, t = T and VT,(0,T) = BcT,(T+Y) - F0,T
• At time t = 0, V0,(0,T) = Bc0,(T+Y) – PV0,T(CI) - F0,T/(1+r)T = 0 because F0,T =
[Bc0,(T+Y) - PV0,T(CI)](1+r)T
66
22
Example
An investor purchased a bond when it was originally issued with a maturity
of five years. The bond pays semiannual coupon of USD50. It is now 150
days into the life of the bond. The investor wants to sell the bond the day
after its fourth coupon. The first coupon occurs 181 days after issue, the
second 365 days, the third 547 days, and the fourth 730 days. At this point
(150 days into the life of the bond), the price is USD1,010.25. The bond
prices quoted here include accrued interest (discrete compounding,
days/365).
A. At what price could the owner enter into a forward contract to sell the bond
on the day after its fourth coupon? Note that the owner would receive that
fourth coupon. The risk-free rate is currently 8%.
B. Now move forward 365 days. The new risk-free interest rate is 7% and the
new price of the bond is USD1,025.375. The counterparty to the forward
contract believes that it has received a gain on the position. Determine the
value of the forward contract and the gain or loss to the counterparty at this
time. Note that we have now introduced a new risk-free rate, because
interest rates can obviously change over the life of the bond and any
calculations of the forward contract value must reflect this fact. The new
risk-free rate is used instead of the old rate in the valuation formula.
Pricing and valuation of interest rate

forward contracts
0 g h h+m
today expiration
• FRA or Eurodollar forward contract pay off based on LIBOR on a given

day.
• In the FRA market, contracts are created with specific day counts.
• h: the day on which the FRA expires
• g: an arbitrage day prior to expiration (the date during the life of the FRA
at which we want to determine a value for FRA)
• We shall initiate an FRA on day 0.
• The FRA expires on day h.
• The rate underlying the FRA is the rate on an m-day Eurodollar deposit.
• Thus, there are h days from today until the FRA expiration and h+m
days until the maturity date of the Eurodollar instrument on which the
68
FRA rate is based.

forward contracts (FRA)
• Li,j: the rate on a j-day LIBOR deposit on an arbitrage day i, which falls
somewhere in the above period from 0 to h.
• For example, the bank borrowing USD1 on day i for j days will pay back
the amount USD1[1 + Li,j(j/360)] in j days.
• Lh,m: the rate for m-day LIBOR on day h. Lh,m determine the payoff of the
FRA.
• FRA0,h,m: the fixed rate on FRA, which stands for the rate on FRA
established on day 0, expiring on day h, and based on m-day LIBOR.
• We shall use a USD1 notional principal for the FRA, which means that
at expiration its payoff is:
[Lh,m – FRA0,(h,m)](m/360) / (1+ Lh,m)(m/360)
– The numerator is the difference between the underlying LIBOR on expiration day and
the rate agreed on when the contract was initiated, multiplied by the adjustment factor
m/360.
– The denominator discounts the payoff by the m-day LIBOR in effect at the time of the
payoff.
69
23
 hm 
• The FRA rate is 1  L0,h  m  360   360 
    1
FRA0,( h ,m )  
 1 L  h   m 
 0,h   
 360  
• The numerator is the future value of a Eurodollar deposit of h+m days.
• The denominator is the future value of a short-term Eurodollar deposit of
h days.
• This ratio is 1 + rate, subtracting 1 (the notional principal) and
multiplying by 360/m annualizes the rate.
70

• Vg,(0,h,m): the value of an FRA on day g, which was established, expires
on day h, and is based on m-day LIBOR.
• The value of the FRA is
  m  
 1  FRA0,( h ,m )  360  
Vg , ( 0 , h , m ) 
1
   
hg   h  m  g 
1  Lg ,h  g 1  Lg ,h  m g  
360   360  
• We are at day g.
• The first term on the right-hand side is the present value of USD1
received at day h.
• The second term is the present value of 1 plus the FRA rate to be
received on day h+m, the maturity date of the underlying Eurodollar time
deposit.
71
Example
A corporate treasure needs to hedge the risk of the interest rate on a
future transaction. The risk is associated with the rate on180-day Euribor
in 30 days. The relevant terms structure of Euribor is given as follows:
30-day Euribor 5.75%
A. State the terminology used to identify the FRA in which the manager in
interested.
B. Determine the rate that the company would get on an FRA expiring in
30 days on 180-day Euribor.
C. Suppose the manager went long this FRA. Now, 20 days later, interest
rates have moved significantly downward to the following:
The manager would like to know where the company stands on this FRA
transaction. Determine the market value of the FRA for a EUR20 million
notional principal.
D. On the expiration day, 180-day Euribor is 5.72%. Determine the payment
made to or by the company to settle the FRA contract.
24
Pricing and valuation of currency forward
contracts
• We shall treat the currency as having an exchange rate of S0, meaning
that it is selling for S0.
• Consider the following transactions:
– Take S0/(1+rf)T units of domestic currency and convert it to 1/(1+rf)T units of the
foreign currency.
– Sell a forward contract to deliver one unit of the foreign currency at the rate F 0,T
expiring at time T.
– Hold the position until time T. The 1/(1+r f)T units of foreign currency will accrue
interest at the rate rf and grow to one unit of the currency at T as follows: [1/(1+rf)T]*
(1+rf)T =1.
– At expiration we shall have one unit of foreign currency, which then delivered to the
holder of the long forward contract, who pays the amount F 0,T. This amount was
known at the start of the transaction.
– Because the risk has been hedged away, the exchange rate at expiration is irrelevant.
Hence this transaction is risk-free. Accordingly, the present value of F 0,T, found by
discounting at the domestic risk-free interest rate, must equal the initial outlay of
S0/(1+rf)T . Setting these amounts equal and solving for F 0,T gives F0,T /(1+r)T =
S0/(1+rf)T  F0,T = [S0/(1+rf)T ](1+r)T: (spot price discounted by foreign interest rate)
compounded at domestic interest rate 73
Pricing and valuation of currency forward

contracts
• The price of a currency forward contract:
F0,T = [S0/(1+rf)T](1+r)T = S0(1+rf)-T(1+r)T (discrete compounding)
or F0,T = S0(e-rfcT)ercT = S0e(rc-rfc)T (continuous compounding)
where rfc = ln(1+rf)
• The value of a currency forward contract
Vt,(0,T) = [St/(1+rf)(T-t)] - F0,T/(1+r)(T-t) (discrete compounding)
Vt,(0,T) = [Ste-rfc(T-t)] - F0,Te-rc(T-t) (continuous compounding)
The currency market makes cash payments that happen to be
called interest. Thus we take the current exchange rate at time t,
St, discount it by the foreign interest rate over the remaining life of
the contract, then we have St/(1+rf)(T-t)
74
Example
Spot rate: USD0.5987/CHF

rUSD = 5.5%, rCHF = 4.75%
Assume that these rates are based on annual
compounding and are not quoted as LIBOR-type rates:
(1+ r)(days/365).
• Determine the forward rate with a maturity of 180days?
• Suppose we go long this forward contract. It is now 40
days later or 140 days until expiration. The spot rate
now is 0.65. Determine the value of the long?
25
HEDGING USING FORWARD
CONTRACTS
Hedging using forward contract
• Interest rate risk management (Forward rate agreements)

• Foreign currency risk management
Managing the interest rate risk of a loan

using an FRA
• An FRA is a forward contract in which one party, the long, agrees to pay
a fixed interest payment at a future date and receive an interest payment
at a rate to be determined at expiration.
• FRA is described by a special notation:
– 1 x 4 FRA (1 by 4): FRA expires 1 month (30 days) and the
underlying Eurodollar matures 4 months (120 days) from now
(standard FRA). Or FRA expires 1 month and 3 months later (or 4
months from contract initiation date), the interest is paid on the
underlying Eurodollar time deposit on whose the contract is based
(90-day LIBOR rate).
– 3x9 FRA: FRA expires in 3 months and 6 months later (or 9 months
from contract initiation date), the interest is paid on the underlying
Eurodollar time deposit on whose the contract is based (180-day
LIBOR rate).
– a FRA expires in 42 days on 122-day LIBOR is nonstandard FRA and
called off the run FRA
26
There are 2 numbers associated with FRA: the number of months until the
contract expires, and the number of months until the underlying loan is settled.
The difference between these two is the maturity of the underlying loan.
Exp, a 2x3 FRA is a contract that expires in two months and the underlying loan
is settled in three months.
The long position in an FRA is the

Long FRA party that would borrow the money
AR (long the loan with the contract price
being the interest on the loan). If the
floating rate at contract expiration
(LIBOR for US dollar deposits and
Profit (%)
Euribor for Euro deposit) is above

the rate specified in the forward
agreement, the long position in the
SR contract can be viewed as the right
AR to borrow at below market rates and
the long will receive payment. If
rates at the expiration date are
-AR below, the short will receive a cash
Short FRA payment from the long.
Notional Principlal x (Underlying rate at expiration – forward contract rate)

x days in underlying rate/360
FRA payoff =
1 + Underlying rate x (days in underlying rate/360)
Notional Principlal
1 + Underlying rate x (days in underlying rate/360) is the present value of loan
Notional principal: an amount corresponds to the amount of the loan
Managing the interest rate risk of a

loan using an FRA
• Buy FRA: a customer will buy an FRA in case he wants
to hedge against a possible rate rise
• Short FRA: a customer will sell an FRA in case he wants
to hedge against a possible rate fall
27
Example
• The treasurer of company A expects to receive a cash

inflow of USD15 million in 90 days and expects short-
term interest rate to fall during the next 90 days. In order
to hedge against this risk, the treasurer decides to use
an FRA that expires in 90 days and based on 90 days
LIBOR. The FRA is quoted at 5%. At expiration, LIBOR
is 4.5%.
A. Indicate whether the treasurer should take a long or
short position to hedge interest risk.
B. Indentify the type of FRA used here.
C. Calculate the gain or loss to company A as a
consequences of entering the FRA
Hedging for arbitrage profit in currency

forward markets
• Take S0/(1+rf)T units of domestic currency and convert it to 1/(1+rf)T
units of the foreign currency.
• Sell a forward contract to deliver one unit of the foreign currency at
the rate F0,T expiring at time T.
• Hold the position until time T. The 1/(1+rf)T units of foreign currency
will accrue interest at the rate rf and grow to one unit of the currency
at T as follows: [1/(1+rf)T]* (1+rf)T =1.
• At expiration we shall have one unit of foreign currency, which then
delivered to the holder of the long forward contract, who pays the
amount F0,T. This amount was known at the start of the transaction.
• Because the risk has been hedged away, the exchange rate at
expiration is irrelevant. Hence this transaction is risk-free.
Accordingly, the present value of F0,T, found by discounting at the
domestic risk-free interest rate, must equal the initial outlay of
S0/(1+rf)T . Setting these amounts equal and solving for F0,T gives
F0,T /(1+r)T = S0/(1+rf)T  F0,T = [S0/(1+rf)T ](1+r)T
Example
The spot rate is USD1.76/GBP. One-year forward contracts
are quoted at a rate of USD1.75
rUSD = 5.1%, rGBP = 6.2%, both are compounded annually.
a. Indentify a strategy with which a trader can earn a profit at
no risk by engaging in a forward contract, regardless of her
view of the pound’s likely movements.
b. Suppose the trader simply shorts the forward contract. It is
now one month later. Assume interest rates are the same,
but the spot rate is now USD1.72. What is the gain or loss
to the counterparty on the trade?
c. At expiration, the pound is USD1.69. What is the value of
the forward contract to the short at expiration?
28
Example
S0 = USD0.6667/CHF.
rUSD = 6%, rCHF = 4%, continuously compounded.
a. Calculate the price at which you could enter into a forward
contract that expires in 90 days.
b. Calculate the value of the forward position 25 days into the
contract. Assume that the spot rat is USD0.65.
Managing the risk of a foreign

currency receipt
Consider a US-based company that exports goods to Switzerland.
The US expects to receive payment on a shipment of goods in three
months. Because the payment will be in CHF, the US company
wants to hedge against a decline in the value of the CHF over the
next three months. rUSD is 2%, rCHF is 5%, discrete compounded
(days/365). Assume that interest rates are expected to remain fixed
over the next six months. The current spot rate is USD0.5974.
A. Indicate whether the US company should use a long or short
contract to hedge currency risk.
B. Calculate the no-arbitrage price at which the US company could
enter into a forward contracts that expires in three months
C. It is now 30 days since the US company enters into the forward
contract. The spot rate is USD0.55. Interest rates are the same as
before. Calculate the value of the US company’s forward position.

currency receipt
• Consider a U.S. company, GateCorp, that exports
products to the United Kingdom. GateCorp has just
closed a sale worth £200,000,000. The amount will be
received in two months. Because it will be paid in
pounds, the U.S. company bears the exchange risk. In
order to hedge this risk, GateCorp intends to use a
forward contract that is priced at $1.4272 per pound.
Indicate how the company would go about constructing
the hedge. Explain what happens when the forward
contract expires in two months.
29
currency payment
Suppose that you are a US-based importer of goods from the UK.
You expect the value of GBP to increase against the USD over the
next 30 days. You will be making payment on a shipment of imported
goods in 30 days and want to hedge your currency exposure. rUSD is
5.5% and rGBP is 4.5%, discrete compounded (days/365). These
interest rates are expected to remain unchanged over the next
month. The current spot rate is USD1.5.
A. Indicate whether you should use a long or short contract to hedge
currency risk.
B. Calculate the no-arbitrage price at which you could enter into a
forward contracts that expires in 30 days.
C. Move forward 10 days. The spot rate is USD1.53. Interest rates are
unchanged. Calculate the value of your forward position.

currency payment
• On 2 March, AMC, a US company determines that it will
need to buy a large quantity of steel from a Japanese
company in 1 April. It has entered into a contract with
Japanese company to pay JPY900 million for the steel.
The current exchange rate is USD0.0083 per JPY.
• What should the company do to hedge exchange risk.

currency payment
• ABCorp is a U.S.-based company that frequently imports
raw materials from Australia. It has just entered into a
contract to purchase A$175,000,000 worth of raw wool,
to be paid in one month. ABCorp fears that the
Australian dollar will strengthen, thereby raising the U.S.
dollar cost. A forward contract is available and is priced
at $0.5249 per Australian dollar. Indicate how ABCorp
would go about constructing a hedge. Explain what
happens when the forward contract expires in one
month.
30

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Risk management applications of

• The forward contract hedge locks in a price

Delivery and settlement of

F0 F1 Short 2 months (42$) 7

Payoff of forward contract

Long Position Short Position

FORWARD PRICING AND

Compounding frequency Value of $100 in one year at 10%

Options, Futures, and Other

Measuring interest rate

• In the limit as we compound more and more

Options, Futures, and Other

• 10% with semiannual compounding is equivalent to

Options, Futures, and Other

Consumption vs Investment Assets

• Investment assets are assets held by significant

Options, Futures, and Other

• Short selling involves selling securities you do not own

Options, Futures, and Other

• At some stage you must buy the securities so

Options, Futures, and Other 19

Options, Futures, and Other

Forward pricing and valuing

Forward price: Example

• Suppose that the spot price of gold is $1000 per ounce

Options, Futures, and Other

Another Arbitrage Opportunity?

Options, Futures, and Other

An asset with no income has spot price S0 today, T is time to

• Consider a four-month forward contract to buy a zero-

When an Investment Asset Provides

Options, Futures, and Other

• Consider a 10-month forward contract on Nishat Mills Ltd

Options, Futures, and Other

• Consider a 6-month forward contract on an asset that is

Options, Futures, and Other

• For the formula to be true it is important that the index

Options, Futures, and Other

Consider a 3-month futures contract on an index.

• When F0 > S0e(r-q)T an arbitrageur buys the stocks

Options, Futures, and Other

• Index arbitrage involves simultaneous trades in futures

Options, Futures, and Other

Futures and Forwards on Currencies

• A foreign currency is analogous to a security providing

Options, Futures, and Other

Explanation of the Relationship

Forward price for foreign currency

• Commodities such as gold and silver, that are

Options, Futures, and Other

• Consider a one-year futures contract on gold. Suppose

Forward price for investment commodities

• If F0 > (S0+U )erT : an arbitrageur can borrow S0+U at

Options, Futures, and Other

• Commodities that are consumption assets usually provide

Forward price for consumption commodities

• We do not necessarily have equality in F0  (S0+U )erT and

• The relationship between futures and spot prices can be

Valuing a Forward Contract

Options, Futures, and Other

Forward price and forward value

Forward value Forward price

• A long forward contract on a non-dividend-paying stock