Outline

Introduction

Pricing Forwards by Replication

Numerical Examples

Currency Forwards

Stock Index Forwards

Valuing Forwards

Forward Pricing: Summary

Futures Pricing
1
Objectives

Pricing of derivatives using no-arbitrage considerations.

Key points:
1. The cost-of-carry method of pricing forward contracts.
2. The role of interest rates and holding costs/benefits in this
process.
3. The valuation of existing forward contracts.

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The Forward Price

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.

3
Pricing Forwards by Replication

4
The Key Assumption: No Arbitrage

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
in efficiency 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.
This is a minimal market rationality condition: it is impossible
to say anything sensible about a market where such
opportunities can persist.

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The Guiding Principle: Replication

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.
Key step: Identifying the replicating portfolio.

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Replicating Forward Contracts

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.

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Replicating Forwards

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?

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Cost of Forward Strategy

The forward strategy involves a single cash outflow of the

delivery price F at time T
So, cost of forward strategy: PV (F ).

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Cost of Replicating Strategy

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.

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The Forward Pricing Condition

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.

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Violation of this Condition Arbitrage

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.

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Determinants of the Forward Price

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?

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Pricing Formulae I: Continuous Compounding

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),

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Pricing Formulae II: Money-Market Convention

Let 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, so

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Numerical Examples

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Example 1

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 F > 1, 142.66, sell forward and buy spot.
If F < 1, 142.66, buy forward and sell spot.

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Abrbitrage with an Overpriced Forward

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 one month at 2.80%.

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Arbitrage with an Underpriced Forward

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%.

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Holding Costs and/or Benefits

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.

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Example 2

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?

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Example 2: The Forward Price

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

Any other forward price leads to arbitrage.

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Arbitrage with an Overvalued Forward

For example, suppose F = 98.

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.

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The Arbitrage Strategy

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%
borrowing 90.123 for 6 months at 10%.
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.

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Cash Flows from the Aribtrage

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

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Currency Forwards

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Forwards on Currencies & Related Assets

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.
The "" inside the PV expression is to emphasize that present

values are being taken with respect to the interest rate.

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Currency Forwards: Replication Costs

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 ).

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Currency Forwards: The General Pricing Expression

By no-arbitrage, we must have

S x PV (1) = F x PV ($1).

Solving we obtain the fundamental forward pricing expression for

currencies:

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Currency Forwards with Continuous Compounding

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) = erT and PV (1) = edT .
Using these in the general currency forward pricing expression and
simplifying, we obtain

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Currency Forwards in the Money-Market Conventions

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

(): T-year GBP interest rate (ACT/365).
Then:

Substituting these into the general currency forward pricing

expression and simplifying, we obtain

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Example 3

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: ($) = 0.251%

3-month GBP Libor rate: () = 0.610%

Therefore, the unique arbitrage-free forward price is:

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Undervalued Forward

Suppose we had F = $1.60/.

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%.
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.

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Cash Flows from the Arbitrage

At inception:

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Cash Flows from the Arbitrage

At maturity:

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Currency Forwards: Exercise

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/.

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Stock Index Forwards

37
Stock Index Forwards

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.

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Example 4: Index Forwards

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

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S&P 500 Futures Prices: Jan 15, 2010

Spot: 1136.03 (S&P on Jan 15, 2010)

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Valuing Forwards

41
Valuing Existing Forwards

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.

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Offsetting the Existing Forward

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?).

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Valuation by Offset

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 ).

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Valuing Forwards: Summary

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?

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Example 5: Valuing Existing Forwards

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?

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Example 5: The Steps Involved

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.

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Example 5: The Forward Price

Since there are no dividends, the forward price must satisfy PV (F ) = S.

This means

or

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Example 5: The Contract Value

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

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Forward Pricing: Summary

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Forward Pricing: Summary

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.

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Futures Pricing

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Pricing Futures: Considerations

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?

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Delivery Options

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?

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Delivery Options

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.

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Margin Accounts

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.

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Margin Accounts

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.

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Futures Pricing: Summary

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.

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