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Forward and Futures

Initially, we will assume that a forward and futures contract is the same thing. Both are contracts where a buyer agrees to buy and a seller agrees to sell at a set price on a future date. The key is that the price for exchange is set today and represents a fair price for both the seller and the buyer. An example of such a contract would be a situation where a farmer (sell) and a cereal producer (buy) agree to exchange 1,000 bushels of corn at $2.54/bushel six months from today. The farmer and the producer both lock in a fixed price for exchange in six months. Without this type of contract neither the farmer nor the producer could lock in prices today for future delivery. The result is that there is a set of prices in the market for commodities with different delivery dates. There is the cash (spot) price, which is the price for delivery today, on December 23, 2002 the cash price for a bushel of oats was $2.22. In addition, there is the price for delivery in 30 days, or 90 days. All of these prices would be different. For example, on December 23, 2002 the futures prices per bushel for oats on the Chicago Board Of Trade were Delivery Date March 2003 May 2003 July 2003 September 2003 December 2003 March 2004 Price $2.0425 1.9500 1.7600 1.5500 1.5600 1.5800

Each of these prices represents the market-clearing price today for payment and delivery of oats at some future date. Relationship between spot prices and Future/Forward prices Financial Assets-No Income Cash prices and futures/forward prices are different; however, an important question is how are these prices related? The simplest example is to consider a share of firm XYZs
____________________________________________________________________________________ This note was prepared by Professor Robert M. Conroy. Copyright 2003 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to dardencases@virginia.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.

stock, which currently sells for $75 per share. Assume there is an investor who wishes to own a share of stock three months from now. This investor can enter into a futures contract to buy the stock at the futures/forward price in three months. The result would be that the investor would pay the fixed price in three months and receive one share of stock. Alternatively the investor could today, borrow $75 for three months 1 , buy one share, hold it for three months and then repay the loan of $75 plus accrued interest in r T three months, $75 e f . We will refer to this as the borrow-buy-hold-repay alternative. In either case, the investor would pay and own the stock in three months. Assuming that the risk-free rate is 6%, the relationship between the current stock price and the futures/forward price should be,

FT = S 0 e

r f T

= $75 e .06. 25 or

FT = $76.133
Since buying a share of stock at S0 and simultaneously entering into a futures contract to sell a share of stock at the futures/forward price, FT , results in a risk less profit, FT S0. Since the payoff is risk less, an investor should earn the risk- free rate of return, rf, on this r T investment. This is exactly what the relationship, FT = S 0 e f is meant to capture. What if this relationship did not hold? For example, what is the effect if the futures/forward price is not $76.1335? If the quoted three- month futures/forward price were not $76.1335 but rather $77.00, it would be possible to buy the stock for $75 and simultaneously agree to sell the stock in three months at the futures/forward price of $77. A trader would earn approximately 10.53% on this set of transactions 2 , which is more than the risk- free rate of return. This would represent an arbitrage opportunity. Alternatively, if the futures/forward price was $76, an investor could sell the stock short collect $75 and agree to buy the stock at $76. If the investor invested the $75 at the riskfree rate for three- months they would have $76.1335. If they bought the stock back at $76, they would be able to realize an arbitrage profit of $0.1335. Hence if the futures/forward price were either $77 or $76, traders would very quickly trade until the futures/forward price was once again $76.1335.

For simplicity let us assume that the investor can borrow at the risk-free rate, rf. Assuming continuous compounding the principal and interest due at the end of three months would be
2

. The investor buys the stock at $75 and with certainty receives $77 for it in three months. The return is

$75 e f = $75 e f

r T

r . 25

$75 e R.25 = $77 77 R = ln 4 = 10.53% 75 Page 2

Financial Assets with Income (Dividends) Consider the same example discussed above but now the stock pays a dividend of $1.00 in two months. Again, we wish to own and pay for the stock in three months. One alternative is to enter into a futures/forward contract with a price of FT . Alternatively, we could borrow $75 for three months today, buy the stock, and hold it for three months. If we own the stock, we get the $1.00 dividend in two months. In order to keep everything on the same timing, we assume that we invest the $1.00 dividend at the risk-free rate, rf, for one month. We can use the proceeds from the invested dividend to offset what we owe on the loan. The relationship between the borrow-buy- hold-repay strategies and taking the buy side of a futures/forward contract must satisfy the following:

FT = S 0 e

rf 3 12

Dividend e
.06 3 12

r f 1 12 .06 1 12

FT = $75.00 e FT = $75.1285

$1.00 e

In Hull (5th edition, Chapter 3, page 48), he expresses the relationship between the futures/forward price and the spot price as r T FT = (S 0 I 0 ) e f

where I 0 = Dividend e

r f 2

12

I0 is the present value of the dividend. This is equivalent to the expression in this note 3 . I personally prefer the basic approached used in this note because it more clearly reflects the physical actions that define the arbitrage relationship between futures/forward prices and spot prices. Above we assumed a single dividend. If the underlying asset was not a stock but rather a stock index, it is easier to think in terms of a dividend yield, q, than to deal with individual dividends. In this case we can think of the dividend yield as a reverse interest rate. In the borrow-buy- hold-repay strategy the interest rate continuously accrues over time. If we assume a continuous dividend, it offsets the interest costs. As such, for stock indexes with a dividend yield, q, the relationship between the spot value of the index and the futures/forward prices is as follows:
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The relationship is as follows:

FT = S 0 e FT = S 0 e

r f 3 12 r f 3

Dividend e Dividend e
r f 112

r f 112 rf 1 12

12

r f 3

12

rf 3 12

FT = ( S 0 Dividend e FT = ( S 0 Dividend e FT = ( S 0 Dividend e

r f 312

) e

r f 3 12

rf ( 1 3 ) 12 12 r f 2 12

) e

rf 3 12

) e

r f 3 12

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FT = S 0 e
Foreign Currency Futures/Forward Prices

( r f q)T

The relationship between currency spot rates and futures/forward rates is based on interest rate parity. It should not be possible to earn more than the domestic risk-free rate of return by doing the following: Today exchanging into a foreign currency at the current spot rate Today enter into an agreement to exchange at the futures/forward rate, Today invest foreign currency at the foreign interest rate, At maturity exchange back to the domestic currency at the futures/forward rate.

As an example, consider a British Pound investor. Her investment horizon is 5 months and risk- free pound denominated investments are yielding 6%. Alternatively, she could exchange one pound for yen at the current exchange rate of 177/1, invest at the yen risk- free rate of 1%, and agree to exchange in 5 months at the current futures/forward rate, F . At maturity, she would exchange the yen back into pounds at the futures/forward rate. In order for no arbitrage opportunities, the relationship between the current spot rate, S , and the futures/forward, F , rate must satisfy,

1 1 e rf T = S e rf T F

Expressing everything in terms of F yields:


F = S e rf T e -rf T

F = S e ( rf

rf )T

For the values in the example, the futures/forward rate should be


F = S e rf T e -rf T

F = S e ( rf

rf )T (.01. 06 ) 5 12

F = 177 e

F = 173.35
From this we can see the usual result, that if the Japanese risk- free rate is less than the British Pound rate, the futures/forward exchange rate will be less than the current spot

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exchange rate. A Yen investor who invests in British Pounds to get the higher rate, has the higher interest rate offset by getting few yen back at maturity.

Commodities Futures/Forward Prices Commodity futures/forward prices are quite different from those for the financial assets that we have examined so far. Commodities are physical assets that have to be stored, can be consumed and deteriorate over time. In addition, unlike financial assets, commodity prices are affected by changes in supply. For agricultural commodities, the supply changes with the harvest cycle. Exhibit 1 shows the average monthly prices by month for the Corn. In addition it also shows the ratio of the monthly price to Januarys price for each month4 . It is apparent that there is a cycle for corn prices. The prices are the lowest during the month of October immediately following the harvest. This cycle does affect futures/forward prices for commodities in a way that we do not see in financial assets.

Exhibit 1 Average Corn Cash Prices by Month January 1980 -December 2002

Monthly Price Relative (Jan. = 1.00)


1.08 1.06 1.04 1.02 1 0.98 0.96 0.94 0.92 January February March April May June Month July August September October

Average Monthly Price/bushel

265 260 255 250 245 240 235 230 225 220 215 210 November December

Ratio

Price

In the sections that follow, we will ignore this price cycle. However, it does cause problems with establishing the no arbitrage pricing relationships that we used with financial assets. Once again we will compare the borrow-buy- hold-repay alternative to entering into a futures/forward contract. For simplicity lets consider you wish to own 1,000 bushels of corn in five months. You can enter into a futures/forward contract to exchange (buy) at a fixed price FT in five months. Alternatively, you can adopt a borrow-buy-hold-repay strategy. In the case of commodities, it is a bit more complicated to implement this strategy than it is for financial assets. The reason is that buying and holding a physical
4

The average price relative for each month is calculated as

It =

Pt t = 1,..,12 . These are then Pt1

averaged for each month over the full twenty-two year period.

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commodity entails storing it. Storing 1,000 shares of stock is not a big problem but storing 1,000 bushels of corn is. Hence, we have to consider the cost of storage in the borrow-buy-hold-repay strategy. Assume that the current spot price for corn is $1.96/bushel, the risk-free rate is 5%, and the cost of storage is $0.05 per bushel per month, which must be paid upfront. The borrow-buy-hold-repay strategy would entail the purchase of 1,000 bushels for $1,960, and a storage cost of $250 ($0.05*1,000*5 months) for a total investment of $2,210. Hence we would borrow $2,210, purchase the corn, and pay for storage. In 5 months with the futures contract we would have to pay FT . In the borrow-buy-hold-repay strategy we would repay, ($2, 210) e 12 = $2,256.53 . For no arbitrage, the relationship between the spot and futures/forward price must be
.05 5

FT = (S 0 + storage) e
or FT = $2.25653 per bushel.

r f T

= ($2, 210) e

.05 5

12

= $2, 256.53

In the analysis above we incorporated storage costs. Another issue for commodities that is not relevant for financial assets is spoilage. For most agriculture commodities, what you put into storage is not what you take out. In this case in order to borrow-buy- holdrepay you have to put more into storage than you plan to take out. In the corn example, if the spoilage rate over five months is 3%, i.e., 100 bushels placed into storage results in 97 bushels in five months, we need to start with more than 1,000 bushels. With a spoilage 1,000.00 rate of 3%, we need to put = 1,030.93 bushels into storage in order to get .97 1,000.00 bushels out in five months. If we consider storage costs and spoilage the Futures/Forward price should satisfy
FT = 1,000 .05 5 (1.96 + .05 5) e 12 = $2,326.32 .97

or $2.32632 per bushel. Convenience yield We have assumed that using futures/forward contracts is a perfect substitute for the borrow-buy-hold-repay strategy. In the case of commodities this is not necessarily true. Actual ownership of the commodity may be more attractive than using futures/forward contracts. As such, there could be reluctance on the part of holders of the commodity to sell and replace the holdings with futures/forward contracts. Consider the situation where a refinery holds an inventory of oil for future use and for simplicity assume that there is r T no loss in storage. If FT is less than the no arbitrage price, FT < (S 0 + storage ) e f , the holder of the inventory could sell at spot, and save storage costs and contract to buy back at FT . This should result in an arbitrage profit. Often however, holders of inventory may be unwilling to sell and replace the inventory with futures/forward contracts. Holding the Page 6

inventory has value. Consequently, it is often the case for commodities that FT is less than the no arbitrage price. This apparent violation of the no arbitrage rule is referred to as a convenience yield5 , y.

(S 0 + storage ) e r T
f

FT = y

Cost of Carry For commodities, the storage costs and spoilage is sometimes expressed as a continuous yield. Lets use for the storage costs and use as the spoilage rate. This yields a relationship between the spot price and the futures/forward price of

FT = S 0 e

(rf + + )T

The exponent (r f + + ) is sometimes referred to as the cost of carry, c, and the relationship between the futures/forward price and the spot price is expressed as
FT = S 0 e cT .

For commodities, the convenience yield is incorporated as follows:


FT = S 0 e ( c y )T .

It is not uncommon for the convenience yield to exceed the cost of carry. A good example of this is found in the futures prices for oats at the beginning of this note. Futures/Forward prices and the expected spot rate One interpretation of the futures/forward price is to say that it is the expected future spot price, FT = E ( ST ). For example, if the current 3- month futures/forward price for oil is $26 per barrel, it is tempting to say that this must be the expected spot price 3-months from now. In general, this is not true. First, it cannot be true for financial assets. Assume we have a stock price of $75, risk-free rate of 6%, and a maturity of 3 months. The no arbitrage futures/forward price would be,

FT = S 0 e f = $75 e .06.25 = $76.133


If FT = E ( ST ) = $76.133, then an investor who purchased the stock today would have an expected return,
5

r T

FT e yT = (S 0 + storage ) e f .
r T

Convenience yield is sometimes also expressed as the rate that satisfies,

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S0 e E ( RT )T = E ( ST )

e E( RT )T =

E( S T ) S0

E ( ST ) FT E ( RT ) T = ln = ln S S 0 0

S 0 e rf T = ln S 0

= rf T

E ( RT ) = r f

Since buying the stock is risky6 , it cannot be the case that E ( RT ) = r f and as such for financial assets, FT < E( S T ). For commodities, it is possible that the Beta of the commodity, i.e., its market risk, is zero. Hence for commodities 7 it is possible for FT = E ( ST ) . However, even if commodities have zero market risk, it does not have to be an equality. If for example, farmers were taking the sell-side of futures/forwards contracts as insurance then they may be willing to accept FT < E ( ST ) . This condition is refereed to as backwardation. Alternatively, if users of the commodity (the General Mills of the world) were the primary users of futures/forwards, they might be willing to accept FT > E ( ST ) . This in turn is refereed to as contango. The result is that the question of the relationship between futures/forward prices and the expected spot rate is an empirical question. Basically, the empirical results are mixed. There is some evidence to support FT = E ( ST ) for commodities but it is not conclusive. Futures verses Forward Prices Futures and Forward prices refer to different types of contracts. A forward contract is usually a specific agreement between two parties. The terms are specific to the needs of each party and any cash settlement of the contract takes places on the maturity date. Futures contracts on the other hand are traded on formal exchanges such as the Chicago Board of Trade, Chicago Mercantile Exchange, or London Metals Exchange. These contracts are standardized (See Exhibit 2 for an example of the futures contract for corn). All of the terms of the contracts that mature in December, or any other month are the same. An important difference between a futures contract and a forward contract is that a futures contract is marked to market on a daily basis. What this means is that unlike a forward contract, which is settled at maturity, a futures contract is settled on a daily basis.
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E ( RT ) = r f + Beta (E( RM ) r f ). As such, for assets with a Beta>0, E ( RT ) > r f .


If Beta =0, then

Risky in this case refers to market risk. From the CAPM, the expected return on an asset must satisfy,

E ( RT ) = r f + 0 (E (RM ) r f ). , and E ( RT ) = rf .

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An example is the easiest way to see how this works. Assume that a person on the buyside and a person on the sell-side agree today to exchange corn in July at a price of $2.41 per bushel. The next day the futures price for July delivery drops to $2.32/bushel. The daily settlement involves the buy-side paying the sell- side $0.09/bushel and the contract for July delivery is rewritten with a price of $2.32/bushe l. The next day the price jumps back up to $2.40/bushel for July delivery. Now the sell-side pays the buy-side $0.08/bushel and the contract is rewritten once again at a price of $2.40/bushel. This daily cash settlement goes on over the life of the cont ract. Exhibit 3 shows the different pattern of cash flows for a futures contract and a forward contract. While the total cash flow payments are the same, the marking to market feature of the futures contract results in interim cash payments between the buy-side and the sellside.

Exhibit 3 Cash flow for futures and forwards.


Buy-side Futures Forward $2.41 $2.41 Cash flow Futures Forward $ (0.09) $ 0.08 $ 0.05 $ 0.04 $ 0.06 $ 0.07 $ (0.05) $ (0.04) $ (0.03) $ 0.05 $ 0.14 $ 0.14 $ 0.14

Beginning Price Days 1 2 3 4 5 6 7 8 9 10 Futures price $ 2.32 $ 2.40 $ 2.45 $ 2.49 $ 2.55 $ 2.62 $ 2.57 $ 2.53 $ 2.50 $ 2.55 Total

Given that the terms of the forward contract and the futures contract are different, it is reasonable to ask if the quoted prices for each contract would be the same. The answer to this question is not clear. Each of the contracts has advantages and disadvantages. The net result is that it comes down to a simple empirical question of whether we observe systematic differences between the prices offered under each contract. The evidence is that there is not systematic difference in forward and futures prices. As such, for the remainder of the course we will refer to futures and forward prices interchangeably. However, it is important to remember that they do refer to different types of contracts.

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Value of Futures and Forward Contracts The value of a futures or forward contract at the time it is accepted by the buy-side and the sell-side is zero. No money changes hands at the point in time when the contract is written8 . However, immediately after this point the futures or forward contract can have value. If the original contract was for July delivery and the agreed upon price was $2.42, immediately after this time if the price for delivery in December changes, the right to buy or sell at $2.42 will have value. Suppose at the end of the day the price increases to $2.50. The value of the original futures contract is easy. For the buyer it is $0.08, $2.50$2.42. Since it is marked to market, the buy-side collects the difference and the contract is rewritten at $2.50. A forward contract on the other hand, is not cash settled at the end of the day. Hence, the value of the forward contract is different. In order to realize the value, the buy-side would have to take the sell- side of a July contract with a price of $2.50. Here the individual would have the right in July to buy at $2.42 and sell at $2.50. The difference is $0.08/bushel but this would only be realized in July. Hence the value of the forward contract would be ($2.50 $2.42 ) e rf T , or just the present value of the $0.08.

Summary
The basic relationship between the futures/forward prices, which mature at time T, and spot prices is

FT = S 0 e

r f T

This is derived from the no arbitrage condition that using a futures contract is the same as a strategy that involves borrowing, buying, holding and repaying. We can use this condition to derive a no arbitrage relationship between futures/forward prices and spot price for any financial asset. For commodities, we can do the same thing but we need to include the effects of actually holding the physical asset. This means that we must include the storage costs and potential spoilage. By incorporating these additional factors we can derive a no arbitrage pricing relationship for commodities. However, for commodities, the price cycle and the value of actually holding the underlying asset are also important factors which cause the no arbitrage condition to be consistently violated when we examine actual futures/forward prices in the market.

Written in this case refers to the point in time that the buy-side and sell-side agree on a price for exchange.

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Exhibit 2. Futures Contract Specifications

Corn Futures Contract Size 5,000 bu Deliverable Grades No. 2 Yellow at par, No. 1 yellow at 1 1/2 cents per bushel over contract price, No. 3 yellow at 1 1/2 cents per bushel under contract price Tick Size 1/4 cent/bu ($12.50/contract) Price Quote Cents and quarter-cents/bu Contract Months Dec, Mar, May, Jul, Sep Last Trading Day The business day prior to the 15th calendar day of the contract month. Last Delivery Day Second business day following the last trading day of the delivery month. Trading Hours Open Outcry: 9:30 a.m. - 1:15 p.m. Chicago time, Mon-Fri. Electronic (a/c/eSM ): 8:30 p.m. - 6:00 a.m. Chicago time, Sun.-Fri. Trading in expiring contracts closes at noon on the last trading day. Ticker Symbols Open Outcry: C Electronic (a/c/e): ZC Daily Price Limit 20 cents/bu ($1,000/contract) above or below the previous day's settlement price. No limit in the spot month (limits are lifted two business days before the spot month begins).

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