Financial Forwards and Futures

Alternative ways to buy a stock

Prepaid forward contracts on stock
Forward contracts on stock
Futures contracts
Uses of index futures
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Introduction
Financial futures and forwards
On stocks and indexes
On currencies
On interest rates
How are they used?
How are they priced?
How are they hedged?
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Alternative Ways to Buy a Stock
Four dierent payment and receipt timing combinations
Outright purchase: ordinary transaction
Fully leveraged purchase: investor borrows the full
amount
Prepaid forward contract: pay today, receive the
share later
Forward contract: agree on price now, pay/receive
later
Payments, receipts, and their timing
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Alternative Ways to Buy a Stock
Four dierent ways to buy a share of stock that has price S
0
at time 0. At time 0 you agree to a price, which is paid either
today or at time T. The shares are received either at 0 or T.
The interest rate is r.
Description Pay at Receive security payment
time at time
Ourtright purchase 0 0 S
0
at time 0
Fully leveraged T 0 S
0
e
rT
at time T
purchase
Prepaid forward 0 T ?
contract
Forward contract T T ? e
rT
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Pricing Prepaid Forwards
If we can price the prepaid forward ( F
P
0,T
), then we can
calculate the price for a forward contract
F
0,T
= Future value of F
P
0,T
Three possible methods to price prepaid forwards
Pricing by analogy
Pricing by discounted present value
Pricing by arbitrage
For now, assume that there are no dividends
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Pricing Prepaid Forwards (contd)
Pricing by analogy
In the absence of dividends, the timing of delivery is
irrelevant
Price of the prepaid forward contract same as current
stock price
F
P
0,T
= S
0
(where the asset is bought at t = 0,
delivered at t = T)
Pricing by discounted preset value ( : risk-adjusted
discount rate)
If expected t = T stock price at t = 0 is E
0
[S
T
] then
F
P
0,T
= E
0
[S
T
]e
T
Since t = 0 expected value of price at t = T is
E
0
[S
T
] = S
0
e
T
Combining the two, F
P
0,T
= S
0
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Pricing Prepaid Forwards (contd)
Pricing by arbitrage
Arbitrage: a situation in which one can generate
positive cash ow by simultaneously buying and
selling related assets, with no net investment and
with no risk. Free money!!!
If at time t = 0, the prepaid forward price somehow
exceeded the stock price, i.e., F
P
0,T
> S
0
, an
arbitrageur could do the following
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Pricing Prepaid Forwards (contd)
Cash ows and transactions to undertake arbitrage when
the prepaid forward price, F
P
0,T
, exceeds the stock price,
S
0
.
Cash ows
Transaction Time 0 Time T (expiration)
Buy stock @ S
0
S
0
S
T
Sell prepaid +F
P
0,T
S
T
forward @F
P
0,T
Total F
P
0,T
S
0
0
Since, this sort of arbitrage prots are traded away
quickly, and cannot persist, at equilibrium we can expect:
F
P
0,T
= S
0
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Pricing Prepaid Forwards (contd)
What if there are dividends? Is F
P
0,T
= S
0
still valid?
No, because the holder of the forward will not receive
dividends that will be paid to the holder of the stock
F
P
0,T
= S
0
PV(all dividends paid from t = 0 to t = T)
For discrete dividends D
t
i
at times t
i
, i = 1, 2, 3...n
The prepaid forward price:
F
P
0,T
= S
0

n
i=1
PV
0,t
i
(D
t
i
)
For continuous dividends with an annualized yield
The prepaid forward price: F
P
0,T
= S
0
e
T
Adjusting the initial quantity in order to oset the eect of the
income from the asset is called tailing the position.
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Pricing Prepaid Forwards (contd)
XYZ stock costs $100 today and is expected to pay a
quarterly dividend of $1.25. If the risk-free rate is 10%
compounded continuously, how much does a 1-year
prepaid forward cost?
$F
P
0,1
= $100

4
i=1
$1.25e
0.025i
= $95.30
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Pricing Prepaid Forwards (contd)
The index is $125 and the dividend yield is 3%
continuously compounded. How much does a 1-year
prepaid forward cost?
F
P
0,1
= $125e
0.03
= $121.31
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Pricing Forwards on Stock
Forward price is the future value of the prepaid forward
No dividends F
0,T
= FV(F
P
0,T
) = FV(S
0
) = S
0
e
rT
Discrete dividends F
0,T
= S
0
e
rT

i=1
e
r(Tt
i
)
D
t
i
Continuous dividends F
0,T
= S
0
e
(r)T
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Pricing Forwards on Stock (contd)
Forward premium
The dierence between current forward price and
stock price
Can be used to infer the current stock price from
forward price
Denition
Forward premium = F
0,T
/S
0
Annualized forward premium =
1
T
ln(
F
0,T
S
0
)
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Creating a Synthetic Forward
One can oset the risk of a forward by creating a synthetic
forward to oset a position in the actual forward contract
How can one do this? (assume continuous dividends at
rate )
Recall the long forward payo at expiration :
S
T
F
0,T
Borrow and purchase shares as follows
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Creating a Synthetic Forward
Demonstration that borrowing S
0
e
T
to buy e
T
shares
of the index replicates the payo to a forward contract,
S
T
F
0,T
.
Cash ows
Transaction Time 0 Time T (expiration)
Buy e
T
units of S
0
e
T
+S
T
the index
Borrow S
0
e
T
+S
0
e
T
S
0
e
(r)T
Total 0 S
T
S
0
e
(r)T
Note that the total payo at expiration is same as forward
payo
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Creating a Synthetic Forward (contd)
The idea of creating synthetic forward leads to following
Forward = Stock zero-coupon bond
Stock = Forward + zero-coupon bond
Zero-coupon bond = Stock forward
Buy the underlying asset and short the osetting forward
contract is cash-and-carry.
If F
0,T
= S
0
e
(r)T
, arbitrage opportunities:
if F
0,T
> S
0
e
(r)T
cash-and-carry arbitrage: buy the
index, short the forward
if F
0,T
< S
0
e
(r)T
reverse cash-and-carry: short the
index, buy the forward
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Cash-and-carry arbitrage
Transactions and cash ows for a cash-and-carry: A
marketmaker is short a forward contract and long a
synthetic forward contract.
Cash ows
Transaction Time 0 Time T (expiration)
Buy tailed position in S
0
e
T
+S
T
stock, paying S
0
e
T
Borrow S
0
e
T
+S
0
e
T
S
0
e
(r)T
Short forward 0 F
0,T
S
T
Total 0 F
0,T
S
0
e
(r)T
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Cash-and-carry arbitrage (contd)
Cash-and-carry arbitrage with transaction costs
Trading fees, bid-ask spreads, dierent
borrowing/lending rates, the price eect of trading in
large quantities, make arbitrage harder
No-arbitrage bounds: F
+
> F
0,T
> F

Suppose
Bid-ask spreads: for stock S
b
> S
a
, and for
forward F
b
< F
a
Cost k of transacting forward
Interest rate for borrowing and lending are
r
b
< r
l
No dividends and no time T transaction costs for
simplicity
Arbitrage possible if
F
0,T
> F
+
= (S
a
0
+ 2k)e
r
b
T
F
0,T
> F

= (S
b
0
+ 2k)e
r
l
T
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Other Issues in Forward Pricing
Does the forward price predict the future price?
According to the formula F
0,T
= S
0
e
(r)T
the
forward price conveys no additional information
beyond what S
0
, r and provides
Moreover, the forward price underestimates the future
stock price
The forward contract is a biased predictor of the
future stock price
Forward pricing formula and cost of carry
Forward price = Spot price +
Interest to carry the asset - asset lease rate

cost of carry, (r)S
Lease rate is what to pay to the lender of the asset
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Futures Contracts
Exchange-traded forward contracts
Typical features of futures contracts
Standardized, with specied delivery dates, locations,
procedures
A clearinghouse
Matches buy and sell orders
Keeps track of members obligations and
payments
After matching the trades, becomes counterparty
Dierences from forward contracts
Settled daily through the mark-to-market process
low credit risk
Highly liquid easier to oset an existing position
Highly standardized structure harder to customize
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Collateral and maintenance margins
Marking to market is a daily settlement feature of
futures contract in which prots and losses are paid over every
day at the end of trading.
The purchaser must deposit a sum as an initial margin or
collateral (initial performance bond (IM), for example, 10
percent of contract value, either in cash or T-bills).
A maintenance margin (MM) (70 80% of initial margin)
is required. The value of the contract is marked to market
daily, and all changes in value are paid in cash daily.
When your initial performance bond drops below the
maintenance level you will be required to post more money
(you receive a margin call).
Excess equity above the IM can be withdrawn
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Daily resettlement: Example
Daily cash ow in a three-day contract (date 0, 1, 2, 3) to
purchase a stock, is computed as follows
Day 0 1 2 3
Futures price 100 98 96 97
Marking to market pay 2 pay 2 receive 1
Final payment for delivery pay 97
(Ignoring time value), the cumulative payments from the buyer
are equal to 2 + 2 1 + 97 = 100
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Example: S&P 500 Futures
Mark-to-market proceeds and margin balance over 10
weeks from long position in 8 S&P 500 futures contracts
(Notional value of a single contract: $250 Index. 8
contracts mean the multiplier of 2,000).
Assume continuous compounding annual interest rate of
6% and 10% margin. The last column does not include
additional margin payments. Expiration week 10, weekly
settlement.
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Example: S&P 500 Futures
Furtures price margin
week multiplier price change balance
0 2000 1100 220,000
1 2000 1027.99 -72.01 76,233.99
2 2000 1037.88 9.89 96,102.01
3 2000 1073.23 35.35 166,912.96
4 2000 1048.78 -24.45 118,205.66
5 2000 1090.32 41.54 201,422.13
6 2000 1106.94 16.62 234,894.67
7 2000 1110.98 4.04 243,245.86
8 2000 1024.74 -86.24 71,046.69
9 2000 1007.30 -17.44 36,248.72
10 2000 1011.65 4.35 44,990.57
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Detailed calculation
25 / 35
Yesterday, you entered into a futures contract to buy
CAD100,000 at $0.95 per CAD. Your initial performance bond
(IM) is $2,000 and your maintenance level (MM) is $1,500. At
what settle price will you get a demand for additional funds to
be posted (i.e, a margin call)?
26 / 35
At what settle price will you be free to withdraw $500 from
your margin account?
27 / 35
Futures prices versus forward prices
Very similar
The dierence negligible especially for short-lived
contracts
Can be signicant for long-lived contracts and/or
when interest rates are correlated with the price of
the underlying asset
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Uses of Index Futures
Why buy an index futures contract instead of synthesizing
it using the stocks in the index? Lower transaction costs
Asset allocation: switching investments among asset
classes
Example: invested in the S&P 500 index and temporarily
wish to temporarily invest in bonds instead of index.
What to do?
Alternative #1: sell all 500 stocks and invest in bonds
Alternative #2: take a short forward position in S&P
500 index
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Switching from stocks to T-bills
Eect of owning the stock and selling forward, assuming that
S
0
= $100 and F
0,1
= $110.
Cash ows
Transaction Today 1 year, S
1
= $80 1 year, S
1
= $130
Own stock @ $100 -$100 $80 $130
Short forward 0 $110-$80 $110-$130
@$100
Total -$100 $110 $110
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Cross hedging: using a derivative on one asset to
hedge another
Cross-hedging with perfect correlation
Suppose we own $100 million stocks with beta of 1.4
(recall CAPM: r
p
= r + (r
M
r))
Better, r
p
r = (r
M
r) is a multiplier
the S&P 500 index is $1,100, annual risk free rate is 6%.
The futures price is $1,166.
The number of contracts needed to cover $100 million of
stock is (100million/250/1100) = 363.636
Adjust for the dierence in beta, multiply that number by
1.4 509.09.
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Uses of Index Futures
Results from shorting 509.09 S&P 500 index futures
against a $100 million portfolio with a beta of 1.4.
S&P 500 Gain on 509 Portfolio Total
index Futures value
900 33.855 72.145 106
950 27.491 78.509 106
1000 21.127 84.873 106
1050 14.764 91.236 106
1100 8.400 97.600 106
1150 2.036 103.964 106
1200 -4.327 110.327 106
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Detailed calculation
If index price turns out to be 1100, index return is
1100 1100
1100
= 0%
our portfolio return is
r
p
= 6% + 1.4 (0%6%)
= 2.4%
index future return is
1166 1100
1100
= 6%
1.4 times 6% is 8.4%.
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Detailed calculation
If index price turns out to be 1150, index return is
1150 1100
1100
= 4.545
our portfolio return is
r
p
= 6% + 1.4 (4.545%6%)
= 3.964%
index future return is
1166 1150
1100
= 1.455%
1.4 times 1.455% is 2.036%.
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Uses of Index Futures
Cross-hedging with imperfect correlation
General asset allocation: futures overlay
Risk management for stock-pickers
35 / 35