Future pricing

By
Dr. Surya Dev
 Cost of Carry model
Assumptions
• Markets are perfect i.e there are no transaction cost, no
commissions or bid-ask spreads.
• There are no taxes.
• Market participants can buy or sell goods without affecting
prices.
• There are no impediments to short selling.
• There is no default risk. Each of the two parties to every
transaction knows that counterparty will perform as
contractually required.
• All individuals are wealth maximisers.
• Market participants have an unlimited ability to borrow and
lend money at the rate r.
• Commodities can be stored indefinitely without any change in
their features such as quality
 Basic Cost of Carry Model

F = S + CC - CR

Where
F=theoretical Forward or future price
S= Spot price
CC= Carrying costs
CR= Carry return
 Proof of Cost of Carry Model

As with all proofs of propositions that are based on the absence

of arbitrage , the proof of the model can be done by contradiction.
Let us assume that

First case: Forward price is higher than theoretical forward price

what if: F > S + CC - CR

Second case: Forward price is lower than theoretical forward price.

What if : F < S + CC -CR or -F + S + CC -CR >0
 First Case
Today, time 0

Sell Forward at F0 No cash Flow

Buy deliverable spot asset -S0

Borrow +S0

Cash Flow at time 0 0

Contd….
Contd….
On the delivery date, time T
make delivery to satisfy the terms of the
forward contract +F0

Pay back loan principal and interest - S0 - CC = - S0 - int

= - S0[1+r]
Receive any carry return +CR

Cash Flow at time T + F0 - S0 - CC -CR>0

Hence arbitrage profit. This is called cash and carry arbitrage.
In cash and carry arbitrage, the arbitrageur borrows to buy the
spot asset, sells forward contract and carries deliverable asset till
forward delivery date.
 Second Case
Today, time 0

Buy Forward at F0 No cash Flow

Sell deliverable spot asset +S0

lend the proceeds from the short sale -S0

Cash Flow at time 0 0

Contd….
Contd….
On the delivery date, time T
Take delivery to satisfy the terms of the
forward contract -F0

receive loan principal and interest S0 + CC = S0 + int

= S0[1+r]
Pay any carry return to the customer -CR

Cash Flow at time T 6235716496 - F0 + S0 - CC -CR>0

Hence arbitrage profit. This is called reverse cash and carry arbitrage.
In reverse cash and carry arbitrage, the arbitrageur sells the goods
short, the proceeds of the sale are lent and a long position in a forward
contract is taken.
 Concepts
• Carry Costs - Additional Costs incurred by
buying and holding one unit of the
commodity. Interest charges on borrowing
to buy the good and the opportunity cost of
having cash tied up in the asset are the most
prominent of the carrying costs. Carrying
costs for physical commodities would also
include the costs of insurance, storage,
obsolescence, spoilage and so on.
 Concepts
• Carry return - There is no carry return for
commodities. For financial assets, the carry
return consists of the future value of the
cash inflows that are provided to the holder.
For example, interest earned on dividends
received before forward delivery, any
interest on coupon received, the interest that
can be earned on a foreign currency is a
carry return for forward exchange contract.
 Illustration

Suppose the price of the gold is $ 280/ per 10 gm. The

yearly interest rate is 10 percent. Calculate the forward price
as per the cost and carry model.

If the gold price for delivery six months hence is $300/10gm, is

there a possibility to earn arbitrage profit. How?

Ans. $ 294
 Pricing of Forward Contracts
✹ Case 1: For securities providing no income

✸ Case 2: For securities providing a given

amount of income

✸ Case 3: For securities providing a known

yield.
 For securities providing no income

F = S0 ert
Illustration: Consider a forward contract on a non-dividend
paying share which is available at Rs 70, to mature in 3-
months’ time. If the risk free rate of interest be 8 percent per
annum compounded continuously, what should be the price
of the contract.

Ans. Rs 71.41
 For securities providing a given
amount of income

F = [S0 - I]ert
Where I = present value of known cash income.

Illustration: let us consider a 6-month forward contract on 100

shares with a price of Rs 38 each. The riskfree rate of interest
(continuously compounded) is 10 percent per annum. The share in
question is expected to yield a dividend of Rs 1.50 in 4 months
from now. What is the expected value of the forward contract?
Ans: Rs 3842.31 [Hint: consider 100 shares as a whole.]
For securities providing a known yield.

F = S0 e (r-y)t
Illustration: Assume that the stocks underlying the index
provide a dividend yield of 4 percent per annum, the current
value of the index is 520 and the continuously compounded
riskfree rate of interest is 10 percent per annum. Calculate
the value of a forward contract with a maturity period of 3
months.
Ans Rs 527.85
Thank You