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Chapter 5
Determination of Forward and
Futures Prices
In this chapter we examine how forward
and futures contracts are priced.

Short selling
2

Short selling: the selling an asset that is not owned (.i.e., borrowed
from a broker).
The short seller is required to maintain a margin account with the
broker.

Similar to the margin account for futures contracts.

In addition, the short seller must pay to the broker any income that
would normally be received on the securities.

The broker will transfer this income to the account of the

client from whom the securities have been borrowed.

Short selling
3

Suppose an investor instructs a broker to short 500 IBM shares:

The broker will borrow the shares from another client and selling
them in the market.
The investor can maintain the short position for as long as
desired, provided there are always shares for the broker to borrow.
At some stage, however, the investor will close out the short
position by purchasing 500 IBM shares.
The investor takes a profit if the stock price has declined and a
loss if it has risen.

Example 1
4

Consider the position of an investor who shorts 500 shares in April when
the price per share is $120 and closes out the position by buying them
back in July when the price per share is $100. Suppose that a dividend of
$1 per share is paid in May. What is the net gain to the short seller?

Example 2
5

Suppose you desire to short-sell 400 shares of JKI stock, which has a bid price of
$25.12 and an ask price of $25.31. You cover the short position 180 days later when
the bid price is$22.87 and the ask price is $23.06. Suppose that there is a 0.3%
commission to engage in the short-sale (this is the commission to sell the stock) and
a 0.3% commission to close the short sale (this is the commission to buy the stock
back). What profit did you earn?

Consumption vs Investment Assets

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When considering forward and futures contracts, it is important to

distinguish between investment assets and consumption assets.
Investment assets are assets held by significant numbers of people
purely for investment purposes.
Consumption assets are assets held primarily for consumption.

The easiest forward contract to price is one written on an

investment asset that does not pay any income.

Investment assets with no Income

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When the underlying asset pays no income, the price of a

forward contract is given as:

F0 = S0erT
F0 = Forward price today
S0 = Spot price of the underlying asset
T = the time until maturity of the contract in years
r = continuously compounded risk-free rate for an investment maturing
at the delivery date (i.e., in T years)

Why is F0 = S0e

rT

true?

If F0 > S0erT then an arbitrageur can:

Borrowing S0 at interest rate r for T years
Buying 1 forward contract size worth of the asset for S0
Shorting a forward contract for F0
Delivering the asset at contract maturity and collect F0
Repaying the loan (with interest) of S0erT
Investors profit = F0 - S0erT

If F0 < S0erT then an arbitrageur can:

Short sell 1 forward contract size of the asset for S0 dollars
Invest the cash from the sale S0 at the interest rate r for T years
long a forward contract for F0
At contract maturity, collect S0erT from cash investment
Then, buy back the asset for F0 and return it to the broker

Example 1
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Consider a 4-month forward contract to buy a zero-coupon bond that will

mature 1 year from today (the bond still has 8 months at the end of the contract).
The current price of the bond is $930. Assume the 4-month risk-free rate of
interest, continuously compounded is 6% per annum. What should the forward
price be?

Example 2
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Consider a long forward contract to purchase a non-dividend-paying stock in 3months. Assume the current stock price is $40 and the 3-month risk-free interest
rate is 5% per annum. What should the forward price be? Suppose the forward
price is $43, what arbitrage opportunity exists (if any)?

Forwards on investments with Known Income

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We now consider pricing forward contracts with a known fixed

income as part of the contract.
When an investment asset provides a known dollar income, the
forward price is given as,
F0 = (S0 I )erT
where I is the present value of the income during the life of the
forward contract
Again
If F0 > (S0 I)erT there is an arbitrage opportunity
If F0 < (S0 I)erT there is an arbitrage opportunity

Example 3
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Consider a long forward contract to purchase a coupon-bearing bond whose current

price is $900. Suppose the forward contract matures in 9 months. Assume the coupon
payment of $40 is expected after 4 months. Assume that the 4-month and 9-month riskfree continuously compounded interest rate are 3% and 4% per annum, respectively.
What should the forward price be? Suppose the forward price is $870, what arbitrage
opportunity exists (if any)?

Example 4
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Consider a 10 month forward contract on a stock with a price of $50 and

expected dividends of $0.75 per share in 3 months, 6 months, and 9 months.
Assume the risk-free rate of interest, continuously compounded, is 8% per
annum for all maturities. What is the price of the forward contract?

Forwards on investments with Known Yield

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We now consider pricing forward contracts with fixed known

yield instead of a known income.
In particular the income is expressed as a percent of the
assets value at the time the income is paid.
Let q be the average yield per annum on an asset during
the life of a forward contract with continuous
compounding.
When an asset provides a known yield rather than a know
dollar income, the forward price is,

F0 = S0 e(r q)T

Example 5
15

Consider a 6 month forward contract on an asset that is expected to provide

an income equal to 2% of the asset price once during a 6-month period. The
asset price is $25.The risk-free rate of interest with continuous compounding
is 10% per annum. What is the price of the forward contract?

Valuing Forward Contracts

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It is important to note the difference between the forward price

today (denoted F0) and the value of the forward contract today
(denoted f ).
Forward contracts initially have a value of zero (f = 0), because
the delivery price in the contract (denoted K) is usually set to
equal the forward price (denoted F0).
However, once the deal is negotiated both the value of the forward
price and the value of the forward contract will change over time.

Banks are required to value all the contracts in their trading

books each day.

Valuing Forward Contracts

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Suppose
K = the delivery price in a forward contract
F0 = the forward price that would apply to the contract today
The value of a long forward contract is f = (F0 K)erT
The value of a short forward contract is f = (K F0)erT
With a little algebra, it can be shown that for a long position:
Value of forward contracts with no income: f = S0 KerT
Value of forward contracts with known income: f = S0 I KerT
Value of forward contracts with known yield: f = S eqT KerT

Example 6
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A long forward contract on a non-dividend-paying stock was entered in the

past. It currently has 6 months to maturity. The risk-free rate of interest
with continuous compounding is 10% per annum, the stock price is $25,
and the delivery price is $24. What is the price of the forward contract?

Pricing futures contracts

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The pricing technique of a futures contract is usually the same as

that for a forward contract, with the exception of Eurodollar
futures contracts.
However, when interest rates are uncertain futures and forward are
priced slightly different.
A positive correlation between interest rates and the asset price implies
that the futures price is slightly higher than the forward price
A negative correlation implies the reverse!

Futures prices of Stock Indices

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A stock index can be regarded as the price of an investment asset

that pays dividends.
The investment asset is the stock portfolio underlying the index.
The dividend paid by this investment asset reflects the dividends that
would be received by the holder of the portfolio of stocks underlying
the index.
It is usually assumed that the stock index pays a known dividend yield
denoted q

Therefore, a stock index futures price is

F0 = S0 e(r q)T

Example 7
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Consider a 3 month futures contracts on the S&P 500. Suppose that the
stocks underlying the index provide a continuously compounded dividend
yield of 1% per annum. Assume also that the current value of the index is
1300, and that the continuously compounded risk-free interest rate is 5% per
annum. What is the price of a futures contract?

Example 8
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The risk free rate is 7% per annum with continuous compounding, and the
dividend yield on the stock index is 3.2% per annum. The current value of
the index is 150. What is the 6 month futures price?

Index Arbitrage
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In practice the dividend yield on the stock portfolio underlying an

index varies week by week throughout the year.
So there may be stock index arbitrage opportunities:
When F0 > Se(r q)T an arbitrageur buys the stocks underlying the
index and sells futures on the index
When F0 < Se(r q)T an arbitrageur buys futures on the index and
shorts (or sells) the stocks underlying the index
These strategies are known as Index Arbitrage.
The process involves simultaneous trades in futures and many
different stocks.

Example 9
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Describe an arbitrage opportunity using the quotes given below. Assume that the
dividend yield on the S&P 500 index is 2.5% per year (continuously
compounded).
Quotes: On March 12, 1998, the S&P 500 Index June Futures settlement price
was 1080.10. One futures contract is for 250 times the index value. The riskfree rate was 5.07% (continuously compounded), and the number of days to
maturity was 98. The spot index value was 1068.47.

Pricing Currency Forwards and Futures

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Unlike other underlying assets, when we buy and store a currency,

it earns interest at an appropriate rate, so that one unit of the
currency grows to more than one unit over time.
In fact, a foreign currency is analogous to a security paying a
dividend yield, where the dividend yield is the risk-free interest
rate in the foreign country.
In this case, the price of a contract is F0 = S0e(r rf )T
Note, this is the well-known interest rate parity relationship from
international finance.

Example 10
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Suppose that the 2-year interest rates in Australia and the United States are 5%
and 7%, respectively, (continuously compounded) and the spot exchange
between the Australian dollar (AUD) and the US dollar (USD) is 0.6200 USD
per AUD. What is the 2-year forward exchange rate? Suppose the forward
exchange rate is 0.63, what arbitrage opportunity exists (if any)?

Futures on Commodities
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We now move to consider futures contracts on commodities.

Some commodities pay income, but almost all of them have
storage costs. Storage cost can be treat as negative income.
Let U be the present value of the net storage costs, so that the
futures price is given as
F0 = (S0+U )erT
If the net storage costs is expressed as a percent of the asset value,
denoted u, the futures price is
F0 = S0 e(r+u )T

Example 11
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Consider a 1 year futures contract on an investment asset that provides

no income. It costs $2 per unit to store the asset, with the payment
being made at the end of the year. Assume that the spot price $600 per
unit and the risk-free rate is 5% per annum for all maturities. What is
the price of the futures contract? Describe a potential arbitrage strategy.

Convenience Yield
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Users of the consumption asset place a different value to the

commodity than investors (who use the asset to speculate).
As a result, consumption asset have a convenience yield. This
measures the extent to which users of the commodity feel that
ownership of the physical asset provides benefits that are not
obtained by holding the future contract.
If the storage cost is known and has a present value, U, the
convenience yield, y, is defined so that
F0eyT = (S0+U )erT
If the cost of storage is proportional to the spot price, u, then the
convenience yield, y, is defined so that
F eyT = S e(r+u)T

or

F = S e(r+u-y)T

Convenience Yield
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The convenience yield reflects the markets expectation

concerning the future availability of the commodity.

The greater the possibility that a shortage of the commodity

may occur in the future, the higher the convenience yield .

The larger the inventories of the commodity, the smaller the

convenience yield.

The Cost of Carry

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The storage cost of the underlying asset plus the interest costs of
financing it minus the income received from it is called the cost
of carry, denoted c.
The concept of the cost of carry summarizes all the ideas we have
discussed in this chapter. For instance,
i. Non-dividend paying stocks: the cost of carry is r
storage & no income)

(no

ii. Stock index: the cost of carry is r q (income earned at rate q)

iii. Currency futures: the cost of carry is r rf
currency earn income at rate rf (foreign risk-free rate))

(foreign

iv. Commodities with income q and storage costs at rate u: the cost of
carry is r q + u

The Cost of Carry

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Thus, with cost of carry the futures price for a contract on an

investment asset can be written as:
F = S0ecT

For a consumption asset it is

F = S0e(c y)T
where y is the convenience yield on the consumption asset

The Implied Repo Rate

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The implied repo rate is the interest rate embedded in futures or

forward prices.
It is the interest rate that would make observed forward or
futures prices be equal to the theoretical prices predicted under
the no-arbitrage pricing method.
For example, suppose that there is a forward contract on an
asset that involves no payouts. Then, the forward and spot
prices are related by the expression
F0 = S0erT
With some basis algebra, implied repo rate given by F0, S0,
1
and T is
r

ln F ln S
0

The Implied Repo Rate

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Similarly, if we consider an asset that has a continuous dividend

yield of d, the forward and spot prices are linked via:

F = S0e (r - q)T
Therefore, the implied repo rate in this case is given by:
1
r q ln F0 ln S0
T

Similarly, if the asset has storage costs at rate u, the implied repo rate
in this case is given by:r q - u 1 ln F ln S
T

Example 1
35

Let the underlying asset on a forward contract be a stock on which

no dividends are expected over the next three months. Suppose the
current spot price of the stock is S0 = $25 and the forward price for
delivery in three months is F0 = $26. What is the implied repo rate?

The Implied Repo Rate and Arbitrage

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The implied repo rate represents the rate at which an investor can
borrow synthetically by simultaneously going short spot and long
forward.

Suppose the implied repo rate is r, and you can borrow at a

rate rb < r .

Then you can create an arbitrage opportunity by borrowing at

the rate rb and investing synthetically at the rate r.

That is, by borrowing at the rate rb, buying the asset in the
spot market, and selling the forward contract.

The Implied Repo Rate and Arbitrage

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Suppose the implied repo rate is r and you can lend at a rate rl > r.
Then you can create an arbitrage opportunity by synthetically
borrowing at the rate r and lending at rl

That is, by buying the forward contract, selling the asset in the
spot market, and lending at the rate rl.
Note that, arbitrage is precluded as long as rl < r < rb.
This means that there is an interval of forward (or futures)
prices that is consistent with no-arbitrage when borrowing and
lending rates differ.
when rl = rb, we obtain a unique forward (or futures) price

Example 2
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Suppose the current spot price of gold is $330 per oz, and the forward
price for delivery in one month is $331.35. Suppose also that the onemonth borrowing and lending rates you face are 5% and 4.85%,
respectively. Finally, suppose that it costs nothing to store gold. Is there an
arbitrage opportunity?

Example 3
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Consider a futures contract on a stock index. Suppose that the current index
level is 1400, the three-month index futures level is 1425, the dividend yield on
the index is 2%, and you can borrow for three months at 8%. Is there an
arbitrage opportunity present here?