Topic 4

Futures and Forwards II

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 Futures and Forwards II
ñ In our second futures and forwards lecture we will:
ñ Develop pricing models for forwards when the underlying asset
has cash flows associated with it during the period of the
forward contract.
ñ Discuss the relationship between futures and forward prices.
ñ Examine the relationship between forward/futures prices and the
expected future spot price.
ñ Discuss accounting issues relating to hedging.

O
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ ½ecall that we demonstrated that a forward contract on a
security that pays no dividends will have, at time 0, a
delivery price of:
›

u ë 
and that we could attribute this formula to the notion of
the opportunity cost that the short party faced: to induce
the short party to enter the contract, the long party must
pay them interest at least in the amount that the short
could get if they simply sold the asset now and invested it
at the risk-
risk-free rate.
J
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ ½ecall, however, that during the period of the forward
contract, if the short party physically holds the underlying
asset, then they will garner any benefits that accrue to
the asset during that period.
ñ For example, if the forward contract were written on a stock, and
the stock paid a dividend, then if the short party physically held
the stock on the ex-
ex-dividend date, they would receive the
dividend.
ñ The short party still has no risk (ignoring credit risk) in
the forward contract; as a result they should still only
earn the risk-
risk-free rate for being the short party.
Consequently, the benefits that accrue to holding the
underlying asset would ›
 the amount that the long
would have to pay the short to induce them to enter the
contract. ?
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ To see this, consider a security that had a perfectly
predicable set of cash flows that will occur between t
and T.
ñ Examples are stocks that have known dividends and coupon
payments from bonds.

ñ Denote the present value of those cash flows as I

(discounting at the risk free rate). For their to be no
arbitrage, the relationship between F and S must be:
(S-I)erT
F = (S-

ÿ
 Forward Contracts on a Security
that Provides a Known Cash Income
Example:
ñ Dssume a 10 month forward on a dividend-
dividend-paying stock. Current
price is $50. Dssume r = 8%, and dividends of .75 in 3, 6, and 9
months.
I = .75e-.08(.25) + .75e-.08(.5) + .75e-.08(.75) = 2.162

ñ T-t = 10/12 = .83333 years:

(50-2.162)e.08*.83333 = 51.136
F = (50-

-
 Forward Contracts on a Security
that Provides a Known Cash Income
Second example:
ñ Dssume a 3 month forward on a dividend-
dividend-paying stock with
current price of $100. Dssume r = 4%, and the stock will pay a
dividend of $2.00 in 1 month.
I = 2.00-.04(1/12) = 1.9933
ñ T-t = 3/12 = .25 years:
(100-1.9933)e.04*.25 = $98.99
F = (100-

ñ We can use this example to demonstrate the arbitrage

opportunity that enforces this rule.

 
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ To see this, consider what would be the case if this did
not hold:
ñ Case 1: F > (S0-I)erT
ñ Letƞs say that we saw F=101, how would the arbitrageur exploit the
opportunity?
ñ Dt time 0:
ñ Short the forward contract (i.e. agree to deliver the stock in three
months for $101).
ñ Borrow $100 today at the risk-
risk-free rate and buy the stock.
ñ Dt time 1 month:
ñ ½einvest the dividend at the risk-
risk-free rate.
ñ Dt time 3 months they do 4 things:
ñ Deliver the stock into the forward contract and receive $101.
ñ ½eceive $2.103 (2e.04(2/12)) from the reinvested dividends.
ñ ½epay $101.005 (100e.04(3/12)) for the $100 you borrowed at time 0.
ñ Net time 3 cash: +101 + 2.013 ƛ 101.005 = $2.008
r
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ We can show this on a timeline:
Dctions

0 1 3
Cash Positions

·
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ We can show this on a timeline:
Dctions
1. Short futures contract
2. Borrow $100 at 4%
3. Buy stock for $100

0 1 3
Cash Positions

1. 0
2. +$100
3. -$100
$0

c
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ We can show this on a timeline:
Dctions
1. Short futures contract 1. ½eceive $2 dividend
2. Borrow $100 at 4% 2. ½einvest at 4%
3. Buy stock for $100

0 1 3
Cash Positions

1. 0 1. +$2
2. +$100 2. -$2
3. -$100 $0
$0

cc
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ We can show this on a timeline:
Dctions
1. Short futures contract 1. ½eceive $2 dividend 1. ½eceive $101 from futures delivery
2. Borrow $100 at 4% 2. ½einvest at 4% 2. ½epay loan ($101.005)
3. Buy stock for $100 3. ½eceive reinvested dividends (2.013)

0 1 3
Cash Positions

1. 0 1. +$2 1. +$101.000
2. +$100 2. -$2 2. -$101.005
3. -$100 $0 3. -$ 2.013
$0 + 2.008

cO
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ What about the opposite situation?
ñ Case 2: F < (S0-I)erT
ñ Letƞs say that we saw F=98, how would the arbitrageur exploit the
opportunity?
ñ Dt time 0:
ñ Take a long position in the forward contract (i.e. agree to buy the stock
in three months at $98).
ñ Short the stock for $100 today and invest at risk
risk--free rate.
ñ Dt time 1 month:
ñ Borrow $2 at risk free rate.
ñ Pay $2 to the person from whom you borrowed the stock.
ñ Dt time 3 months:
ñ ½eceive 101.005 (100e.04(3/12)) from $100 you invested at risk-
risk-free rate.
ñ Buy stock for $98 via forward contract. ½eturn stock to original owner.
ñ ½epay $2.013 (2e.04(2/12)) for the $2 you borrowed at time 1.
ñ Net time 3 cash: +101.005 - 2.013-
2.013- 98.00 = $0.9920
cJ
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ We can also show this on a timeline:
Dctions

0 1 3
Cash Positions

c?
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ We can show this on a timeline:
Dctions
1. Go long futures contract
2. Short stock at $100
3. Invest $100 at 4%

0 1 3
Cash Positions

1. 0
2. +$100
3. -$100
$0

cÿ
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ We can show this on a timeline:
Dctions
1. Short futures contract 1. ½eceive $2 dividend
2. Borrow $100 at 4% 2. ½einvest at 4%
3. Buy stock for $100

0 1 3
Cash Positions

1. 0 1. +$2
2. +$100 2. -$2
3. -$100 $0
$0

c-
 Forward Contracts on a Security
that Provides a Known Cash Income
ñ We can show this on a timeline:
Dctions
1. Short futures contract 1. ½eceive $2 dividend 1. ½eceive $101 from futures delivery
2. Borrow $100 at 4% 2. ½einvest at 4% 2. ½epay loan ($101.005)
3. Buy stock for $100 3. ½eceive reinvested dividends (2.013)

0 1 3
Cash Positions

1. 0 1. +$2 1. +$101.000
2. +$100 2. -$2 2. -$101.005
3. -$100 $0 3. -$ 2.013
$0 + 2.008

c 
Forward Contracts on a Security that
Provides a Known Dividend Yield
ñ Some securities such as stock indices and currencies
essentially have a continuous dividend yield instead of a
discrete dividend.
ñ Thus you can think of the asset as paying a continuous
dividend at rate q, based on the value of the security.
ñ Thus if q=.10, and the security price is $50, the dividends in the
next small period of time are paid at the rate of $5 per year.
ñ The same basic logic for pricing forward contracts on
instruments that pay a discrete dividend applies to
forward contracts on instruments that pay a dividend
yield: the total earnings of the short party still should still
be the risk-
risk-free rate. Ds a result the dividend yield
›
  the rate that the long party must pay. cr
Forward Contracts on a Security that
Provides a Known Dividend Yield
ñ Thus, the formula for determining the forward price is:
F = S0e(r(r--q)T
where q is the dividend yield, expressed in annual terms.

ñ For example, if the S&P 500 had a dividend yield of 4%

the six-
six-month risk free rate were 3%, and the value of
the S&P were 1009.37, then the 6 month forward price
for an S&P forward contract would be:
F = 1009.37e(.03
(.03--.04)(.5)= $1004.34

ñ Note that when q>r, you will find an inverted market

market.. The next
page shows CME quotes for the S&P 500 index for 9/13/06.

c·
Forward Contracts on a Security that
Provides a Known Dividend Yield

ƥ What does the fact that the prices are rising with maturity indicate?

O
Forward Contracts on a Security that
Provides a Known Dividend Yield
ñ We can develop a somewhat more formal proof of the
pricing formula:
ñ Dgain consider two portfolios,
1. One long forward contract and cash equal to Ke-r(T- r(T-t) (f+Ke-r(T-
r(T-t)).

2. 1*e-q(T-
q(T-t) units of the security with all income being reinvested in the security. Thus

at time T you will once again have one unit of the security, which is worth ST.
ñ Clearly D and B once again have the same payoffs at time T, and so
once again, setting them equivalent:
f+Ke-rT = Se-qT
Or f = Se-qT - Ke-rT
setting f = 0 and solving for K leads to:
K = F = Se(r(r--q)T

Oc
Forward Prices Versus Futures Prices
ñ ßull demonstrates that if interest rates are constant, then forwards and
futures prices are the same.
ñ Obviously in the real world interest rates are not constant, and so forward
and futures prices are not the same.
ñ The reason for this is the discounting of the mark to market cash flows.
ñ One way to see this is to consider if St is highly correlated with rt - so that
when r increases, S tends to increase.
ñ When rates rise, the spot price of the asset will rise as well and so will the futures
price.
ñ D short party in the futures contract will have to raise cash to mark to market ƛ
when rates are high.
ñ If rates fall, the spot price of the asset will fall, and so will the futures price. The
short party will receive cash from the mark to market, when rates are low.
ñ So on average the short party in the futures contract must raise funds when rates
are high and invest funds when the rate is low. If instead they had used a forward
contract they would not have any marking to market ƛ so, assuming they wind up
at the same closing price, the short futures contract would be more expensive
than the short forward contract.
ñ The short party, therefore, would demand a higher futures price to induce them to
enter into this contract as opposed to a forward contract.
OO
 Forward Prices Versus Futures Prices
ñ There are a some empirical papers that address the
differences between futures and forwards prices.

ñ Cornell and ½einganum studied forward and futures prices on

Pounds, C. Dollars, Marks, Yen and Swiss Francs and found little
statistical differences between them.

ñ For commodities and precious metals, French as well as Park

and Chen, find that forward and futures prices are significantly
different from each other, and that the futures prices tend to be
higher than the forward prices.

OJ
 Stock Index Futures
ñ D stock index tracks the changes in the value of a
hypothetical portfolio of stocks. The weight of a stock in
the portfolio equals the proportion of the portfolio
invested in the stock.
ñ D few tidbits about stock index futures:
1. The percentage increase in the value of a stock index over a
small interval of time is usually defined so that it is equal to the
percentage increase in the total value of the stocks in the
portfolio at that time.
2. Cash dividends received on the portfolio are ignored when
percentage changes in most indices are calculated.
3. If the hypothetical portfolio of stocks remains fixed, the weights
assigned to each stock do not remain fixed. Consider this
example of three stocks.
O?
 Stock Indices
ñ In practice, the weights for stock indices are calculated
in one of two ways:
ñ Price weighted (DJID and Nikkei 250): Stocks are price
weighted -> i.e. assume you own one share of each stock and
then add prices together (adjusting for splits, changes, etc.)
ñ Market capitalization weighted (S&P and most other indices):
weighted based on percentage of market capitalization for
entire portfolio:
x
 x
   
ü u
   

 
 


Oÿ
 Futures Prices of Stock Indices
ñ Ds mentioned earlier, most indices can be thought of as
a security that pays dividends. Usually it is convenient
to consider them as paying dividends continuously. Let
q be the dividend yield rate, then the futures price is
given by:
F = Se(r(r--q)(T-
q)(T-T).

ñ If you were uncomfortable with using the dividend yield

approach (say if you were using a small index), then you could
estimate individual dividends and apply the formula for a futures
contract on a security paying a known dividend.

O-
 Index Drbitrage
ñ Once again we can use arbitrage arguments to prove the equation:
ñ If F > Se(r(r--q)(T-
q)(T-T), then buy the stocks underlying the index and short

futures contracts. If F < Se(r(r--q)(T-

q)(T-T), do the opposite: short the stock and

buy the futures contract.

ñ Because the transactions costs of buying the stocks are relatively

high, arbitrage can sometimes be found in the market; this is known
as index arbitrage. So-
So-called Program Trading is where your
computer system executes trades as soon as the arbitrage becomes
possible.

ñ Note that during the 1987 crash, there was a breakdown in the
relationship between F and S. This was due to poor mechanics of
trading (on the 19th) and then due to restrictions placed by NYSE on
program trading (on the 20th).

O 
 ßedging Using Index Futures
ñ Consider the problem faced by the manager of a large
equity portfolio:
ñ They may wish to change the risk-
risk-profile of the portfolio, but do
not want to bear the transactions costs associated with changing
the actual holdings.
ñ Consider, for example, a large mutual fund such as Fidelity
Magellan, which has roughly $45 Billion in assets.*
ñ It has a Beta of approximately 1.01 (relative to the S&P 500). So it
has an almost perfect exposure to the general market risk of the
stock market.
ñ Letƞs just assume for a moment that the managers of Fidelity
decided that they wanted to reduce the exposure of the fund to
the stock market (assuming that the prospectus of the fund
would allow them to do this.) Letƞs say they want to reduce the
Beta of the portfolio to 0.5.

* Ds of 9/12/2003. Source: Fidelity web site (http://personal.fidelity.com/products/funds/mfl_frame.shtml?316184100 )

Or
ßedging Using Index Futures
ñ One way to do this would be to sell half of the fundƞs assets and
invest it in the risk-
risk-free rate.
ñ This is not practical, there is no way they could unload $22.5 Billion
in stocks without depressing the market. They would get terrible
prices for the assets, not to mention that they would lose a lot of
money on commissions as well. Further, selling the assets would
take quite a bit of time.
ñ In addition, the fund managers may only want to „ ››

change the risk profile of the portfolio. They may want to hold the
stocks for the long run, but want to temporarily reduce the risk of
the portfolio ƛ for say 3 months.
ñ D relatively easy way for them to change the portfolioƞs risk
would be to hedge that risk using a stock index futures contract.
ñ The next few slides discuss the general method for doing this
(as outlined in ßullƞs book), and then we will return to an
example based on Magellan.

O·
 ßedging Using Index Futures
ñ ½ecall the definition of ë: it is the slope of the regression
line between the excess returns (i.e. returns less the risk
free rate) on a portfolio of stocks and the excess return
on the market (i.e. the stock market as a whole.)



 
›       
›   

ñ When ë=1, the return on the portfolio tends to mirror the return
on the market: i.e. the portfolio has the same risk as the market.
When ë=2, the excess return on the portfolio is twice that of the
market - its risk is twice as high.
ñ Consider also that for a futures contract on large indices, such
as the S&P 500, the index can serve as a proxy for the market
as a whole.
ñ Thus we can say that if a portfolio has a ë=3, its expected excess
return will be equal to three times the excess return on the
underlying index.
J
 ßedging Using Index Futures
ñ ßull defines the following terms:
ñ P - the value of the portfolio
ñ D - underlying asset value of one futures contract (if one futures
contract is on m times the index, D = mF)
ñ If you are working with a portfolio that exactly mirrors a
specific index upon which futures contracts are written,
and you want to completely hedge the risk of the
portfolio, all you have to do is short an appropriate
number of future contracts.
ñ The optimal number of contracts to short when hedging is:
N* = P/D

Jc
 ßedging Using Index Futures
ñ If, however, your portfolio does not exactly match the
underlying index, (but assuming that your underlying
index has a Beta of 1), then the optimal number of
futures contracts to completely hedge the risk is
proportional to the Beta of your portfolio:

N* = ë(P/D)

ñ Note that if the your index had a Beta that was

something other than one, the optimal number futures
contracts would be proportional to the ratio of your
portfolios Beta to the Beta of the underlying index, with
both of those Betaƞs defined relative to the same
underlying market.
JO
 ßedging Using Index Futures
ñ The previous formulas, while important, do not exactly help our
Magellan fund manager. They do not want to completely eliminate
the exposure to the stock market (i.e. to have a net ë of 0), but
rather want to reduce that exposure in half, i.e. to have a net ë of
0.5.
ñ Let ë be the current portfolio position and let ë* be the desired portfolio
position. To get to the new portfolio position the optimal number of
index futures contracts to short is:
N*= (ë
(ë- ë*)(P/D)

ñ Note that if ë*> ë, that is, you want to increase risk, you will get a
negative number for N*, that means you take a LONG position (since N*
is the number of contracts to short). ßull flips ë and ë* and then says
that is the number of contract to go long, but the effect is the same!

JJ
 ßedging Using Index Futures
ñ So let us return to our Magellan example.
ñ ½emember that the ë of Magellan is 1.01, and that we want to
reduce it to 0.50.
ñ We will assume that we want to reduce that risk for 1 month.
ñ We should use the S&P 500 index futures contract to do this.
ñ There are two S&P 500 Index Futures contracts, and each trade on
the CME.
ñ The S&P Index Futures contract is based on $250 times the index
amount.
ñ The ƠMiniơ S&P Futures contract is based on $20 times the index
amount.
ñ Obviously to hedge a $45 Billion position, we will use the larger
contract.

J?
ßedging Using Index Futures
ñ On 9/12/2006, the S&P 500 settled at 1318.07, and the S&P 500 index
futures contract settled at 1317.60. The value of the portfolio was
(roughly) $45,000,000,000. Thus:
P = $45,000,000,000
D = $250*1317.60 = 329,400.00
ë = 1.01
ë*= 0.50

ñ So our optimal number of contracts to hedge would be:

N*=(
=(ëë-ë*)*(P/D)
N*=(1.01
=(1.01--0.50)*(45,000,000,000/329,400)
N*=(0.51)*(136,612.02) = 69,672 contracts.

ñ In reality, there will be a problem with this, because the largest position the
CME allows is 20,000 contracts in a given month, so you would really have
to spread your hedge over 6 or 7 months worth of contracts, but we will
ignore this for now.

Jÿ
 ßedging Using Index Futures
ñ So how well would the hedge work?
ñ On 9/13/2003, the S&P is at 1318.07, and the net value of the portfolio
was $45,000,000,000.

ñ Dssume that on 9/18/2006, the S&P closes at 1351.09, so it had

increased in value by 2.505%. Since the ë of the portfolio was 1.01, we
would expect the value of the portfolio to increase by 2.505*1.01, or
2.53%. Thus, the new portfolio value would be:
45,000,000,000 * 1.0253 = 46,127,250,000.
That is you have made (46,127,250,000-
(46,127,250,000-45,000,000,000 = 1,127,250,000)
on the portfolio.

ñ Of course, the S&P index futures would rise as well, and you are ›„
the index. Indeed, assume that the September Futures contract on
9/18/2003 settles at 1349.61. So your hedge has moved:
-69,672 * (1349.61-
(1349.61-1317.60)*250 = -557,479,467

J-
 ßedging Using Index Futures
ñ So what is the net change in your position?
ñ ½emember, you made 1,127,250,000 on the portfolio, but lost
557,479,467 on the hedge (the S&P index futures), so net you
have made: 1,127,250,000 - 557,479,467 = 569,770,533 on
your net position.
ñ This is 50.5% of what you would have made had you not
hedged.
ñ Why was it not exactly 50% or 49%? Because the ë of your
portfolio was probably changing when rates change.
ñ This illustrates the notion that you will frequently make
more money by not hedging, but that what you are
doing is reducing risk.

J 
 ßedging Using Index Futures
ñ Indeed, the following table shows the hedged and un-
un-
hedged position for various dates in September, 2006.
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Jr
 ßedging Using Index Futures
ñ ßedging an Individual Stockƞs exposure.
ñ Basically you just treat the stock as a portfolio, and use its ë to
determine the hedge ratio.

ñ Forwards and Futures on Currencies

ñ You are not responsible for Forwards/Futures on Currencies

J·
 Commodities Futures
ñ Commodities futures contracts fall into two groups:
those where the underlying is held primarily for
investment and those where the underlying is held
primarily for consumption. This is really important
because if it is held for consumption some of our
arbitrage arguments break down and no longer hold.
ñ Examples: Gold is held primarily for investment, whereas wheat,
oil, cattle, etc. is primarily held for consumption.

?
 Commodities ßeld for Investment
ñ Some commodities, primarily gold and silver, are held by
a significant number of investors solely for investment.
If storage costs are zero, then they can be treated as
securities that pay no income. Thus the correct formula
is:
F = Ser(T
r(T--t)

ñ If there is a fixed storage cost, then let U be the present

value of those storage costs incurred during the life of
the contract, and treat it as negative income. This
allows us to use the standard formula for securities that
pay a known income:
F = (S - (-U))er(T
r(T--t) = (S+U)er(T
r(T--t)

?c
 Commodities ßeld for Investment
ñ If the storage costs are proportional to the price of the
commodity, they can be treated as a negative dividend
yield:
F = Se(r(r--(-u))(T-
u))(T-t) =Se(r+u)(T
(r+u)(T--t)

where u is a per annum proportion of the spot price.

ñ Consider a one year gold futures contract, and assume that it

costs $2 per ounce to store gold, payment made at the end of
the year. If the spot price is $450 and the risk free rate is 7%
for one year, then:
U = 2.00e-.07=1.865, and so the forward price would be:
F = (S0+U)erT = (450+1.865)e.07(1)=484.63

?O
 Commodities ßeld for Investment
ñ Suppose that an arbitrageur observes a violation of the
pricing rule of this type:
F>(S+U)er(T
r(T--t)

ñ Ds usual, they would take the following actions to

exploit the arbitrage:
1. Borrow S+U dollars at the risk-
risk-free rate and use it to buy one
unit of the commodity and to pay the storage costs.
2. Short a futures contract on the commodity.

ñ Clearly, then, as arbitrageurs do this F will approach

(S+U)er(T
r(T--t), so the situation will not last long.

?J
 Commodities ßeld for Investment
ñ Suppose next that the arbitrageur notes the following:
F<(S+U)er(Tr(T--t)

ñ If the commodity is held primarily for investment they can do

the following:
1. Sell the commodity, save the storage costs, and invest the proceeds
at the risk-
risk-free rate.
2. Buy the futures contract.

ñ If, however, the majority of investors are holding the

commodity for consumption, not investment, then they will
not be willing to execute this second strategy.
ñ The reason for this is that they need to be able to use the commodity.
Therefore this last strategy will not apply, and as a result the lower
bound will not hold. Thus, for futures on commodities not held for
investment, the following is the most we can say: Fà(S+U)er(T r(T--t)

ñ If storage costs are proportional: FàSe(r+u)(T

(r+u)(T--t).

??
 Convenience Yields
ñ In the equation above, the difference between F and
(S+U)er(T
r(T--t) is the    

.

. Frequently it can
be written as:
Fey(T
y(T--t) = (S+U)er(T r(T--t)

ñ where y is the c. yield. If using the proportional version:

Fey(T
y(T--t) = Se(r+u)(T
(r+u)(T--t)

ñ or rewriting this in the more usual form:

F = Se(r+u (r+u--y)(T-
y)(T-t)

?ÿ
The General Cost of Carry Model
ñ Dll of the futures and spot price relationships we have seen before
have a common theme. The general name for this is the Ơcost of
carryơ model. Essentially this says that the futures price is a
function of the cost of carrying (holding) the underlying asset. This
is consistent with our intuition that the forward price is really a form
of compensating the ›„ for Ơholdingơ the asset for the long
party.
ñ For non-
non-dividend paying securities, the cost of carry is r.
ñ For a stock index it is r-
r-q, where q is the dividend yield.
ñ For a commodity with storage costs proportional to its price, it is r+u.

ñ Define the cost of carry as c. The general model to use, then is:
F = S ec(Tc(T--t)

and for a consumption asset it is:

F = S e(c
(c--y)(T-
y)(T-t).
?-
 Futures Pricing Models
ñ Weƞve developed quite a few pricing models, letƞs make
sure we enunciate them:
ñ Security paying no income: F = S0erT
ñ Security with known discrete dividends: F = (S0-I)erT
ñ Security with dividend yield: F = S0e(r(r--y)T
ñ Investment Commodity with fixed storage costs: F = (S0+U)erT
ñ Investment Commodity with proportional storage costs: F=S0e(r+u)T
ñ Consumption Commodity with fixed storage costs: F<=(S0+U)erT
ñ Consumption Commodity with proportional costs: F<=S0e(r+u)T
ñ Consumption Commodity with convenience yield: F=S0e(r+u
(r+u--y)T

ñ General cost of carry model:

ñ F=S0ecT, where c = r, r- r-q, r+u, etc. as appropriate.
ñ F=S0e(c
(c--y)T, where c is as above and y is the convenience yield.

? 
 Delivery Choices
ñ Most futures contracts do not specify a delivery date, but
rather a range when delivery is permissible. Ds a result,
the short party in the contract will choose to make
delivery when it is to their advantage. This presents a
problem when trying to determine futures prices: what
day to use for T in all of the (T-
(T-t) equations?
ñ Consider the dividend yield model: F=S0e(r(r--y)T.
ñ If F increases as T increases, the benefits from holding the asset are
less than the risk-
risk-free rate - so the short party must want to get their
money out as soon as possible. They will then want to make delivery
as soon as possible, so you should assume T will be the soonest date
possible.
ñ If, however, F decreases as T increases, the opposite is true, and they
will deliver as late as possible, or so you should assume.

?r
Futures Prices and the Expected
Future Spot Price
ñ D common question is whether the futures price is the
same as the expected future spot price. That is, is the
price of a wheat futures contract for delivery in three
months the same as the marketƞs expected spot price of
that wheat in three months?

ñ I would begin by pointing out that none of our pricing

equations utilize the expected spot price, so I would not
expect any such relationship to hold.

?·
 Futures Prices and the Expected
Future Spot Price
ñ To answer this we must look at a risk and return
analysis.
ñ From CDPM, recall that there are two types of risk. Non-
Non-
systematic risk is that risk which can be diversified away,
whereas systematic risk cannot. In general, the higher the
systematic risk of an investment, the higher the expected return
demanded by an investor.
ñ Consider now the risk in a futures position.
ñ Begin by assuming that at time t the speculator puts the present
value of the futures price into a risk-
risk-free investment, i.e. they
invest:
Fe-rT
at the risk free rate (giving F dollars at time T) and they take a
long position in the futures contract.
ÿ
 Futures Prices and the Expected
Future Spot Price
ñ Dt time T they use the cash in the risk-
risk-free account (F) to take
delivery of the contract and then sell the commodity for S
dollars.
ñ Thus the cash flows are:
Time 0: -Fe-r(T-
r(T-t)

Time T: +ST

ñ Dt time 0 the present value of the investment is:

-Fe-r(T-
r(T-t) + E(S )e-k(T-
T
k(T-t)

ñ where k is the discount rate for this stock.

ÿc
 Futures Prices and the Expected
Future Spot Price
ñ Note that -Fe-r(T-
r(T-t) is an amount, not a discount rate.

ñ Dssuming that all investment opportunities in securities

markets have $ › „›  „
 :
-Fe-r(T-
r(T-t) + E(S )e-k(T-
T
k(T-t) = 0, or

F = E(ST)e(r(r--k)(T-
k)(T-t)

Thus only if k=r will F=E(ST).

ñ What does it mean that all investment opportunities in a
securities market are correctly priced: you do not earn (on
average) more than the appropriate risk-
risk-adjusted rate for that
asset, i.e. there are no arbitrage opportunities.

ÿO
 General ½esult
ñ Forward contracts, by design, are set to have an initial
value, ft = 0. Ds time progresses, this value may become
positive or negative.

ñ There is a general relationship, applicable to all forward

contracts, that gives the value of a long road contract, f, in
terms of the originally negotiated delivery price K and the
current forward price F:
(F-K)e-r(T-
f = (F- r(T-t)

ñ Note that if you compare two forwards, one with delivery

set at K and one at F, but otherwise identical, then the only
difference between the two is the delivery price.
Discounting that back to today yields the above formula.
ÿJ
 Seasonality
ñ Certain commodities, especially agricultural and fuel
commodities, have a seasonal component.
ñ Corn, for example, is harvested in the fall but is consumed
throughout the year.
ñ If corn supply/demand were constant, then you would expect
the price at harvest to be the same year after year.
ñ Of course since it is consumed throughout the year it requires
storage, so you would expect to see futures prices rising through
the year at the risk free rate plus storage costs (i.e. F=S0e(r(r--u)T).
ñ The difference here is that u changes, essentially it is lower for
maturities near the harvest and larger for maturities further from
the harvest.

ÿ?
 Futures ßedge Dccounting
ñ Financial Dccount Standard (FDS) #133, specifies how
firms that use futures contracts must account for the
hedge transactions.
ñ These standards primarily affect two of the firms
accounting statements: the balance sheet and the
income statement.
ñ The balance sheet lists the value of each asset and liability of
the firm.
ñ Many items, such as inventory, are recorded on the balance sheet
at their purchase price, regardless of their current market value.
These values are known as Ơbookơ value and may not be related to
current market values. This is also true for certain liabilities that the
firm may have on their books.

ÿÿ
 Futures ßedge Dccounting
ñ The income statement is intended to show the net
income (i.e. earnings) of the firm.
ñ Traditionally items such as inventory did not show up in the
income statement except when it was purchased and then when
it was sold.
ñ Speculative futures positions have to be shown on both
the balance sheet and the income statement at their fair
market value as of the reporting date.
ñ The problem was (and still is to some degree) that when you put
a hedge on with a financial derivative, the change in the
derivative would show up in the income statement, but the
change in the asset you were hedging (if say inventory) would
not! The accounting system tended to only show half the hedge.

ÿ-
 Futures ßedge Dccounting
ñ Ds more firms began to use derivatives to hedge, it
became clear that the system had to be changed. The
idea behind FDS 133 was to try to modernize the
accounting system.
ñ FDS 133 allows futures positions used for hedging to be
accounted for differently than speculative positions.
ñ The full text and a summary of FDS 133 can be found at
this web site:
http://www.fasb.org/st/#fas50

ÿ 
 FDS 133
General ½ule
ñ The general rule is that all derivatives must be marked-
marked-to
to--
market and recorded on the companyƞs balance sheet as
separate assets/liabilities each period.
ñ Derivatives that are used for hedging  qualify for Ơhedge
accountingơ treatment, if specific criteria are met.
ñ FDS 133 covers three different types of hedges that a firm might
use:
1. Cash Flow ßedge
2. Fair Value ßedge
3. Foreign Currency ßedge

ÿr
 FDS 133
ñ Cash Flow ßedge ƛ D derivative that hedges the changes in
forecasted cash flows of a transaction
ñ Fair--Value ßedge ƛ D derivative that hedges the changes in its
Fair
fair value of underlying assets or liabilities.

ñ D cash-
cash-flow hedge must be a hedge instigated to protect against
price changes in a specific, identified underlying instrument. The
net effect is that gains/losses on the hedge position are deferred
until the forecasted cash flows occur.
ñ D fair-
fair-value hedge is a hedge instigated to hedge the price
change in an asset or liability. Both the hedge instrument (i.e.
the futures contract) and the hedged instrument/asset are
marked to market each period.

ÿ·
 FDS 133
ñ ßere are the summaries of each of these:
ñ Cash flow hedge:
ñ For a derivative designated as hedging the exposure to variable cash flows
of a forecasted transaction (referred to as a cash flow hedge), the effective
portion of the derivative's gain or loss is initially reported as a component of
other comprehensive income (outside earnings) and subsequently
reclassified into earnings when the forecasted transaction affects earnings.
The ineffective portion of the gain or loss is reported in earnings
immediately.
ñ Fair Value hedge:
ñ For a derivative designated as hedging the exposure to changes in the fair
value of a recognized asset or liability or a firm commitment (referred to as
a fair value hedge), the gain or loss is recognized in earnings in the period
of change together with the offsetting loss or gain on the hedged item
attributable to the risk being hedged. The effect of that accounting is to
reflect in earnings the extent to which the hedge is not effective in achieving
offsetting changes in fair value.

-
 FDS 133
ñ The real difficulty with FDS 133 is that it applies only to
Ơhighly effectiveơ hedges. Meaning that you must
demonstrate (quantitatively) how effective a derivative
will be at hedging a risk.
ñ Generally this has been held to mean that the hedge instrument
must produce the inverse of 80% to 125% of the cumulative
change in the value of the instrument being hedged.
ñ To the degree that the hedge is not Ơhighly effectiveơ, you have
to allocate part of the hedge instrumentsƞ changes to the hedge,
and part to Ơhedge ineffectivenessơ.
ñ The hedge instrument must be Ơhighly effectiveơ when you first
put it on 
„›„„ 
 „ 
 . Literally you
can lose your right to hedge accounting.

-c
 FDS 133
ñ Thus, you must constantly demonstrate that your hedge
is Ơhighly effectiveơ.
ñ This is not too bad if the underlying instrument you are hedging
is liquid, and there is an easy to define market price for it, but it
can become a very big problem if the underlying is not that
liquid; if there is not a lot of trading in the instrument, how do
you prove the effectiveness of the hedges?
ñ Mortgage Servicing ½ights are a good example of this.

-O
 Futures and Forwards
ñ This ends our discussion of futures and forward
contracts.
ñ We next move on to options contracts, although we will
continue to use forwards both in deriving option and
other derivatives pricing formulas, and, of course, when
valuing options on futures contracts.

-J