Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

FIN 411: Financial Derivatives Determination of Forward and Futures Prices

We will now examine how forward and futures prices are related to the spot price of the underlying asset. Because they only involve a single payment at maturity, forward contracts are easier to analyze. We will therefore focus on forward contracts in deriving the relationship between forward prices and spot prices. However, we will show that the differences for futures contracts due to daily settlement are generally negligible, which will allow us to apply our results to both types of contracts.

1.

Preliminary Concepts

Our analysis of forward and futures prices will rely on the Principle of No Arbitrage. That is, the assumption that arbitrage opportunities should not exist in well-functioning nancial markets will allow us to pin down the relationship that must hold between forward or futures prices and the spot price of an asset. In order to apply this principle, we must rst establish a few preliminary concepts, as well as the assumptions and notation that we will use.

1.1.

Investment Assets vs. Consumption Assets

In our analysis of forward and futures prices, it is important to distinguish between investment assets and consumption assets. An investment asset is an asset that is held primarily for investment purposes by a signicant number of investors. Stocks and bonds are clearly investment assets. Other assets, such as gold and silver, can also be considered investment assets even though they have a number of industrial uses. For our purposes, we only require that a signicant number of investors do hold the asset primarily for investment purposes. A consumption asset is an asset that is primarily used for consumption or as an input to production, such as copper, oil, or pork bellies. The reason this distinction is important is because our arbitrage-based analysis assumes that investors will freely sell an asset to take advantage of arbitrage opportunities. As we will see later, there are limitations to this argument for consumption assets where it may be valuable for users to maintain the asset in inventory.

1.2.

Short Selling

On a related note, the arbitrage strategies involved in deriving the relationship between forward and spot prices usually involve short selling. This type of transaction, usually 1

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

referred to simply as shorting, involves selling an asset that is not owned. Short selling is possible for some, but not all, investment assets. For example, suppose a trader instructs her broker to short 500 shares of a certain stock. The broker borrows the shares from another account holder who owns them, and sells the shares in the market in the usual way. The proceeds from the sale are deposited in the short sellers account. At some point in the futures, the short seller will close out her position by repurchasing the 500 shares in the market, which the broker will use to replace the original borrowed shares. In between the sale and repurchase of the shares, the short seller is required to pay the amount of any dividends that would have been paid out by the borrowed shares (or more generally, any income generated by the asset being shorted). The short seller prots if the share price declines (by more than any dividends that the shares pay) between the sale and repurchase of the shares. If the share price increases, the short seller loses money. Similar to the margin accounts required for futures positions, short sellers must maintain a margin account with the broker, consisting of cash or marketable securities to guarantee that the trader can cover the short position. As with a futures position, the short seller may be required to post additional margin if the price of the asset increases beyond a certain point. If the additional margin is not posted, the short position will be closed out. In many cases the short seller must also pay a fee for borrowing shares or other securities.

1.3.

Assumptions and Notation

In deriving formulas for forward and futures prices, we will make the following simplifying assumptions: 1. Market participants face no transaction costs when they trade 2. Market participants are subject to the same tax rate on all net trading prots 3. Market participants can borrow and lend money at the same risk-free rate of interest 4. Market participants can take advantage of arbitrage opportunities as they occur Note that these assumptions do not need to hold for all market participants. Rather they only need to be true (or approximately true) for a few key participants such as large derivatives traders. It is the trading activity of these key market participants and their eagerness to identify and take advantage of arbitrage opportunities as they occur that determines the relationship between forward and spot prices. We will use the following notation throughout: 2

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

T : Time (in years) until the delivery date in the forward or futures contract S0 : Current spot price of the asset underlying the forward or futures contract F0 : Forward or futures price today r : Zero coupon risk-free rate for maturity of T years, expressed as an annualized continuously compounded rate. This is the rate at which money can be borrowed or lent without default risk. Participants in derivatives markets typically use LIBOR rather than Treasury rates, because it more closely represents the rates at which nancial institutions and other market participants can actually borrow funds. Since the credit crisis in 2007, however, many dealers have begun to consider alternatives to LIBOR as a proxy for the risk-free rate. What is the risk-free rate? Derivatives dealers argue that the interest rates implied by Treasury bills and Treasury bonds are articially low because: 1. Treasury bills and Treasury bonds must be purchased by nancial institutions to fulll a variety of regulatory requirements. This increases demand for these Treasury instruments, driving the price up and the yield down. 2. The amount of capital a bank is required to hold to support an investment in Treasury bills and bonds is substantially smaller than the capital required to support a similar investment in other instruments with very low risk. 3. In the U.S., Treasury instruments are given favorable tax treatment compared with most other xed-income investments because they are not taxed at the state level. Traditionally, derivatives dealers have used LIBOR rates to proxy for the risk-free rate. LIBOR stands for London Interbank Offered Rate, a reference rate which is published daily to reect the rate of interest at which banks can obtain unsecured loans from other banks. LIBOR rates are not entirely risk-free, because there is some probability (albeit very small) that the bank borrowing funds will default during the life of the loan. LIBOR rates shot up during the crisis as the possibility of banks defaulting on became more salient. Also, a scamdal emerged in the wake of the crisis regarding manipulation of the reported LIBOR rates. These

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

What is the risk-free rate? (continued) issues have led many derivatives dealers to consider alternative proxies for the risk-free rate. An increasingly popular one is the overnight indexed swap (OIS) rate, particularly when valuing collateralized transactions.

2.

Forward Price for an Investment Asset

We will begin our analysis of forward prices with the simplest case: a forward contract on an investment asset that provides no intermediate income. An example of such an asset would be a non-dividend-paying stock or a zero coupon bond. Consider a long forward contract to purchase a non-dividend-paying stock in 3 months. Suppose the current price of the stock is $40 and the (annualized, continuously compounded) 3-month risk-free rate is 5%. What should the forward price, F0 , of this contract be? To see how the forward price of the stock must relate to its current spot price, consider two alternative ways in which an investor could lock in a price today to own the stock in three months: 1. Take a long position in the 3-month forward contract, which costs nothing today, and in three months pay the forward price F0 to obtain the stock. 2. Buy the stock today for the price of $40, and hold it for three months. Both strategies lead to ownership of the stock three months from now, and in both cases the price to be paid for the stock is determined today. The only difference is whether you pay now or pay later. The relationship between the spot price and the forward price of the stock should thus be determined simply by the time value of money. Given the 3-month interest rate of 5%, paying $40 today is equivalent to paying $40 e5 3/ 12 = $40.50 in three months. Therefore, the forward price for the 3-month contract should be F0 = $40.50. To reinforce this point, suppose that a forward contract were available at a forward price of $43. An arbitrageur could borrow $40 at 5% interest, buy the stock for $40, and take a short position in the forward contract. In three months, the arbitrageur would sell his share to the long party in the forward contract for the forward price of $43, and repay the loan with interest, $40 e5%tmes3/ 12 = $40.50. The arbitrageur thus locks in a prot of $43 - $40.50 = $2.50 at the end of three months. A similar arbitrage opportunity would arise if the forward price were $39. In this case, an arbitrageur would short one share of the stock for $40 and invest the proceeds at 5% 4

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

for three months, while taking a long position in the forward contract. At the end of three months, his $40 will have grown to $40.50. Out of this $40.50, he will purchase the stock from the forward contract for $39 and close out the short position, retaining the difference of $40.50 $39 = $1.50. In order to preclude arbitrage opportunities such as these, we see that the forward price must be exactly $40.50. Generalizing this argument, we have the following fact: Fact 1. The forward price for an asset that pays no intermediate income is F0 = S0 erT (1)

where S0 is the current spot price of the asset, T is the time in years until the delivery date of the contract, and r is the risk-free rate for a maturity of T years. Note that when the underlying asset pays no intermediate income, the forward price is always greater than the spot price. Example 1 Consider a 4-month forward contract to buy a zero-coupon bond that will mature 1 year from today. The current price of the bond is $930.The continuously compounded 4-month risk-free rate of interest is 6% per annum. Thus T = 4/ 12, r = 0.06, and S0 = 930. The forward price, F0 , is F0,T = 930e0.06 4/ 12 = 948.79 This would be the delivery price in a contract negotiated today.

In our analysis above, we assumed that investors can sell the asset short to take advantage of a forward price that is too low.1 However, short sales are not possible for all investment assets. It turns out that this does not matter, as long as there is a signicant number of people who hold the asset purely as an investment (which is how dened investment assets in the rst place). If the forward price is too low, investors who hold the asset will nd it attractive to sell it and take a long position in the forward contract. To see this, suppose that F0 < S0 erT . Then the investor who owns the asset can: 1. Sell the asset for S0 .
If the forward price is too high, an investor would take advantage of the opportunity by borrowing funds to buy the asset and taking a short position in the forward contract. It is not necessary to short the asset in this case.
1

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

2. Invest the proceeds at interest rate r for time T . 3. Take a long position in a forward contract on the asset. At time T , the cash invested will have grown to S0 erT . The asset is repurchased for F0 under the terms of the forward contract. The investor will have the asset back in her portfolio and will have made an arbitrage prot of S0 erT F0 .

2.1.

Forward Price for an Investment Asset with Known Income

We can extend the previous analysis to a forward contract written on an asset which pays a predictable income to the holder, such as a coupon bond or a dividend-paying stock. Consider a long position in a 9-month forward contract to purchase a coupon bond whose current price is $900. The bond will make a coupon payment of $40 in four months. The 4-month and 9-month risk-free interest rates are 3% and 4%, respectively. What should the forward price be? As before, there are two potential strategies by which an investor can lock in a price today to own the bond in nine months: 1. Enter the long forward contract and paying F0 in nine months; or 2. Buying the asset today and holding it for nine months. In the previous example, the only difference between these two strategies was whether you pay now or pay later. In this case, there is another important difference. If you buy the bond today and hold it, you will receive the coupon payment due in four months. If you enter the forward contract, the coupon will have been paid before you receive the bond in nine months. The spot price of the bond today includes the present value of the coupon payment that will be paid in four months, whereas at the delivery date of the forward contract, that coupon will have already been paid out. Thus, the forward price should equal the future value of todays bond price, after excluding the value of the intermediate coupon payment. Specically, the present value of coupon payment is 40 e 3% 4/ 12 = $39.60, so that the spot price of the bond excluding the value of the coupon payment is $900 - $39.60 = $860.40. Thus, the forward price should be equal to $860.40, grossed up at the 9-month interest rate: F0 = 860.40 e4 9/ 12 = $886.60. What if the forward price were too high at $910, or too low at $870? Table 6.1 summarizes the trade an arbitrageur could make and the cash ows today, in four months, and in nine months. By a no-arbitrage argument, the forward price must be equal to the spot

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

Table 1: Arbitrage opportunities when 9-month forward price is out of line with spot price of bond providing known cash income. (Bond price=$900; income of $40 occurs in 4 months; 4-month and 9-month rates are 3% and 4%, respectively.) Forward price = $910 Action now: Borrow $900: $39.60 for 4 months and $860.40 for 9 months Buy 1 unit of bond Enter into forward contract to sell bond in 9 months for $910 Action in 4 months: Receive $40 of income from bond Use $40 to repay rst loan with interest Action in 9 months: Sell bond for $910 Use $886.60 to repay second loan with interest Prot realized = $23.40 Forward price = $870 Action now: Short 1 unit of bond to realize $900 Invest $39.60 for 4 months and $860.40 for 9 months Enter into forward contract to buy buy in 9 months for $870 Action in 4 months: Receive $40 from 4-month investment Pay income of $40 on bond

Action in 9 months: Receive $886.60 from 9-month investment Buy bond for $870 Close out short position Prot realized = $16.60

price minus the present value of any intermediate income, grossed up by the risk-free rate. Fact 2. The forward price of an investment asset that provides intermediate income during the life of the contract is F0 = (S0 )erT (2) where S0 is the spot price of the asset, is the present value of the intermediate income paid by the asset during the life of the contract, T is the time in years until the delivery date of the contract, and r is the risk-free rate for a maturity of T .

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

Example 2 Consider a 10-month forward contract on a stock with S0 = 50 that will pay dividends of $0.75 per share at 3 months, 6 months, and 9 months. Suppose the yield curve is at at 8% interest for all maturities. Then the present value of the dividends is = 0.75e 0.08 3/ 12 + 0.75e 0.08 6/ 12 + 0.75e 0.08 9/ 12 = 2.162 The the forward price is then given by F0 = (50 2.162)e0.08 10/ 12 = 51.14

2.2.

Forward Price for an Investment Asset with Known Yield

Some assets, such as stock index futures or currency futures, provide income that is best expressed as a yield rather than discrete cash payments as in the formulation above. That is, the income is expressed as a percentage of of the assets price at the time that the income is paid. Suppose that an asset provides a yield of 5% per annum. This could mean that income accrues once per year and is equal to the 5% of the assets price at the time it is paid. This would be 5% yield with annual compounding. Alternatively, income equal to 2.5% of the assets value could be paid twice a year, in which case the yield would be 5% with semi annual compounding. We will generally express yields with continuous compounding, in which case we can rewrite the formula for the forward price as follows: Fact 3. Let q be the average yield per annum on an asset during the life of a forward contract with continuous compounding. The forward price is then F0 = S0 e(r q)T (3)

where S0 is the current, T is the time in years until the delivery date of the contract, and r is the risk-free rate for a maturity of T .

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

Example 3 Consider a 6-month forward contract on an asset that is expected to provide income equal to 2% of the asset price once during a 6-month period. The yield is thus 4% with semi annual compounding, which translates to a continuously compounded yield of = 2 ln(1 + .02/ 2) = 3.96%. The current spot price of the asset is $25, and the risk-free interest rate for maturity of six months is 10%. The forward price is thus F0 = 25 e(0.10 0.0396) 0.5 = $25.77

2.3.

No-arbitrage bounds

In practice, trading fees, bid-ask spreads, different borrowing/lending rates, the price effect of trading in large quantities, and other market frictions make pure arbitrage trades more difcult. In the presence of transaction costs and other frictions, we can no longer identify an exact no-arbitrage forward price. Instead, the best we can do is identify a range within which the forward price must fall to preclude arbitrage. That is, we can determine lower and upper bounds F and F + such that F < F0 < F + Consider the following trading costs and frictions: Bid-ask spreads: for stock Sb < S , and for forward F b < F Cost k of transacting forward (e.g. broker fee) Different interest rate for borrowing and lending such that r b < r For simplicity, no dividends and no time T transaction costs Then arbitrage is possible if 1. F0,T > F + = (S + 2k )er 0
bT

, or

2. F0,T < F = (Sb + 2k )er T 0

Winter 2014

Determination of Forward and Futures Prices

Prof. J. Page

3.

TL;DR
In deriving the relationship between spot prices and forward or futures prices, it is convenient to distinguish between investment assets, which are held primarily for investment purposes by a signicant number of investors, and consumption assets, which are held primarily for consumption or as inputs to production. For investment assets, the forward price for a contract with delivery at time T should equal the cost of buying the asset today and nancing the payment or the asset until time T . If the forward price were higher or lower than this, it would create an arbitrage opportunity. For an investment asset that provides no intermediate income (such as dividend or interest payments) during the life of the forward contract, the forward price should equal F0 = S0 erT or in other words, the spot price grossed up by the risk-free rate. For an investment asset that provides one or more predictable cash payments during the life of the contract, the forward price is F0 = (S0 )erT where is the present value of income paid by the asset during the life of the forward contract. If an asset provides income that can be expressed as a continuously compounded rate or yield, the forward price can be written as F0 = S0 e(r q)T where q is the annualized, continuously compounded yield on the asset. If there are transaction costs such as bid-ask spreads or broker fees, then instead of a unique arbitrage-free forward price, there is a range of forward prices that can hold without creating arbitrage opportunities.

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