Part-18

Valuation, Hedging, and

Speculation

1
Pricing of a Forward
Contract
 How do we decide as to what price
we should transact at in the future,
when we enter into a forward
contract?
 Let us first review a forward
contract.
 It entails an obligation on the part of
the short to make delivery of the
asset on a future date
 And an equivalent obligation on the
2
part of the long to take delivery.
Pricing (Cont…)
 From the perspective of the short,
if he buys the asset at the market
price prevailing at the outset and
simply holds on to it, he is assured
of a selling price at the time of
delivery by virtue of the contract.

3
Pricing (Cont…)
 So if the difference between the
forward price as per the contract
and the spot price at the outset,
were to exceed the cost of carrying
the asset until delivery, then there
would exist an arbitrage
opportunity.
 Thus the relationship between the spot
price and the forward price at any point in
time, is a function of the carrying cost. 4
An Asset That Pays No
Income
 Consider an asset that pays no
income.
 Examples include stocks that are
unlikely to pay any dividends or
bonds that are not scheduled to pay
any coupons.
 In this case the cost of carrying the asset
is purely the interest cost.
 That is, if the spot price is S, the interest
cost is rS.

5
No Income (Cont…)
 This interest cost is an actual
expenditure if funds are borrowed
to purchase the asset, else it is an
opportunity cost.
 Consequently the lack of potential
for arbitrage would imply that
F = S + rS

6
Cash and Carry Arbitrage
 What would be the consequence if
F > S + rS
 If so, an arbitrageur would borrow
and buy the asset and go short in a
forward contract to deliver at a
future date.
 At the time of delivery he would
receive F, return S + rS, which
represents the loan plus interest,
and pocket the difference. 7
Arbitrage (Cont…)
 Such a strategy is called Cash and
Carry Arbitrage.
 To rule it out, we require that
F – S ≤ rS ⇒ F ≤ S(1+r)

8
Illustration
 Assume that TISCO is currently
selling for Rs 100 per share, and is
not expected to pay any dividends
for the next six months.
 The price of a forward contract for
one share of TISCO to be delivered
after six months is Rs 106.
 An arbitrageur is able to borrow at
the rate of 5% for six months.
9
Illustration (Cont…)
 In this case, the arbitrageur can borrow
Rs 100 and acquire a share, and
simultaneously go short in a forward
contract to deliver the share after six
months for Rs 106.
 The rate of return on investment is
(106 – 100)
-------------- = 0.06 ≡ 6%
100
10
Illustration (Cont…)
 The borrowing cost it must be
remembered is only 5%.
 Consequently cash and carry
arbitrage is profitable.
 This is because the contract is
overpriced, that is
F > S(1+r)

11
Cash and Carry Arbitrage
(Cont…)
 The rate of return obtained from a
cash and carry arbitrage strategy
is called the Implied Repo Rate.
 Thus cash and carry arbitrage is
profitable only if the Implied Repo
Rate exceeds the borrowing rate.

12
Arbitrage-The Long’s
Perspective
 We have seen that if F > S + rS
then it can be exploited by an
arbitrageur by going short in a
forward contract.
 However, what if F < S + rS?
 This too represents an arbitrage
opportunity.
 However to exploit it, one would have
to take a long position in a forward
13
contract.
Reverse Cash and Carry
Arbitrage
 Under such circumstances, the
arbitrageur would have to short
sell the asset and invest the
proceeds at the risk-less rate.
 He would have to simultaneously
go long in a forward contract to
reacquire the asset at a
predetermined price.
 Such a strategy is called Reverse
Cash and Carry Arbitrage. 14
Short Sales
 What is a short sale?
 It entails the borrowing of an asset
from another party in order to sell it.
 The borrower or the short-seller is
responsible for eventually returning
the asset to the lender.

15
Short sales (Cont…)
 He must also compensate the
lender for any cash flows that he
would have received from the
asset had he not parted with it.
 This is because the lender continues
to be the owner of the asset and is
consequently entitled to the lost
income.

16
Illustration of
Reverse cash and carry
arbitrage
 Assume that shares of TISCO are
selling at Rs 100 each and that the
company is not expected to pay
any dividends for the next six
months.
 Let the price of a forward contract
that calls for the delivery of one
share of TISCO six months hence
be Rs 104. 17
Illustration (Cont…)
 Consider an arbitrageur who can
lend money at a rate of 5% for six
months.
 He can short sell a share of TISCO,
receive Rs 100 and invest it at 5%
for six months.
 He can simultaneously go long in a
forward contract to acquire the
share after six months for Rs 104. 18
Illustration (Cont…)
 The effective borrowing cost is:
(104 – 100)
------------- = 0.04 ≡ 4%
100
Which is less than the lending rate
of 5%.

19
Illustration (Cont…)
 Consequently reverse cash and
carry arbitrage is profitable.
 This is because F < S(1+r), or in
other words the contract is under
priced.
 The cost of borrowing funds using
a reverse cash and carry strategy
is called the Implied Reverse Repo
Rate. 20
Illustration (Cont…)
 Thus reverse cash and carry is
profitable only if the Implied
Reverse Repo Rate is less than the
lending rate.

21
The No-Arbitrage
Condition
 In order to rule out cash and carry
arbitrage, we require that
F ≤ S(1+r)
 In order to rule out reverse cash
and carry arbitrage we require that
F ≥ S(1+r)
Hence to rule out both forms of
arbitrage it must be the case that
F = S(1+r)
22
Assets That Pay a Known
Income
 If a person receives income from
an asset that is in his possession,
then such a cash inflow will
obviously reduce the carrying cost
 The carrying cost can now be
defined as
rS – I, where I is the future value of
the income as computed at the
time of expiration of the forward 23
Known Income (Cont…)
 Why use the future value of the
income and not just the income?
 We need to calculate the future value
of the income, because the interest
cost incurred for financing the
purchase of the asset is payable only
at the end
 And due to the principle of Time Value
of Money, all cash flows must be
measured at the same point in time in
order to be comparable 24
Known Income (Cont…)
 Consequently in order to rule out
cash and carry arbitrage we
require that
F – S ≤ rS – I ⇒ F ≤ S(1+r) - I
 Similarly from a short seller’s
perspective, in the case of such
assets, the effective income
obtained by investing the proceeds
from the short sale will be reduced
by the amount of income received25
Known Income (Cont…)
 This is because the short seller is
required to compensate the lender
of the asset for the income
generate by the asset
 Thus in order to preclude reverse
cash and carry arbitrage, we
require that
F – S ≥ rS – I ⇒ F ≥S(1+r) - I
 Consequently the no arbitrage
condition is: 26
Illustration of
Cash and Carry Arbitrage
 Consider the case of TISCO once
again
 Assume that the share price is Rs
100, and that the stock is expected to
pay a dividend of Rs 5 after three
months, and another Rs 5 after six
months
 Forward contracts expiring after
six months are available at a price
of Rs 96 per share 27
Illustration (Cont…)
 We will assume that the second
dividend payment will be made just
an instant before the forward contract
matures
 Take the case of an arbitrageur
who can borrow at 10% per annum
 He can borrow Rs 100 and buy a
share of TISCO

28
Illustration (Cont…)
 He can simultaneously go short in a
forward contract to sell the share
after six months for Rs 96
 After three months he will receive the
first dividend of Rs 5
 This can be reinvested for the three
months that remain in the life of the
contract at a rate of 10% per annum

29
Illustration (Cont…)
 Finally, just prior to the maturity of
the forward contract, he will receive
the second dividend of Rs 5
 Thus at the time of delivery of the
share, the investor’s cash inflow is
96 + 5 x (1 + 0.10) + 5 =
106.025
-----
4 30
Illustration (Cont…)
 The rate of return on investment is
(106.025 –100) = 0.0625 ≡
6.25%
-------------------
100
 Which is greater than the borrowing
rate of 5% for six months

31
Illustration (Cont…)
 Cash and carry arbitrage was
profitable in this case since F >
S(1+r) - I
 That is, the contract was overpriced

32
Illustration of Reverse
Cash and Carry Arbitrage
 Assume that the price of the
forward contract is Rs 94 and not
Rs 96
 An arbitrageur can short sell the stock
and receive Rs 100
 This can be invested at 10% per
annum so as to receive Rs 105 after
six months
 Simultaneously he can go long in a
forward contract in order to reacquire
the asset after 6 months 33
Illustration (Cont…)
 After 3 months, the company will
declare a dividend of Rs 5
 Since the arbitrageur has short sold
the share, he must compensate the
lender of the share
 This Rs 5 can be borrowed at the rate
of 10% per annum
 Similarly, at the end of 6 months,
another Rs 5 will have to be paid
when the second dividend is declared
34
Illustration (Cont…)
 So the inflow at the end of six months
is Rs 105
 The outflow at the end of six months
is:
94 + 5x (1.025) + 5 = Rs 104.125
 Thus there is clearly an arbitrage
profit of Rs 0.875
 Reverse cash and carry arbitrage was
profitable because
F < S(1+r) - I 35
The No-Arbitrage
Condition
 The no-arbitrage condition is:
 F = S(1+r) – I
 In our example the correct price of
the forward contract is:
F = 100(1+.05) – 10.125 = Rs 94.875

36
Physical Assets
 While financial assets like stocks
and bonds generate cash flows for
investors who hold them, physical
assets entail the incurrence of
expenditure
 Investors have to bear the costs of
storage as well as related
expenses like insurance premiums
37
Physical Assets (Cont…)
 A cost is nothing but a negative
income
 Hence if we denote the future value
of all storage related costs as Z, as
calculated at the time of expiration of
the forward contract, then Z = -I
 Thus the no-arbitrage condition may
be expressed as F = S(1+r) – (-Z) =
S(1+r) + Z
38
The Value of a Forward
Contract
 When a forward contract is entered
into, its value to both the parties is
zero
 That is, neither the long nor the short
has to pay any money to get into a
forward contract
 Of course both of them have to post
margins.
 But a margin is a performance guarantee
and not a cost 39
Forward Price versus
Delivery Price
 The delivery price is the price
specified in the forward contract
 It is the price at which the short
agrees to deliver and the long
agrees to accept delivery as per
the contract

40
Forward Price versus
Delivery Price (Cont…)
 What then is a Forward Price?
 The forward price at a given point in
time is the delivery price that is
applicable for a contract being
negotiated at that particular instant
 Once a contract is sealed, its delivery
price will not change
 However, as each new trade is
negotiated, the forward price will
keep changing
41
Forward Price versus
Delivery Price (Cont…)
 To put things in perspective, if one
were to come and say that he had
entered into a forward contract a
week ago, we would ask ``what was
the delivery price?” and not ``what
was the forward price then?”,
although both would mean the same

42
Forward Price versus
Delivery Price
 However, if we were to negotiate a
contract at a particular point in time,
we would ask ``what is the forward
price?”
 And if the negotiation were to be
successful and the contract were to
be sealed, then the prevailing forward
price would become the delivery price
of the contract being entered into
43
Evolution of Value
 When a contract is first entered
into, its value to both parties will
be zero
 However, as time passes, a pre-
existing contract will acquire value
 Consider a long forward position that
was entered into in the past at a time
when the forward price was K
 Consequently its delivery price as of
today will be K
44
Evolution of Value (Cont…)
 In order to offset this position, the
investor will have to take a short
position, which will obviously be
executed at the prevailing forward
price F
 Thus if a counter-position is taken,
the investor will have a payoff of (F-K)
awaiting him at the time of expiration
of the contract
45
Evolution of value (Cont…)
 The value of the original contract is
nothing but the present value of this
payoff

46
Illustration
 Assume that a forward contract
exists that expires at time T
 Let the delivery price be K
 Let F be the current forward price
for a contract expiring at time T
 Let r be the risk-less rate of
interest for a loan between now
and time T
47
Illustration (Cont…)
 The value of a long forward
position is therefore
F–K
---------
(1+r)

48
Illustration (Cont…)
 The value of a short position will be
the negative of this, that is:
-(F – K) K-F
----------- = --------
(1+r) (1+r)

49
Numerical Illustration
 A long position in a 9 month
forward contract was entered into
3 months ago
 The delivery price is $ 100
 Today the forward price for a 6
month contract is $ 120
 The risk-less rate of interest for six
months is 10%
50
Numerical Illustration
(Cont…)
 The value of a long forward
position with a delivery price of $
100 is therefore:
120 – 100
------------ = 18.18
1.10
 The value of a short forward
position with a delivery price of $
100 will be –18.18 51
Value
 As you can see, once a contract is
sealed, a subsequent increase in
the forward price will lead to an
increase in value for the holder of
a long position
 A subsequent decline in the
forward price will lead to an
increase in value for the holder of
a short position 52
Value of a Futures
Contract
 The value of a futures contract is
zero when the contract is initiated
 That is, no money is required to
take either a long or a short
position in futures
 Assume that a futures contract is
entered into at a price F0
 Let the settlement price at the end
of the day be F1
53
Value of a Futures
Contract (Cont…)
 Using the same logic as for forward
contracts, if this contract were to
be offset, the profit for the long
would be F1 – F0
 This is precisely the amount that
will be paid to/received from the
long when the contract is marked
to market at the end of the day
54
Value of a Futures
Contract (Cont…)
 Thus the process of marking to
market ensures that the value of a
futures position, whether long or
short, is reset to zero at the end of
the day
 Thus between the end of one trading
day and the next, a futures contract
will build up value
 However at the end of the next day,
the value will revert to zero 55
Net Carry
 The term `Net Carry’ refers to the net
carrying cost of the underlying asset,
expressed as a fraction of the current
spot price
 If the risk-less rate is r, and the future value
of income from the asset is I, then
 Net Carry = rS – I = r–I
------- --
S S
56
Net Carry (Cont…)
 For physical assets which entail
the payment of storage costs
Net Carry = r + Z
---
S

57
Net Carry (Cont…)
 For financial assets:
F = S(1+r) – I = S + Net Carry x
S
 For physical assets which are held
for investment purposes:
F = S(1+r) + Z = S + Net Carry
xS

58
Net Carry (Cont…)
 If the futures price of an asset
exceeds the spot market price, or
if the price of a near month
contract is less than the price of a
far month contract, then we say
that the market is in Contango

59
Net Carry (Cont…)
 However if the futures price is less
than the spot price, or if the price
of the near month contract is more
than the price of a far month
contract, then we say that the
market is in Backwardation

60
Illustration of a Contango
Market
Contract Price
Spot 500
March Futures 510
June Futures 520
September Futures 525
December Futures 540

61
Illustration of a
Backwardation Market
Contract Price
Spot 500
March Futures 485
June Futures 470
September Futures 450
December Futures 440

62
Net Carry
 For financial assets, the net carry can
either be positive or negative,
depending on the relationship between
the financing cost, rS, and the future
value of the income from the asset, I
 A positive net carry will manifest itself
as a Contango market, whereas a
negative net carry will reveal itself as a
market in Backwardation
63
Hedging with Futures
 Consider a person who owns an
asset.
 Technically speaking he is said to
have a long position in the asset.
 His worry will always be that the
price of the asset will decline by
the time he is ready to sell it.
 Such a person can hedge by going
short in a futures contract.
64
Illustration
 Gaurav owns 100 kg of rice which he
wishes to sell after 3 months.
 His worry is that the price will fall by
then.
 Assume that he can go short in a
futures contract at a price of Rs 12 per
kg.
 If he were to take a short position in
such a contract he is assured of an
amount of
Rs 1200 irrespective of what the price is65
Illustration
 Remember that a short futures
position is an obligation to sell.
 Hence while he is assured of a sum
of
Rs 1200, he cannot take
advantage of the situation if the
market price after three months
were to be greater than Rs 12 per
kg. 66
Hedging a Short Position
 If you have a short position in the
asset, it means that you have
made a sale transaction without
owning the asset.
 Thus you have to procure it at the
prevailing market price.
 Consequently your worry is that
prices would have increased by the
time you acquire the asset.

67
Hedging with Futures
 Such an investor can hedge by
going long in a futures contract.
 This way he can lock in a price at
which he can acquire the asset,
and will therefore be protected
against rising prices.

68
Illustration
 Vinayak has short sold a share of
TISCO and is required to buy it
back after 2 weeks.
 His worry is that the share price
will have risen by then.
 Assume that he can go long in a
futures contract at a price of Rs
105.
 If so he can be assured of being
able to buy at this price. 69
Illustration (Cont…)
 However, if the market price after
2 weeks were to be less than Rs
105, he will be unable to take
advantage of the situation.
 This is because a futures contract
is an obligation.

70
Speculation
 Unlike hedgers who are trying to
avoid risk, speculators wish to
consciously take on risk.
 A speculator will take on either a
long or a short position depending
on his hunch as to whether the
market is going to rise or to fall.

71
Speculation (Cont…)
 If he calls the market right, he can
make enormous profits.
 Else if he reads the market wrong,
he can make substantial losses.

72
Speculating With Futures
 Consider an investor who is of the
view that the market is going to
rise.
 One way for him to speculate
would be to buy the asset in the
spot commodity and hold it.
 However if he buys the asset in the
spot commodity, he would have to
pay the full price of the asset.
73
Speculating With Futures
(Cont…)
 Paying the full price means
incurring substantial costs or
opportunity costs.
 In addition, if the commodity is a
physical asset, the investor would
have to take the hassle of storing
it and insuring it.
 All this can be avoided if he were
to speculate using the futures 74
Speculating With Futures
(Cont…)
 The principle involved is the same.
 Such a speculator is betting that
the market is going to move up.
 So instead of buying the asset in
the spot market, he can take a
long position in the futures market.

75
Speculating With Futures
(Cont…)
 If the spot price were to rise the
speculator will obviously realize a
profit since he can acquire the
asset at the initial futures price,
and sell it at the terminal spot
price.

76
Speculating With Futures
(Cont…)
 The advantage of speculating with
futures is that the entire value of
the asset need not be paid in order
to acquire a long position.
 All that the speculator has to do is
to deposit the required margin.
 Secondly, because of the high
volumes of transactions involved,
transactions costs are much lower
in futures markets. 77
Illustration
 Let us assume that the current futures
price for a contract calling for delivery
of rice three months hence is Rs 12 per
kg.
 Abhishek, a speculator, is of the opinion
that the price three months hence will
be at least Rs 15.
 He therefore chooses to speculate by
going long in a futures contract, which
we will assume is for 100 kg of rice.
78
Pitfalls
 Remember, a long futures position
is an obligation to buy.
 If Abhishek were to have read the
market wrong, and the price after
3 months were to be Rs 9 per kg,
then he would incur a loss of Rs
300.

79
Pitfalls (Cont…)
 This is because while he still has to
acquire the rice at Rs 12 per kg, he
can only sell it for Rs 9.
 Thus speculation with futures can
lead to substantial gains if one
forecasts price movements
accurately, but can lead to
substantial losses otherwise.
80
Illustration (Cont…)
 If he is right, and the market price
three months hence turns out to
be Rs 16 per kg, then he can
simply sell the rice at this price
after taking delivery under the
futures contract.
 He will obviously make a profit of
Rs 400 on the deal.
81
Speculation by Bears
 A person who anticipates that the
market will move up is a Bull.
 He can speculate by either going
long in futures, or by buying call
options.
 An investor who anticipates that
the market will fall is called a Bear.
 A Bear can speculate by going
short in futures or by buying put
options. 82
Bears & Futures Contracts
 Consider a person who feels that
the market is going to fall.
 He can speculate by going short in
futures.
 If his hunch turns out be right, he
can acquire the underlying asset at
the terminal market price and
deliver it under the contract at the
initial futures price, which by
assumption is higher. 83
Illustration
 Nisha is a speculator like Abhishek.
 However she feels that the price of
rice after three months will not be
more than Rs 9 per kg.
 The current futures price is Rs 12
per kg.
 She can take a speculative position
by going short in a futures
contract. 84
Illustration (Cont…)
 Assume that her hunch is right and
that the market price at the end of
three months is Rs 8.
 She can now acquire the asset in
the spot market for Rs 8 and
deliver as per the contract at Rs
12, thereby making a profit of Rs
400 for 100 kg.
85