Lecture 4.

Determination of Forward
and Futures Prices I
EF4420. Derivative Analysis and Advanced Investment Strategies

Dr. Yongjin Kim

10 February, 2017

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Lecture Outline

Setting
No Arbitrage Argument
Short Selling

Determination of Forward Prices

Forward on an underlying asset paying no dividends
Forward on an underlying asset paying discrete dividends

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Determination of Forward and Futures Prices

Previously, we have taken forward/futures prices as given and looked

at their payos and usages.

Now, we discuss how to determine forward/futures prices.

In the market, these prices are determined by supply and demand.
We can also determine the theoretical price, using no arbitrage
argument.

Forward prices are easier to analyze. Thus, we discuss how to

determine forward prices first and then discuss on futures prices.

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No Arbitrage Argument
arbitrage: same cash flow but not same price, then has arbitrage
No Arbitrage Argument
: If two assets (portfolios) A and B generate the same cash flows in
the future, the two current prices should also be the same.

If current prices are not the same, an arbitrage opportunity exists.

The general way to construct an arbitrage strategy is to buy low and
sell high.

We consider an investor who has nothing in hand at the beginning of

the strategy and liquidates all assets at the end.
If necessary, the investor can borrow money (sell a bond).

In order to formally prove the arbitrage, we need to show that the

strategy always generates non-negative cash flows and sometimes
generates positive cash flows.
0 T
buy asset sell asset
borrow money pay back
(sell bond) (cash
flow) 4 / 24
0 1
No Arbitrage Argument - Example

Is each of the following strategies an arbitrage?

Cash flows T = 0 T =1 T =2
no arbitrage
real: investment Strategy 1 -2 1 3
arbitrage Strategy 2 0 0 0.5
once we pay money after period 0, there is no arbitrage

Cash flows T = 0 T =1
case 1 case 2
Strategy 3 0 0.2 0.2
Strategy 4 0 0 0.3

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No Arbitrage Argument - Short Selling

In order for no arbitrage argument to work in general, we assume that

the market allows short selling.

Def. Short selling is to sell an asset that is not owned.

Ex. If an investor shorts a share at time 0 whose current price is $120,

At time 0, the investor borrows a share, sells immediately, and receives
the proceeds of $120.
One year later, stock price falls to $100. To close the position, the
investor buys a share and pays back the share to the original owner.
The resulting profit is 120-100 = $20.

0 1
borrow share(no div) buy share
sell return
$120 -$100

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No Arbitrage Argument - Short Selling

What if the share pays dividend?

Then, the shorting investor needs to pay the dividend to the original
owner.

Ex. An investor shorts a share at time 0 whose current price is $120. The
stock pays $5 dividend in six month.
Again, by borrowing and selling immediately, the investor receives $120.
In six month, the investor provides the original owner with the $5
dividend.
One year later, stock price falls to $90. By closing the position then,
the investor makes the profit of 120-5-90 = $25.
6 mon 1
$5(div) buy(return)
-$5 -$90

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Determination of Forward and Futures Prices

Investors enter long or short position of forward contract at zero

cost.

In other words, the value of forward contract is zero at the time of

initiating the contract.

Thus, the forward price is determined so that the current value of

forward contract becomes zero.

For the same underlying asset and maturity, the futures and forward
prices are very close to each other, but can be dierent (due to daily
settlement of futures).

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Determination of Forward Price - Setting
Assumptions

No transaction costs.
The market participants have the same tax rate on all net trading
profits. no tax

The market participants can borrow or lend money at the risk-free rate
of interest.
The market participants take advantage of arbitrage opportunities.

Notation

T : time to maturity of contract

S0 : price of the underlying asset today
ST : price of the underlying asset at time T
F0 : forward or futures price today
r : risk-free rate per annum.
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Determination of Forward Price
Under no-arbitrage, the forward price should be

F0 = S0 e rT

if the underlying asset pays no dividend.

Ex. Consider a 3-month forward contract on a stock whose current price

is $40. The 3-month risk-free interest rate is 5% per annum.

1 What if the forward price is 43 (> 40e 0.053/12 )? = 40.503

) There is an arbitrage strategy: buy underlying asset and sell forward 0

Action Cash flow in 0 Cash flow in 3 month

buy stock -40 ST
short forward 0 43 ST
sell bond 40 40e 0.053/12
net 0 2.497

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Determination of Forward Price

2 What if the forward price is 39 (< 40e 0.053/12 )?

) There is an arbitrage strategy:
Action Cash flow in 0 Cash flow in 3 month
sell stock 40 ST
buy forward 0 ST 39
buy bond -40 40e 0.053/12
net 0 1.503

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Determination of Forward Price

In general, consider the following two portfolios:

1 long forward with F0 + buy a bond that will pay F0

2 buy a stock

At the contract maturity T , the two portfolios have the same value:
time-t time-0
(1) ST-F0 0+ F0e -rT
1 (ST F0 ) + F0 (2) st S0
(1)= (2)

2 ST

Thus, their current value should be the same:

rT
0 + F0 e = S0

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Determination of Forward Price - Example

Q. Consider a 1-year forward contract on a stock whose current price is

$50. The forward price is $51, and the risk-free interest rate is 7% per
annum. Is there an arbitrage? If so, show the arbitrage strategy.
50* e0.07= 53.625 > 51

Action Cash flow in 0 Cash flow in 1 year

BUY STOCK $-50 ST
Short forward 0 51-ST
Sell bond $50 -$ 50 e 7%

sell stock

net 0 51-50 e 0.07

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Determination of Forward Price
Consider a forward contract initiating at time t. Given the maturity
date T , the forward price is

Ft = St e r (T t)

Thus, as time passes, the forward price changes.

FT and ST is getting close to each other
62
Spot price
0 1 t T 60 Froward price

F0= S0 e rT F1=S1 e r(T-1) Ft= St e r(T-t)

58

56

54

52

50

48

46

44
0 5 10 15 20 25
time

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Determination of Forward Price - Dividend-Paying
St-

Underlying Assets 0
Stock
t
Dt
T

S0 St
Long Forward

St- (cum-dividend price)= Dt+ St(ex- dividend price)

Until now, we have considered forward contracts on underlying assets

that pay no dividend.

What if the underlying asset will pay dividends in the future? Are
there changes in forward prices?

) Yes, because...
The current price S0 of the underlying asset includes the future
dividends.
However, a long position of forward will not receive the dividends.

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Determination of Forward Price - Discrete Dividends

We consider two dierent forms of dividend payments.

1 Discrete dividends: dividends will be paid at certain points in time.
2 Continuous dividends: dividends will be paid at every instant
continuously. ex: stock index

We first look at the case of discrete dividends.

Suppose that stock pays dividends until the maturity T . The present
value of all future dividends is I .

The forward price is

F0 = (S0 I )e rT
future value

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Determination of Forward Price - Discrete Dividends

Why? Consider the following two portfolios:

1 long forward with F0 + buy a bond that will pay F0

2 buy a stock + sell a bond that will pay Ie rT

At the contract maturity T , the two portfolios have the same value:
Time T Time 0 (no arbitrage)
(1) ST-F0 +F0 0+F0 e -rT
1 (ST F0 ) + F0 (2) ST+I e rT - I e rT S0- I erT* e-rT

(1)= (2) S0-I= F0 e -rT

rT rT
2 (ST + Ie ) Ie (S0-I) e rT= F0

The portfolio values are the same at T . Thus, their current values are
the same:
rT
F0 e = S0 I

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Determination of Forward Price - Discrete Dividends

Q1. Consider a 9-month forward contract on a corporate bond. The

current price of the corporate bond is $900 and it will pay $40 coupon
in 4 months. The 4-month and 9-month risk-free rates are 3% and
4%, respectively. If there is no arbitrage, what is the forward price?
(S0-I) e rT= (900-40e power of -0.03*4/12) e 0.04*9/12

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Determination of Forward Price - Discrete Dividends

Q1. Consider a 9-month forward contract on a corporate bond. The

current price of the corporate bond is $900 and it will pay $40 coupon
in 4 months. The 4-month and 9-month risk-free rates are 3% and
4%, respectively. If there is no arbitrage, what is the forward price?

Answer: The forward price is

0.034/12
F0 = (900 40e )e 0.049/12 = $886.60

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Determination of Forward Price - Discrete Dividends

Q2. Consider the same 9-month forward contract on the corporate bond
(the current price of the corporate bond is $900 and it will pay $40
coupon in 4 months). The 4-month and 9-month risk-free rates are
3% and 4%, respectively. The forward price is $910. Is there an
arbitrage? If so, show the arbitrage strategy.

886.6< 910

buy bond -900 40 SB

short forward 0 0 910-SB
sell 4-mon bond 900
sell 9-mon bond

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Determination of Forward Price - Discrete Dividends

Q2. Consider the same 9-month forward contract on the corporate bond
(the current price of the corporate bond is $900 and it will pay $40
coupon in 4 months). The 4-month and 9-month risk-free rates are
3% and 4%, respectively. The forward price is $910. Is there an
arbitrage? If so, show the arbitrage strategy.
Answer: 886.60 < 910. Thus, we can think of the following arbitrage
strategy:
Action Cash flow in 0 Cash flow Cash flow
in 4 month in 9 month
buy corporate bond -900 40 ST
short forward 910 ST
0.034/12
sell 4-month bond 40e -40
sell 9-month bond [900 [900 40e 0.034/12 ]
0.034/12
40e ] e 0.049/12
net 0 0 23.399

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Determination of Forward Price - Discrete Dividends

Q3. Consider the same 9-month forward contract on the corporate bond
(the current price of the corporate bond is $900 and it will pay $40
coupon in 4 months). The 4-month and 9-month risk-free rates are
3% and 4%, respectively. The forward price is $850. Is there an
arbitrage? If so, show the arbitrage strategy.

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Things To Do

Read the textbook chapters 5.1-5.5

Assignment 3 (due on Friday, 17 February at 11 pm)

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