Financial Forwards & Futures

5-1

Pricing Prepaid Forwards

If we can price the prepaid forward (FP), then we can calculate the forward price (F) for a regular forward contract F = FV(FP) For now, assume that there are no dividends

5-2

Pricing Prepaid Forwards with arbitrage

Arbitrage: a situation in which one can generate positive cash flow by simultaneously buying and selling related assets, with no net investment and with no risk If, at time t=0, the prepaid forward price somehow exceeded the stock price, i.e., F P 0, T S0 , an arbitrageur could do the following:

Since arbitrage profits are traded away quickly, in equilibrium we expect:

F P 0,T S0
5-3

Pricing Prepaid Forwards (contd)

What if there are dividends? Is F still valid?

P 0, T

S0

No, because the holder of the forward will not receive dividends that will be paid to the holder of the stock so you will not pay for it in forward mrkt

F P 0,T S0 PV (all dividends paid from t=0 to t=T)

For discrete dividends Dti at times ti, i = 1,., n

P n

The prepaid forward price: F 0,T S0 i 1PV0,ti ( Dti ) For continuous dividends with an annualized yield d P d T The prepaid forward price: F 0, T S0 e

5-4

Pricing Prepaid Forwards (contd)

Example 5.1

XYZ stock costs $100 today and is expected to pay a quarterly dividend of $1.25. If the risk-free rate is 10% compounded continuously, how much does a 1-year prepaid forward cost?

F p 0,1 $100 4 i 1 $1.25 e0.025 i $95.30

5-5

Pricing Prepaid Forwards (contd)

Example 5.2

The index is $125 and the dividend yield is 3% continuously compounded. How much does a 1-year prepaid forward cost?

P 0,1

$125 e

0.03

$121.31

5-6

Pricing Forwards on Stock

Forward price is the future value of the prepaid forward

No dividends:

F0,T S 0 e rT

Discrete dividends: F S erT n er (T ti ) D 0,T 0 i 1 ti Continuous dividends:

F0,T S0e( rd )T

5-7

Forward when underlying pays discrete dividends (alt question 5.2) A $50 stock pays $1 dividend every 3 months, with the next in exactly 3 months. What is the 1 year forward price if the continuously compounded rate is 6%?

5-8

Forward premium
Premium = the difference between current forward price and stock price

Can be used to infer the current stock price from forward price

Definition

Forward premium = F0, T / S0

Annualized forward premium = (1/T) ln (F0, T / S0)
5-9

Another synthetic forward:

Step Borrow S Buy and Sell Asset Repay S*(1+r) Net Investment/Payoff Payoffs: Today +S -S 0 time=t +S(T) -S(1+r) S(T)-S(1+r)

This replicates a long forward, right?

5-10

Creating a Synthetic Forward

One can offset the risk of a forward by creating a synthetic forward to offset a position in the actual forward contract How can one do this? (assume continuous dividends at rate d)

Recall the long forward payoff at expiration: = ST F0, T Borrow and purchase shares as follows

A tailed position

Note that the total payoff at expiration is same as forward payoff

5-11

Creating a Synthetic Forward (contd)

Arbitrage proof of pricing relation

The idea of creating synthetic forward leads to following

Forward = Stock zero-coupon bond (buy index on borrowed $) Stock = Forward zero-coupon bond Zero-coupon bond = Stock forward

Cash-and-carry arbitrage: Buy the index, short the forward

5-12

Forward-spot no-arbitrage, again

Imagine F = $20, but S=$10 and r=10% effective annual yield. I could borrow $10 and buy the asset, and then simultaneously enter short forward contract. At maturity, I sell at F=$20, and repay $11, earning a risk-free return with zero net investment. To eliminate such opportunities, it must be that F = the cost of carry

The cost of carry often includes dividends (bonds, currencies, equities), storage costs and convenience yields (commodities) Above the cost of carry is S(1+r), therefore,

F = S(1+r)

5-13

Forward-Spot No-Arbitrage, again

Imagine F = $20, but S=$10, r=10%, and it will pay a $1 dividend in one year. I could borrow $10 and buy the asset, and then simultaneously enter short forward contract. At maturity, I sell at F=$20, and repay $11 and keep $1 dividend

The dividend lowers the cost of carry

To eliminate such opportunities, it must be that F = the cost of carry Here the cost of carry = FV(S) - FV(dividend) F = 10(1.1) -1 = 10 To conduct arbitrage:
Step Borrow S Buy Asset Receive Dividend Payback Loan Sell Forward SUM Today 10 -10 1 Year 1 -11 10 0
5-14

0 0

Other Issues in Forward Pricing

Does the forward price predict the future price?

According the formula F0,T S0e( rd )T the forward price conveys no additional information beyond what S0 , r, and d provides
The forward price does converge to the spot price as maturity approaches

Forward pricing formula and cost of carry

Forward price =
Spot price + Interest to carry the asset asset lease rate Cost of carry, (r-d)S
5-15

Futures Contracts
Futures are exchange-traded forward contracts Typical features of futures contracts

Standardized, with specified delivery dates, locations, procedures

A clearinghouse
Matches buy and sell orders Keeps track of members obligations and payments

After matching the trades, becomes counterparty

Differences from forward contracts

Settled daily through the mark-to-market process low credit risk Highly liquid easier to offset an existing position

Highly standardized structure harder to customize

5-16

Example: S&P 500 Futures

Notional value: $250 x Index Cash-settled contract

Open interest: total number of buy/sell pairs

Margin and mark-to-market

Initial margin (5-10%)

Maintenance margin (70 80% of initial margin)

Daily mark-to-market

5-17

Example: S&P 500 Futures (contd)

Futures prices versus forward prices

The difference is negligible especially for short-lived contracts

Small differences due to time-value of margin gain/losses

Can be significant for long-lived contracts when forward contracts contain greater default premia
5-18

Example: S&P 500 Futures (contd)

Mark-to-market proceeds and margin balance for 8 long futures

10% initial margin, r=6%

=.1(250*8*F)

Implies loss of $177,562 If forward contract, 1011.65-1100=-88.35 or -176700

5-19

Uses of Index Futures

Why buy an index futures contract instead of synthesizing it using the stocks in the index? Lower transaction costs

Asset allocation/ Hedging: switching investments among asset classes

Example: invested in the S&P 500 index and temporarily wish to invest in bonds instead of index. What to do?
Alternative #1: sell all 500 stocks and invest in bonds Alternative #2: take a short forward position in S&P 500 index and keep your stock position

You converted your stock investment into a bond

5-20

A hedging example
Suppose we invest $Ip in a portfolio of SP500 stocks. Recall: H * What is in this case?

Since my asset is SP500 and there are SP500 futures, this is a direct hedge: =1.

But dont short one contract, we need to adjust for portfolio size

Let N=notional value of forward contract, Ip then

H* N

5-21

Example continued
Suppose we have $1,200,000 invested in the SP500. The SP500 futures contracts are priced at 1270e(.04-.02)1=1295.65, and each contract has notional value of 250*S0. Solve for H*

Ip = $1,200,000, N= 250*1270=$317,500
H*=-{1200000/(317,500)}(1) H*=-3.78
which means we short 3.78 contracts

Direct hedge

Note: weve invested in 1,200,000/1270=944.88 shares

5-22

Lets suppose we short 4 contracts

Outcome of hedge?
Payoff = ST*944.88 +4*250*(1295.65-ST) What if ST = 0?

Payoff = 0 +1,295,650 = 1,295,650

What if ST= 2000?

Payoff = 1,889,760+4(250)(-704.35) Payoff = 1,889,760-704,350 = 1,185,410

Its not equal, what happened?

We overhedged (on short side we did better when prices fell)
5-23

What if we did short 3.78 contracts?

Outcome of hedge?
Payoff = ST*944.88 +3.78*250*(1295.65-ST) What if ST = 0?

Payoff = 0 + 1,224,389 = 1,224,389 Payoff = 1,889,760+3.78(250)(-704.35) Payoff = 1,889,760- 665,610 = 1,224,150 Rounding errors

What if ST= 2000?

Note, I end with more than I started, indeed I earned the risk-free rate
See Table 5.10 (and discussion thereof)
5-24

Currency Contracts: Pricing

Currency prepaid forward

Suppose you want to purchase 1 one year from today using $s

F P 0,T x0e

ry T

Where x0 is current ($/ ) exchange rate, and ry is the yen-denominated interest rate Why? By deferring exchange of the currency one loses interest income from deposits denominated in that currency

Currency forward

F0,T x0e

( r ry )t

r is the $-denominated domestic interest rate F0, T > x0 if r > ry (domestic risk-free rate exceeds foreign risk-free rate), and vice-versa
5-25

Currency Contracts: Pricing (contd)

Example 5.3

-denominated interest rate is 2% and current ($/ ) exchange rate is 0.009 $/ . To have 1 in one year, one needs to invest today
0.009$/ x 1 x e-0.02 = $0.008822
Check:

$.008822*(1/.009)*e0.02= 1

Example 5.4

-denominated interest rate is 2% and $-denominated rate is 6%. The current ($/ ) exchange rate is 0.009. The 1-year forward rate
0.009e0.06-0.02 = 0.009367

5-26

Currency Contracts: Pricing (contd)

Synthetic currency forward: borrowing in one currency and lending in another creates the same cash flow as a forward contract Covered interest arbitrage: offset the synthetic forward position with an actual forward contract
$(xT)-$0.009367

Now, imagine if F = .01?

Table 5.12

Short actual forward and lock in $0.000633

5-27