3.1.5 Pricing Financial Forwards and Futures

5. Pricing Financial Forwards and Futures

5.1 Pricing Financial Forwards

The price is the predetermined price in the contract that the long should pay to the short to buy the underlying asset at the settlement date.

The contract value is zero to both parties at initiation.

5.1.1 Short Selling/Short Sales

The short selling is the sale of an asset that is not owned with the intention of buying it back later.

Short selling is profitable if the asset price declines but incurs losses if the asset price increases.

The short seller will usually have to pay dividends of the borrowed shares while the position is open.

The short seller must deposit collateral to make sure that they can repurchase the security.

5.1.2 Assumptions of Pricing Forward Price

The market participants are subject to no transaction costs when they trade.

The market participants are subject to the same tax rate on all net trading profits.

The market participants can borrow at the same risk-free rate of interest as they can lend money.

The market participants take advantage of arbitrage opportunities as they occur.

5.1.3 Forward Price without the Income

When compounding annually, the no-arbitrage forward price is given by:

$$F_0(T)=S_0\times (1+R{)}^T$$

When compounding continuously, the forward price is given by:

$$F_0(T)=S_0\times e^{rT}$$

• $F_0(T)$: Forward price of asset at time 0.
• $T$: Time to maturity of the forward contract.
• $S_0$: Spot price of asset at time 0.
• $R/r$: Risk-free interest rate per year for maturity $T$ with annual/continuous compounding.

5.1.4 Cash-and-Carry Arbitrage Principle

Cash-and-Carry Arbitrage when the forward contract is overpriced.
$$F_0(T)>S_0\ast (1+R{)}^T\text{or}{S}_0\ast e^{rT}$$

At initiation	At At settlement date
Financing an amount of $S$ at rate $R$	Selling the underlying asset at price $F_0(T)$
Buying the underlying asset at price $S_0$	Repaying the loan of $S_0(1+R{)}^T$
Entering into a forward contract to sell it at $F_0(T)$	Getting a risk-free return of $F_0(T)-S_0(1+R{)}^T$

5.1.5 Reverse Cash-and-Carry Arbitrage Principle

Reverse Cash-and-Carry Arbitrage when the forward contract is under-priced.
$$F_0(T)<S_0\ast (1+R{)}^T\text{or}{S}_0\ast e^{rT}$$

At initiation	At At settlement date
Short shelling the underlying asset at price $S_0$	Withdrawing the deposit of $S_0(1+R{)}^T$
Depositing the amount of $S$ at rate $R$	Buying the underlying asset at price $F_0(T)$
Entering into a forward contract to buy it back at $F_0(T)$	Getting a risk-free return of $S_0(1+R{)}^T-F_0(T)$

5.1.6 Forward Price with the Known Income/Yield

A forward contract on an investment asset that will provide a perfectly predictable cash income to the holder.

The cash flow that cannot be obtained during the period needs to be eliminated from the spot price when calculating the forward price.
$$F_0(T)=(S_0-I)\ast (1+R{)}^T\text{or}(S_0-I)\ast e^{rT}$$

If the yield $Q$ per year with annual compounding,

$$F_0(T)=S_0\ast (\frac{1+R}{1+Q}{)}^T$$

If $q$ is the average yield per annum on an asset during the life of a forward contract with continuous compounding dividend yield.

$$F_0(T)=S_0\ast e^{(r-q)T}$$

5.1.7 Index Arbitrage

If an index futures price is greater than its theoretical value, an arbitrageur can buy the portfolio of stocks underlying the index and sell the futures.

If the futures price is less than the theoretical price, the arbitrageur can short the stocks underlying the index and take a long futures position.

For indices involving many stocks, index arbitrage is sometimes accomplished by trading a relatively small representative sample of stocks whose movements closely mirror those of the index.

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5.2 Valuing Financial Forwards

5.2.1 Valuing Forward Contracts without the Income

Suppose that we are valuing a long forward contract to buy an asset for price $F_0(T)$.

At initiation, the forward contract has zero value: $V=0$

During its life $t<T$, the value of a forward contract is
$$V=\frac{F_t(T)-F_0(T)}{(1+R{)}^{(T-t)}}=S_t-\frac{F_0(T)}{(1+R{)}^{(T-t)}}$$

$$V=[F_t(T)-F_0(T)]\times e^{-r(T-t)}=S_t-F_0(T)\times e^{-r(T-t)}$$

At expiration $t=T$, the value of a forward contract is:
$$V=S_T-F_0(T)$$

5.2.2 Valuing Forward Contracts with the Known Income/Yield

$$V==S_t-l-\frac{F_0(T)}{(1+R{)}^{(T-t)}}$$
$$V=S_t-l-F_0(T)\ast e^{-r(T-t)}$$
$$V=\frac{S_t}{(1+Q{)}^{T-t}}-\frac{F_0(T)}{(1+R{)}^{T-t}}$$
$$V=S_t{e}^{-q(T-t)}-F_0(T)e^{-r(T-t)}$$

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5.3 Forward and Futures Price

Recall that futures contracts are settled daily, while forward contracts are settled at maturity, futures prices are therefore different from forward prices due to the correlations between the futures prices and interest rates.

• If the futures price is positively correlated with interest rate, futures price is larger than forward price.
• If the futures price is negatively correlated with interest rate, future price is smaller than forward price.

While futures contracts can have a range of delivery dates, forward contracts do not. It is the party with the short position that chooses the delivery time.

• If the interest rate is greater than the income: short position will deliver early.
• if the income is greater than the interest rate: short position will deliver late.

5.4 Expected Future Spot Price

5.4.1 Expected Future Spot Price vs. Futures Price

Expected Future Spot Price $E(S_T)$ of an asset is the market’s average opinion about what the spot price will be in the future.

Futures Price $F(T)$ converges to the spot price at maturity of the contract.

• If an investor thinks $E(S_T)>F(T)$, he can take a long futures position.
• If an investor thinks $E(S_T)<F(T)$, he can take a short futures position.

5.4.2 Early work of expected future spot prices

Speculators require compensation for the risks they are bearing in the futures market.

Hedgers might be prepared to lose money because their overall market risks are reduced by hedging.

• If hedgers tend to hold short positions, and speculators tend to hold long positions,$E(S_T)>F(T)$
• If hedgers tend to hold long positions, and the speculators tend to hold short position, $E(S_T)<F(T)$

5.4.3 Modern Theory of Expected Future Spot Prices

Using CAPM, we can conclude that an investor should earn a return greater than the risk-free rate when the systematic risk of his or her portfolio is positive

$$\frac{E(S_T)}{[1+E(R_i){]}^T}=\frac{F(T)}{(1+r_f{)}^T}$$

• The expected return $E(R_i)=r_f+{\beta }_i[E(R_m-r_f)]$
• ${\beta }_i>0\to E(R_i)>r_f\to E(S_T)>F(T)$
• ${\beta }_i<0\to E(R_i)<r_f\to E(S_T)<F(T)$

The theoretical relationship between the futures price and the expected future spot price depends on whether the return on the underlying asset and the return on the stock market is positively or negatively correlated.

$${\beta }_i=\frac{Cov(R_i,R_m)}{{\sigma }_m^2}={\rho }_{(i,m)}\frac{{\sigma }_i}{{\sigma }_m}$$

• Positive correlation: $E(S_T)>F(T)$
• Negative correlation: $E(S_T)<F(T)$