3.1 Forwards and Futures

1. Introduction to Forward and Futures

1.1 Basics of Derivatives

1.1.1 Definition of Derivative

Derivatives are contracts whose values depend on the values of one or more financial variables (e.g., equity prices, exchange rates, and interest rates). These variables are referred to as underlying asset.

The underlying assets include:

• Financial asset: equity, fixed-income security, currency;
• Physical asset: commodity;
• Other: interest rate, credit, weather, other derivatives, etc.

Derivatives are created in the form of legal contracts.

• The long: buyer, holder
• The short: seller, writer

1.1.2 Linear and Non-linear Derivatives

Derivatives can be categorized into linear and non-linear products. Linear derivatives provide a payoff that is linearly related to the value of the underlying asset(s).

Forward, Futures and Swap contracts are an example of linear derivatives.

Options are non-linear derivatives because their payoff is a non-linear function of the value of their underlying assets.

1.1.3 Market participants

Derivatives are versatile instruments that can be used for hedging, speculation, or arbitrage.

Hedgers: reduce risk, transfer risk

Speculators: actively take risk to make profit

Arbitrageurs: make risk-less profit (arbitrage opportunity)

1.2 Forward and Futures

1.2.1 Forward Contracts

Forward contract is an over-the-counter derivative contract, in which two parties agree that the buyer will purchase an underlying asset from the seller at a later date at a fixed price (forward price) they agree on when the contract is signed.

In addition to the (forward) price, the two parties also agree on several other matters, such as the identity and the quantity of the underlying.

1.2.2 Forward Payoff

$S_T$ is the asset price at the maturity of a forward contract.
$F_0(T)$ is the delivery price (i.e., the forward price when the contract was initiated).

The payoff from a long forward contract on one unit of the asset is $S_T-F_0(T)$.
The payoff from a short forward contract on one unit of the asset is $F_0(T)—S_T$.

1.2.3 Future Contracts

Futures contracts are specialized forward contracts that have been standardized and trade on a futures exchange.

The exchange offers a facility in the form of a physical location and/or an electronic system as well as liquidity provided by authorized market makers.

Futures contracts have specific underlying assets, times to expiration, delivery and settlement conditions, and quantities.

Futures trade on a wide range of other underlying assets. This includes:

• corn, wheat, and live cattle
• gold, silver, copper, and platinum
• S&P 500 and the Nasdaq 100
• oil, natural gas, and electricity
• real estate indices
• cryptocurrencies like bitcoin

1.2.4 Future Payoff

$F_t(T)$ is the futures price when the contract is closed at time $t$.
$F_0(T)$ is the futures price at time $0$ (the futures price when the contract was initiated).

The payoff from a long futures contract on one unit of the asset is $F_t(T)—F_0(T)$.
The payoff from a short futures contract on one unit of the asset is $F_0(T)—F_t(T)$.

Forward	Futures
Private traded	Exchange-traded
Unique customized contracts	Standardized contracts
Default risk is present	Guaranteed by clearinghouse
Little or no regulation	Regulated
No margin deposit required	Margin required and adjusted
Settlement at maturity	Daily settlement (mark to market)
Delivery usually happens	Closed out before maturity

2. Exchanges and OTC Markets

2.1 Exchange-Traded Markets

2.1.1 Operations of Exchange

An exchange market is a market where investors trade standardized contracts made by exchange.

Traditionally, derivatives exchanges have used what is referred to as the open-outcry system. This involves traders meeting on the floor of the exchange and indicating their proposed trades with hand signals and shouting.

However, with computers being used to match buyers and sellers. Sometimes electronic trading is initiated by computer algorithms without any human intervention at all.

Today, exchanges clear all trades between members through so-called central counterparties(CCPs).

Positions can be closed out by entering into offsetting positions.

Trades are settled daily by variation margin flowing from one side to other.

2.1.2 Central Counterparty

In derivatives trading, the central counterparty replaces bilateral liquidation, becoming the buyer of each seller and the seller of each buyer. If one party defaults, it can also ensure the completion of the transaction.

For a CCP to clear a product, several conditions must be satisfied:

• The legal and economic terms of the product must be standard within the market.
• There must be generally accepted models for valuing the product.
• The product must trade actively.
• Extensive historical data on the price of the product should be made available to enable initial margin requirements to be determined.

2.1.3 How CCPs Handle Credit Risk

Netting: a procedure where short positions
and long positions in a particular contract offset each other.

Daily settlement: trades made on an exchange are not settled at maturity. Instead, it marked to market day by day.

The exchange requires members to protect themselves by providing margin, which refers to the cash or assets transferred from one trader to another for protection against counterparty default.

Initial margin are funds or marketable securities that must be deposited with the CCP. It is set by the exchange and reflects the volatility of the futures price.

Members are also required to submit a defund fund as a loss protection. If the initial margin is not sufficient to cover a member’s losses during a default, the members’ default fund contributions will be used to cover the difference. If these funds remain insufficient, they are replenished by the default funds of other members.

Maintenance margin: the margin account balance is adjusted each day to reflect gains and losses. If the balance in the margin account falls below the maintenance margin level, the trader will get a margin call and will be asked for funds to bring the balance up to the initial margin level.

Variation margin: Used to bring the margin balance back up to the initial margin level. Each day, the losing member pays the exchange CCP an amount equal to the loss, while the profitable member receives an amount equal to the gain from the exchange CCP. These payments variation margin and usually occur daily.

2.1.4 Use of Margin Accounts

Buying on margin refers to the practice of borrowing funds from a broker to buy shares or other assets.

Options on stock: traders with short positions are therefore required to post margin.

Short sales: a retail trader who chooses to short a stock is required to post margin.

2.2 Over-the-Counter Markets

2.2.1 Operations of OTC Markets

OTC market participants can be categorized as either end users or dealers.
End users are corporations, fund managers, and other financial institutions.
Dealers are large financial institutions that provide commonly traded derivatives.

An advantage of OTC markets is that the contracts traded do not have to be the standard contracts defined by exchanges.

2.2.2 Ways to reduce credit risk in OTC markets

Bilateral Netting: Two market participants would enter into a master agreement applying all they traded, and treat all the transactions as a single transaction.

Example: Suppose now, Company B gets into financial difficulties. It will default on Transactions 1 and 3, but keep Transactions 2 and 4. How much will company A lose in transactions 1 and 3?

With netting: Company A will loss $20\text{million}$.
Without netting: Company A will loss $60\text{million}$ (The profits of transactions 1 and 3 are not available).

Transaction	Value to Company A	Value to Company B
1	+40	-40
2	-30	+30
3	+20	-20
4	-10	+10

Collateral: the credit support annex (CSA) of a master agreement between two parties specifies how the required collateral is to be calculated and what securities can be posted.

Special Purpose Vehicles (SPVs): SPV, also called Special Purpose Entities (SPE), are legal entities created typically to isolate a firm from financial risk.

Derivatives Product Companies (DPCs): were well-capitalized subsidiaries of dealers designed to receive AAA credit ratings.

Credit Default Swaps: these are insurance-like contracts between a protection buyer and a protection seller. The buyer pays a regular premium to the seller, and if there is a default by a specified entity (not the buyer or seller), the seller makes a payment to the buyer.

Monolines: are insurance companies with strong credit ratings, and they provide investor credit default wraps, i.e. financial guarantees.

Exchange Traded	OTC(over-the-counter)
Standardized	Customized
Backed by a clearing house	Trade with counterparty (default risk)
Trade in a physical exchange	Not trade in a central location
Regulate	Unregulated
Small trading volume	Large trading volume

3. Futures Markets

3.1 Futures of a Features Contract

3.1.1 Key Features of a Futures Contract

Underlying asset: financial assets and commodities

Contract size: setting a suitable size to attract both retail investors and large corporations.

• Treasury bond futures has a face value of $ $100,000$.
• S&P $500$ futures contract has a multiplier of $250X$.

Delivery location: for some contracts, the delivery location may factor into the price of the underlying asset.

Delivery time: exchanges determine the delivery month for which a contract trades, the time when a contract starts trading, and the time when it finishes trading.

The party with the short position can choose among the delivery dates specified by the exchange.

Price quotes: minimum price movements for each contract.

Price limit: exchanges set limits on how much a futures price can move in one day.

The purpose of price limits is to prevent large price movements resulting from speculation. If the price during a day moves up or down by the price limit, trading is normally halted for the day. Meanwhile, price limits may be changed from time to time.

However, there price restrictions may also hamper the determination of true market prices if limit moves arise from new information reaching the market.

Position limits: a limit on the size of a position that a speculator can hold.

Prevent speculators from exercising an unreasonable influence on the market.

Position limits are often in the tens of thousands of contracts and do not affect most traders.

Open interest: The number of contracts in existence at any time, also as the number of long positions, or, equivalently, the number of short position.

• when both members are taking new positions, the open interest increases by one.
• when one member is closing out a position while the other is taking a new position, the open interest remains the same.
• When both members are closing out their respective position, the open interest decreases by one.

Trading volume: the number of contracts traded in a day.

If many traders close their positions, the volume of the day may be greater than the open interest. It can also happen if there is a large amount of intraday trade.

3.1.2 Delivery Mechanics

Physical delivery: at the end of the contract, the long position holder will take delivery and the short will deliver the physical commodity.

Cash settlement: at the end of the contract, net cash position would be solved by money.

3.1.3 Placing Orders

Traders of futures and other securities can place many different types of orders.

Market order is a request to buy or sell futures (i.e., take a long or short position) as quickly as possible at the best available price.

Limit order is that the trader specifies a price limit. A limit order can only be executed at the specified price or at a price more favorable to the trader.

Stop/Stop-Loss order is the order that becomes a market order once the asset reaches a specified or a less favorable price. Stop-loss orders (as the name implies) are orders that are designed to limit a trader’s loss on a certain position.

Stop-Limit order becomes a limit order when the stop price is reached. Two prices must be specified: the stop price and limit price.

Market-if-Touched(MIT) order is an order that becomes a market order if a trade occurs at the specified price or a more favorable price.

Discretionay order is an order that the broker can delay filling in hopes of getting a better price.

Fill-or Kill order is an order that must be executed immediately on receipt or not at all.

3.1.4 Accounting

Normal accounting rules call for gains and losses from futures to be accounted for as they occur.

Accounting for gains and losses year-by-year when hedging could lead to an increase in reported earnings volatility.

The rules to use of hedge accounting are strict:

• The hedge must be fully documented and clearly identified.
• The hedge relationship is not dominated by credit risk.

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3.2 Patterns of Futures Prices

3.2.1 Contango and Backwardation

The futures price converges(相交) to the spot price as the delivery period approaches.

3.2.2 Normal Market

If the futures price increases as time to maturity increases, this is referred to as a normal market.

Maturity Month	Settlement Price (USD Per Ounce)
June 2018	1256.6
July 2018	1267.2
August 2018	1268.9
October 2018	1274.7

3.2.3 Inverted Market

If the futures price decreases as time to maturity increases, this is referred to as a inverted market.

Maturity Month	Settlement Price (USD Per Ounce)
June 2018	68.08
July 2018	66.18
August 2018	65.47
October 2018	63.36

4. Using Futures for Hedging

4.1 Short and Long Hedging

Short Hedge	Long Hedge
Hedgers short a futures contract	Hedgers long a futures contract
Against a price decrease in existing long position	Against a price increase in existing short position
Realizes a positive return when the price of the hedged asset decreases	Realizes a positive return when the price of the hedged asset increases
Appropriate for long position	Appropriate for short position

A short hedge is appropriate when the hedger already owns or will receive certain assets and expects to sell it at some time in the future.

A long hedge is appropriate when a company knows it will have to purchase certain assets in the future and wants to lock in a price now.

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4.2 Pros and Cons of Hedging

Arguments for Hedging
Hedging can reduce the risk arising from changes in asset prices.

Hedging can help firms reduce the volatility of their earnings and potentially make themselves more attractive to investors.

Arguments against Hedging
Shareholder may prefer no hedging. Shareholders can do their own hedging and decide whether they wan to take on a particular risk.

The outcome with hedging will sometimes be worst than the outcome without hedging.

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4.3 Basis Risk

4.3.1 Definition of basis risk

The basis is the difference between the spot price of an asset and its futures price.

$$\text{Basis}=\text{Spot price}—\text{Futures price}$$

Perfect hedging: If the asset to be hedged and the asset underlying the futures contract are the same, the basis should be zero at the expiration of the futures contract.

Basis risk is the uncertainty associated with the basis at the time a hedge is closed, thus the prefect hedging assumptions may be violated:

• The asset being hedgd and the underlying asset of futures contract is not the same.
• The futures price and the spot price are not equal at the time the hedge is closed out before maturity.

4.3.2 The impact of basis risk

Net cost of long position/Net receiving of short position

$$S_t+(F_0-F_t)=F_0+(S_t-F_t)=F_0+basi{s}_t$$

Long the basis refers to a set of positions that consists of a short futures position and a long cash position.
Position that are long the basis benefit when the basis is strengthening.

Short the basis refers to a set of positions that consists of a long futures position and a short cash position.
Position that are short the basis benefit when the basis is weakening.

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4.4 Hedge Ratio

4.4.1 Optimal hedge ratio

The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure(underlying asset).

Suppose that historical data, used in conjunction with linear regression, shows that the best fit linear relationship between $\Delta S$ and $\Delta F$ is $\Delta S=a+b\Delta F+ϵ$

Suppose further that $h$ is the hedge ratio, $\Delta S-h\Delta F=a+(b-h)\Delta F+ϵ$

The variance of the right-hand side is minimized by setting $h=b$(so that the second term is zero).

$$h^{\ast }=\rho \ast \frac{{\sigma }_S}{{\sigma }_F}$$
$$h^{\ast }=\rho \ast \frac{{\sigma }_S}{{\sigma }_F}=\frac{Cov(S,F)}{{\sigma }_F^2}=\frac{\rho \ast {\sigma }_F{\sigma }_S}{{\sigma }_F^2}=\beta$$

• ${\sigma }_S$: standard deviation of change in spot price $S$.
• ${\sigma }_F$: standard deviation of change in future price $F$.
• $\rho$: coefficient of correlation between spot price and futures price.

4.4.2 Hedge Effectiveness

The optimal hedge ratio, $h^{\ast }$, is the slope of the best fit line when $\Delta S$ is regressed against $\Delta F$.

Hedge effectiveness can be defined as the proportion of the variance that is eliminated by hedging.
$${\rho }^2=R^2=(h^{\ast }{)}^2\frac{{\sigma }_F^2}{{\sigma }_S^2}$$

4.4.3 Optimal Number of Futures Contracts

The futures contracts used have a face value of $h\times N_A$, the most appropriate number of futures contracts required is:

$$N^{\ast }\times Q_F\times \Delta F=Q_A\times \Delta S\to N^{\ast }=\frac{h^{\ast }{Q}_A}{Q_F}$$

• $Q_A$: size of position being hedged (units)
• $Q_F$: size of one futures contact (units)
• $N^{\ast }$: optimal number of futures contracts for hedging

4.4.4 Hedging with Stock Index Futures

Stock index futures can be used to hedge a well-diversified equity portfolio.

The standard deviation of the daily return for the hedged asset can be assumed to be $\beta$ multiplied by the standard deviation of the return provided by the futures price.

The correlation between the daily returns on the asset and the futures is approximately 1.

The number of futures contracts is calculated as the following:

$$h^{\ast }={\rho }_{S,F}\frac{{\sigma }_S}{{\sigma }_F}=1\times \frac{\beta \times {\sigma }_F}{{\sigma }_F}=\beta$$

$$N^{\ast }=\beta \ast \frac{V_A}{V_F}$$

• $V_A$ is the current value of the portfolio.
• $V_F$ is the current value of the futures contract (the futures price times the contract size).

4.4.5 Managing Beta

A hedge using index futures removes the systematic risk($\beta =0$) arising from market moves.

$$\text{Number of contracts}=({\beta }^{\ast }-\beta )\ast \frac{V_A}{V_F}$$

• ${\beta }^{\ast }$ is the target beta
• $V_A$ is the current value of the portfolio.
• $V_F$ is the current value of the futures contract (the futures price times the contract size).

Negative result indicates that selling futures to decrease systematic risk.
Positive result indicates that buying futures to increase systematic risk.

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4.5 Other Types of Hedging

4.5.1 Cross Hedging

Cross hedging occurs when the assets underlying the futures contract and the asset whose price is being hedgd are different.

An airline that is concerned about the futures price of jet fuel might choose to use heating oil futures contracts to hedge its exposure on jet fuel.

4.5.2 Tailing the hedging

When futures contracts are used for hedging, there is daily settlement and series of one-day hedges. Tailing the hedge can deal with this case when making hedging decision.

4.5.3 Stock and roll

Sometimes hedgers are faced with a lack of liquid(i.e., actively trader) futures contracts for the required hedge maturities. Because the most liquid futures contracts are those with relatively short maturities, a hedger can work around this issue by following what is termed a stack and roll strategy.

• Implementing a short maturity futures hedge
• Closing the hedge out just prior to the delivery period and replacing it with another short-maturity futures hedge
• Closing the new hedge out just prior to the delivery period and replacing it with yet another short-maturity futures hedge, and so on.
  

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: $E(S_T)<F(T)$

6. Commodity Forwards and Futures

6.1 Features of Commodities

6.1.1 Difference between Commodities and Financial Assets

Storage costs: can be quite substantial for commodities, including insurance for metals and special care for corn, natural gas, etc.
Transportation:the costs depend on their location.
Lease rate: a commodity held for investment purposes (e.g., gold or silver) can be borrowed for shorting.
Mean reverting: the prices of most commodities tend to get pulled back toward some central value.

6.1.2 Types of Commodities

Agricultural Commodities
Metals
Energy
Weather

6.1.3 Consumption and Investment Commodity

Most commodities are consumption assets. storage cost and convenience yield should be considered in pricing.

Some precious metals (like gold, silver or lesser extent platinum and palladium) are held for investment purposes. Lease rate should be considered in pricing.

6.2 Pricing Commodity Forwards

6.2.1 Lease Rate

The lease rate for an investment commodity is the interest rate charged to borrow the underlying asset.

Let $L/l$ be the lease rate pre year for maturity $T$ with annual/continuous compounding. The relationship between the forward price and the spot price is :

$$F=S(\frac{1+R}{1+L}{)}^T\text{or}F=S\times e^{(r-l)T}$$

This equation can produce an implied lease rate

$$L=(\frac{S}{F}{)}^{\frac{1}{T}}(1+R)-1\text{or}l=r-\frac{In(F/S)}{T}$$

6.2.2 Convenience Yield

The convenience yield measures the benefits to the asset holder of having it in their inventory as a protection against future shortages or delivery delays.

Let $U/u$ and $Y/y$ be the storage cost and convenience yield per year for maturity $T$ with annual/continuous compounding.

$$F=(S+U)(\frac{1+R}{1+Y}{)}^T\text{or}F=S\times e^{(r+u-y)T}$$

This equation can produce an implied convenience yield:

$$Y=(\frac{S+U}{F}{)}^{\frac{1}{T}}(1+R)-1\text{or}y=r+u-\frac{In(\frac{F}{S})}{T}$$

6.2.3 Cost of Carry

The cost of carry for an asset reflects the impact of (in the percentage form):

Storage cost ($u$), Financing cost ($r$), Income earned on the asset ($q$)

The cost of carry per year is:
$$(1+r)(1+u)/(1+q)-1\approx r+u-q$$

In the case of a financial asset, there are no storage costs.
In the case of a commodity, there is usually no income.