Determination of Forward and Futures
Determination of Forward and Futures
Futures Prices
RAVICHANDRAN
Forward / Futures Prices
• we will examine how forward prices and
futures prices are related to the spot price
of the underlying asset.
• Forward contracts are easier to analyse
than futures contracts because there is no
daily settlement—only a single payment at
maturity.
ASSUMPTIONS AND
NOTATION
1. The market participants are subject to no
transaction costs when they trade.
2. The market participants are subject to the
same tax rate on all net trading profits.
3. The market participants can borrow
money at the same risk-free rate of interest
as they can lend money.
4. The market participants take advantage of
arbitrage opportunities as they occur.
Assumption and Notation
﹡NOTATION:
S0: Price of the asset underlying the
forward or futures contract today
F0: Futures or forward price today
• F = S * e(r-y)t
• Incidentally, convenience yields are often implied from, or
backed out of observed market prices and not explicitly entered
in to a formula like other factors. They are something of a “fudge
factor” to make the equality between forward prices and their
other input factors hold true.
Futures Prices Of Stock Index
• Can be viewed as an investment asset
paying a dividend yield
• The futures price and spot price relationship
is therefore
F0 = S0 * e(r–q )T
where q is the average dividend yield on the
portfolio represented by the index during
life of contract
Futures Prices Of Stock Index
• F0 = S0e(r-q)T
q:The dividend yield
Example:
r = 0.05 S0 = 1,300 T = 3/12 (0.25) q = 0.01
F0 = 1,300e(0.05-0.01)x0.25 = $1,313.07
Forward price of currency
• When the underlier is a foreign currency,
we consider the domestic interest rate but
also the foreign rate.(rf)
• Foreign interest rate represents income to
short party and is just proportional income.
• F = S *e(rh-rf)t
Forward price of currency - example
• X agrees to buy 5000 Tuluvian Krinkets from a
currency dealer Y in 9 months. Krinklets are
currently trading for $0.55. (when dealing foreign
currency, just think of each unit of other currency
as a share of stock, which is bought with some
amount of local currency)
• The risk free int. rate in Tuluvia is 2 percent.. The
risk free int. rate at home is 6 per cent.
• This is exactly a forward underlier with
proportional income, replacing I with rf(foreign
rate). Here’s what we got:
Forward price of currency - example
• S = 5000 * 0.35 = 1750
• r = 0.06
• rf = 0.02
• t=0.75
• Putting all together we have
• F = S* e(r-rf)t
• F = 1750 * e(0.06-0.02)(0.75)
• F = 1750* e0.03
• F = 1803.30
• The fair –market delivery price for this contract is
$1803.30
Forward Price Summary
Description Forward Price formula
Basic Forward Price F = S* ert
With Proportional
F = S * e (r+U)t
Storage
With Fixed Income F= (S-I) * ert
With Proportional
F= S* e(r-i)t
Income
With Convenience
F = S * e (i-y)t
Yield
Foreign Currency
F = S * e(r-rf)t
Forward
Forward Price - together
• Putting these all together:
• Forward Price = (S + U - I)* e(r+ u –i-y-rf)t
• Where S = Spot price , U –Fixed storage
cost
• I – Fixed Income, r – risk-free interest rate
• u- proportional storage cost ,
• i - proportional income, y - convenience
yield, rf – foreign interest rate
Forward vs Futures Prices
• A strong positive correlation between interest
rates and the asset price implies the futures price
is slightly higher than the forward price
• A strong negative correlation implies the reverse
• Last only a few months are in most circumstances
sufficiently small to be ignored
• Forward and futures prices are usually assumed
to be the same. When interest rates are uncertain
they are, in theory, slightly different