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Determination of Forward and Futures Prices Chapter 5 Note: In this chapter forward and futures contracts are treated identically. 5.1 Consumption vs. Investment Assets l Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver); no convenience yield l Consumption assets are assets held primarily for consumption/usage in production process (Examples: copper, oil); positive convenience yield 5.2 4 Underlying Assets in this Course l Common stock: financial, investment asset l Debt: financial, investment asset l Foreign Exchange: financial, investment asset l Commodities: nonfinancial, may be investment or consumption assets l Note: Financial assets are investment assets. Nonfinancial assets (i.e. commodities) may be investment or consumption assets Short Selling l Short selling involves selling securities you do not own l Your broker borrows the securities from another client and sells them in the market l So what? Short selling of consumption assets is problematic 5.4 Short Selling (continued) l At some stage you must buy the securities back so they can be replaced in the account of the client l You must pay dividends and other benefits the owner of the securities receives; the income flow of the shorted asset is the short-seller’s liability 5.5 Notation S0: Spot price today F0: Futures or forward price today T: Time until delivery date r: Risk-free interest rate, quoted per annum cc (default assumption), for maturity T 5.6 1. Gold: An Arbitrage Opportunity? l Suppose that: l The spot price of gold is US$600 l The 1-year futures price of gold is US$650 l The 1-year US$ interest rate is 5% l No income or storage costs for gold l Is there an arbitrage opportunity? 650>630.76 Now: Sell futures, borrow & buy spot, “carry” to yearend to satisfy futures obligation 5.7 2. Gold: Another Arbitrage Opportunity? l Suppose that: l The spot price of gold is US$600 l The 1-year gold futures price = US$590 l The 1-year US$ interest rate is 5% l No income or storage costs for gold l Is there an arbitrage opportunity? 590<630.76 Now: short gold spot, deposit proceeds, long futures. Later: close out deposit, cover short position via futures contract. 5.8 The Futures Price of Gold If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F0 = S0erT where r is the 1-year cc (domestic currency) risk -free rate of interest. In our examples, S=600, T=1, and r=0.05 so that F = 600e0.05x1 = 630.76 5.9 Interest Rates Measured with Continuous Compounding (default) F0 = S0erT This equation relates the forward price and the spot price for any investment asset that provides no income and has no storage costs 5.10 When an Investment Asset Provides a Known Dollar Income F0 = (S0 – I )erT where I is the present value of the income during life of futures contract; underlying asset income flow depicted as a present value. If the underlying asset generates an income flow, the cost of carrying the asset is thereby reduced. Thus, the negative sign. 5.11 Investment Asset Provides a Known Yield F0 = S0 e(r–q )T where q is the average yield during the life of the contract (expressed with continuous compounding); underlying asset income flow depicted as a cc rate. Consistency requires: S0 (1-e–qT ) = I 5.12 Valuing a Forward/Futures Contract: post-inception or when contractual price differs from prevailing forward/futures price l Suppose that K is delivery/contractual price in a forward contract & F0 is forward price that would apply to the contract today l The value of a long forward contract, ƒ, is ƒ = (F0 – K )e–rT l Similarly, the value of a short forward contract is ƒ = (K – F0 )e–rT In the above expressions, the cost-of-carry model can be substituted for F0. 5.13 Post-inception value of forward/futures = f l K = original forward/futures rate l F0 = prevailing forward/futures rate l For F0 can substitute cost-of-carry model l F0=Se^(r+u-q-y)T: r=interest rate, u=storage cost (u>0 for commodities), q=income yield (q=0 for commodities), y=convenience yield (y>0 for consumption assets, i.e. commodities used in production). Forward vs. Futures Prices l Forward and futures prices are usually assumed to be the same. When interest rates are uncertain they are, in theory, slightly different: l A strong positive correlation between interest rates and the asset price implies the futures price is higher than the forward price. Long position experiences increases in his MAB when interest rates are rising. Thus, he prefers futures to forward. l A strong negative correlation implies the futures price is lower than the forward price. Long position experiences margin calls when interest rates rise. Thus, he prefers forward to futures. 5.15 Stock Index l Can be viewed as an investment asset paying a dividend yield l The futures price and spot price relationship is therefore F0 = S0 e(r–q )T where q is the dividend yield on the portfolio represented by the index during life of contract 5.16 Stock Index (continued) l For the formula to be true it is important that the index represent an investment asset l In other words, changes in the index must correspond to changes in the value of a tradable portfolio l CME’s Nikkei 225 futures contract (quanto): underlying asset = $5x Nikkei225 index is not traded 5.17 Index Arbitrage l When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures l When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index 5.18 Index Arbitrage (continued) l Index arbitrage involves simultaneous computer-generated trades in futures and many different stocks l Occasionally (e.g., on Black Monday) simultaneous trades are not possible l Result: theoretical no-arbitrage relationship between F0 and S0 fails to hold at times 5.19 Futures and Forwards on Currencies l A foreign currency is analogous to a security providing a dividend yield l The continuous dividend yield is the foreign risk -free interest rate l It follows that if rf is the foreign risk-free interest rate 5.20 Why the Relation Must Be True: 2 different ways of accumulating $’s at time T 5.21 Futures on assets that incur storage costs, i.e., nonfinancial assets F0 £ S0 e(r+u)T where u is the storage cost per unit time as a cc percent of the asset value. Alternative way of depiction: F0 £ (S0+U )erT where U is the present value of the storage costs. Consistency: S0 (euT -1) = U 5.22 The Cost of Carry l The cost of carry, c, is the storage cost plus the interest costs less the income earned l For an investment asset F0 = S0ecT l For a consumption asset F0 £ S0ecT . Cannot arbitrage: Short spot and long futures is problematic l The convenience yield on the consumption asset, y, is defined so that F0 = S0 e(c–y )T l Note: y is not observed, it is inferred. 5.23 Futures Prices & Expected Future Spot Prices l Suppose k is the expected return required by investors on an asset l We can deposit F0e–r T and undertake long futures now, obtaining ST at maturity of the futures contract. l NPV = - F0e–rT +ST e–kT l Profit seeking drives E(NPV) = 0 which implies F0 = E (ST )e(r–k )T 5.24 Futures Prices & Future Spot Prices (continued) l If the asset has l no systematic risk, then k = r and F0 is an unbiased estimator of ST l positive systematic risk, then k > r and F0 < E (ST ) Normal Backwardation Implication: profit by long futures then sell spot. l negative systematic risk, then k < r and F0 > E (ST ) Contango Implication: profit by short futures then buy spot. CAPM: k is positive function of systematic risk. 5.25