Determination of Forward and

Futures Prices and their

relation with Spot Prices

Readings:

Chapter 5: 5.1 - 5.6, 5.8, 5.9-5.14

 Pricing Forwards & Futures
 We will determine forward/futures price in
relation to the spot price by using a no-arbitrage
argument
 We start by looking at underlying assets that do
not provide interim cash payments (dividends or
interest payments) and require no storage costs
 Extensions (conceptually small) to cash
payments, yields, storage costs will follow
 We will first consider forward prices (i.e., prices
of forward contracts), as they are a bit simpler.
 Then, we will make the extension to futures
prices
 Assumptions for Pricing
 No or negligible transaction costs
 Same tax rates for all market participants
 Market participants can borrow or lend at
risk-free rate (Libor…)
 Investors rationally take advantage of
arbitrage opportunities
 All above assumptions need not apply to
all investors: only a few large players
suffice
 Arbitrage
Arbitrage - arises if an investor can
construct a zero investment portfolio with
a sure (i.e., no risk) profit.
 Since no investment is required, an
investor can create large positions to
secure large levels of profit.
 In efficient markets, profitable arbitrage
opportunities will quickly disappear.
 One of the most important concepts in
finance (and in this subject!)
 Also referred to as free lunch.
 Notation
• T: Time to maturity
• S0: Initial spot price
• ST: Spot price at maturity of the contract
• F0: Initial Forward or Futures Price
• r: risk free rate continuously compounded p.a.
• q: Continuous p.a. yield
• I: Discrete payments (dividends, income)
• U: Discrete storage costs (gold, commodities)
• u: continuous p.a. storage costs (like a
negative dividend yield)
 No Arbitrage Argument
Action Cash Flow Cash Flow at T
at t=0
Buy 1 unit of -S0 ST
asset at t=0

Short 1 0 F0 – ST
forward at t=0

Borrow $S0 at S0 -S0erT

rate r at t=0

Overall 0 ST+F0-ST-S0erT
Position
 No Arbitrage Argument
 If it does not cost anything to enter into
the position at time t, then riskless
profits (CF>0) should not be earned at
time T

 Therefore, the forward price at t=0 must

be:
F0 = S0erT
 Example 1
 A forward contract is written on a
stock (no dividend). The maturity of
the contract is 6 months. The stock
price is $50 today and the risk free
rate is 10% per year. What is the
no-arbitrage forward price?
 F0 = S0erT = 50e0.10(0.5) = $52.56
 What if F0 is NOT $52.56?
 Arbitrage
 Suppose F0=$53, and all other values
are those on the previous slide
  you can earn a riskless profit by
• At t=0 (no cash outlay):
 Borrow $50 at the 10% p.a. rate for 6 months
 Buy 1 share of stock at $50
 Take a short position in the forward expiring at
T for delivery at $53:
• At t=T
 Sell asset for 53
 Pay back loan 50*e(0.1*6/12)=52.56
 Realize a profit of $(53-52.56)=$0.44
 Arbitrage
 If F0 > S0erT, arbitrageurs buy the
asset spot and short forward
contracts

 If F0 < S0erT, arbitrageurs short the

asset spot and buy (long) forward
contracts.
 What Happens if the
Security Pays Income?
 Dividend paying stocks with a known
(discrete) dividend
 Coupon bonds
 Let ‘I’ be present value of all known
cash income

 Still determine today’s forward price

using no-arbitrage argument
 Pricing a Forward with Income
 It can be shown that the price of a
forward contract at time t=0 is:
F0=(S0-I)erT

• where S0-I is the dividend adjusted

underlying asset price and arbitrage
activities force the relation to hold
 Known Yield
 For some securities, like stock
indices, it is easier and more
common to denote with a yield the
income they pay.
 Assume that the yield is paid at an
annual rate of q, continuously
compounded (q is a proportion of S0)
 Thus, we can use the same no-
arbitrage arguments to find the
forward price.
No Arbitrage… with Known Yield
 Instead of subtracting the income
from S0, we reduce S0 by adjusting
it for the dividend yield
S0e- q T
 It can be shown that, if there is
no arbitrage, for assets paying a
dividend yield of q
F0 = S0e- q T*erT =
S0e(r- q)T
 Stock Index Futures/Forwards
Pricing
 The previous formula applies to, for
instance, forwards written on stock
indices as a they are dividend-paying
assets
• Dividend is paid continuously with a
dividend yield rate of q p.a.
 Currency Forwards Pricing
 Notation:
• S0: price in local currency of one unit of
foreign currency. EX: 1.4 AUD per USD
• r: domestic interest rate with continuous
compounding
• rf: foreign interest rate with continuous
compounding
 A foreign currency is analogous to a stock paying
a known dividend yield
 The “yield” is rf
 Currency Forwards Pricing
 Recall that
F0=S0e(r- q)T
 Replacing q by rf we can obtain the
forward/futures price on a foreign currency
F0 =S0e(r-rf)T

 Also called Covered Interest Parity (CIP) in

International Finance
 When r – rf < 0
• Futures price is less than the spot price, S0
 When r – rf > 0
• Futures price is greater than the spot price, S0
 Commodity Forward/Futures
 Unlike financial instruments which
are designed for investment,
commodities can be held for either
immediate consumption or for
investment.
• Examples: pork bellies, gold, sugar,
crude oil, beef, wheat, corn, etc.
 Let’s consider investment
commodities first
 Gold Forward/Futures (and, more generally,
on investment commodities)
 If there are no storage costs (SC),
then gold could be seen as an asset
paying no income.
 Thus, the futures price is F0 = S0erT
 If there are storage costs, they can be
regarded as negative income. If U is
the PV(SC) incurred during the life of
the contract and we replace I by –U in
the previous expressions, then:
F0 = (S0+U)erT
 (Investment) Commodity Futures
Example
 A futures contract is written on gold.
The maturity of the contract is one
year and the storage cost is $2/oz
per year. The payment will be made
at the end of the year. The spot
price is $1500 and the risk free rate
is 1% per annum.
 What is the no-arbitrage futures
price?
 (Investment) Commodity Futures
Example (cont’d)
 First we need to find U
• U = 2e-0.01(1) = 1.980

 Then the (theoretical?) futures price

is:
• F0 = (S0+U)erT = (1500+1.980)e0.01(1)
• F0 = 1517.08
 Notice that U is a known dollar cost
Gold Forward/Futures (and, more generally,
on investment commodities)
 Storage costs can also be seen as a
negative dividend yield.
 Denote storage costs with ‘u’
 Conceptually, we can replace q with
–u
 Then
F0= S0e(r+u)T
 Notice tha t u is a known cost,
expressed as a proportion of S0
Futures/Forwards on Consumption
Commodities
 If F0>(S0+U)erT
Borrow S0 + U, buy commodity spot, short
futures ….equality
 If F0<(S0+U)erT

Sell commodity spot (to save storage cost),

invest at risk-free rate, long futures
But market participants holding commodity
for consumption are reluctant to sell
 F0<=(S0+U)erT (limited arbitrage)
 Convenience Yield
 The previous concept is related to the
convenience yield: i.e., the benefit from
holding the physical asset
 In formulas, c.y. is defined as the rate y
such that
F0eyT = (S0+U)erT
or
F0eyT=S0e(r+u)T
 The greater the expectation of shortage
the higher y (check level of inventories)
 y=0 for investment assets
 Note: y is generally not directly observable in the
market but it is implied in the formulae above
 Cost of Carry
 We can simplify and summarize our
discussion using the cost of carry
concept
 Cost of carry is equal to:
 The storage cost
 Plus any interest paid to finance the asset
 Less any income earned on the asset
 Cost of Carry
 For a non-dividend paying stock, c = r
 For a dividend-paying stock, c = r- q

 For a currency, c = r – rf

 For a commodity, c = r + u

 Thus, for any investment asset, the forward

price is:
F0 = S0ecT
For any consumption asset
F0 = S0e(c-y)T
 Time 0 and Time t
 All previous arbitrage examples assumed
that actions were taken at time t=0
 But everything conceptually holds at any
time t during the life of the contract
  All previous pricing formulas hold at
each time t between contact inception
(t=0) and contract expiration (t=T)

  General formula: Ft = Ste(c-y)(T-t)

 Forward vs. Futures Prices
 Thus far we have looked at the pricing of
forward contract by no arbitrage and
ignored daily settlements
 At first glance, futures prices ought to
differ from forward prices as the cash flow
stream differs between the two
 More specifically, with futures gains earn
interest and losses need to be financed
 However, it turns out that forward and
futures price may not differ by any
appreciable amount
 Relation between Forwards &
Futures Prices
 Specifically, when interest rates are constant, or
change in a deterministic way, or are
uncorrelated with spot / forward / futures prices
forward and futures prices are the same
 It can be shown mathematically, assuming (quite
realistically…) that on a daily basis futures prices
are unpredictable (random walk)
 At the intuitive level, accrued interest (on gains)
and financing costs (on losses) tend to offset
each other  the more they offset each other,
the more a futures looks like a forward
 As interest rates change over time in an
unpredictable (random, stochastic) way, there
may be a divergence between forward and
futures prices
 Relation between Forwards &
Futures Prices
 If the underlying asset price is positively correlated
with interest rates, futures prices tend to be higher
than forward prices (long position is ‘better off’ with
futures).
 If the underlying asset price is negatively correlated
with interest rates, futures prices tend to be lower
than forward prices (long position is better off with
forwards).
 If the underlying asset price is uncorrelated with
interest rates (like, e.g., when interest rates are
constant) futures and forward prices tend to be very
close
 If the maturity is only a few months, the difference
between the two prices is very small even if interest
rates are correlated with spot prices.
 Relation between Forwards &
Futures Prices
 Other factors such as taxes,
transaction costs and default risk
may create a divergence between
forward and futures prices.
 In general, we will continue to
assume that forward and futures
prices are, in most situations, equal
or almost so.
 Futures (Forward) Curves
 Curve is the relation between time-to-maturity (x –
axis) and futures price (y-axis)

 Upward sloping (or, normal)

 Downward sloping (or, inverted)

 In the industry (and financial press), slope of curve

often “confused” with contango/backwardation
 Contango and Backwardation (again)
 Normal Backwardation: F below expected S.
 Normal Contango: F above expected S

 In the industry, the two concepts (‘Bw’ & ‘Cn’) define

the relation between F and current S. So:
• F<S (i.e., positive basis)  ‘Backwardation’
• F>S  ‘Contango’

 With the “industry” definition

• ‘Cn’ corresponds to an upward sloping (or, normal) futures
curve (futures prices above the current spot price S0)
• ‘Bw’ corresponds to a downward sloping (or, inverted) futures
curve (futures prices below the current spot price S0)
 Contango and Backwardation (again)
 Just terminology….
https://www.youtube.com/watch?v=o2X_XNdmWws

 To summarize:

• Contango: S0 < F0(T)

• Normal Contango: E(ST) < F0(T)

• Backwardation: F0(T) < S0

• Normal Backwardation: F0(T)<E(ST)
 Contango and Backwardation
 Commodities can be in “industry” contango
(negative basis), yet be in normal backwardation
• EX: S0 = $30, E(ST) = 34, F0 = 32.
•  Market is in “N.B.” but curve is upward sloping, i.e.,
basis is <0 [ since S0 < F0(T)]
 Similarly, we can have a commodity in “industry”
backwardation (positive basis) and, at the same
time, in normal contango
 Part of the reason for the industry shortcut (or,
for the confusion) is that E(ST) is unobservable
(not on traders’ screen) but S0 is observable.
 Less confusing to use “basis” or “slope of curve”
for observed prices
 Contango and Backwardation
 Once we are clear about the terminology, the
more substantial issues are:
1. What affects the slope of the curve (and,
hence, the basis)?
2. Does the slope of the curve contain relevant
information for (i.e., predict) future prices (S
and F)? - i.e., is it useful to investors (hedgers
and/or speculators) ?
Slope of Curve and Future Returns

 An upward- or downward-sloping term

structure of futures prices creates the
possibility of roll return (or, roll yield)
on futures positions.

 Beware: those return are not

guaranteed
 Slope of Curve and Roll Yield
 EX:WTI Futures as of May 2004
FJuly 2004 =$40.95 FJuly 2005= $36.65
 You could, in May 2004, go long the July 2005 contract
and hold the position for one year, then roll it over
 IF the term structure of oil remained unchanged
between May 2004 and May 2005….
  The roll return (“rolling down the curve”) would have
been $40.95/$36.65 – 1= 11.7%
 Similar examples can be constructed for shorting
futures on normal curve
 In actuality, the curve may shift
  Total Return on futures may differ from hypothetical
roll return
 Beware of paper roll returns!
Slope of Curve and Future Returns
 For investment assets slope of curve
simply reflects cost of carry
• if c>0  upward sloping

  Slope does not necessarily predict

future prices or returns (spot or
futures).
 Slope of Curve and Future Returns
 For consumption assets (and gold…), curve is
inverted if c<y (as seen earlier)
 Economically, y should decline as inventory
increases
 Curve may have predictive power as it tells us
about conv. yield and, hence, about
probability of shortages through the inventory
channel
 More generally, (slope of ) curve may tell us
about fundamentals (demand and supply)
 Conv. yield and/or basis (slope of curve) are,
indeed, used as trading signals by some
 But remember: it’s like predicting stock returns!