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Futures Contracts Pricing & Valuation Guide

The document discusses the pricing and valuation of futures contracts, highlighting the no-arbitrage pricing relationship with forward contracts and the impact of mark-to-market (MTM) cash flows. It explains how futures prices are reset daily due to MTM settlements, contrasting them with forward prices that remain constant after initiation. Additionally, it covers the implications of interest rate changes on futures and forward payoffs, emphasizing the convexity of forward payoffs and its value to investors.

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16 views5 pages

Futures Contracts Pricing & Valuation Guide

The document discusses the pricing and valuation of futures contracts, highlighting the no-arbitrage pricing relationship with forward contracts and the impact of mark-to-market (MTM) cash flows. It explains how futures prices are reset daily due to MTM settlements, contrasting them with forward prices that remain constant after initiation. Additionally, it covers the implications of interest rate changes on futures and forward payoffs, emphasizing the convexity of forward payoffs and its value to investors.

Uploaded by

harsoftware3
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Derivatives

Derivatives

Pricing and Valuation of


Futures Contracts

LOS a Compare Pricing and Valuation of Futures Contracts

Futures Contracts
At initiation, the no-arbitrage futures price is the same as the no-
arbitrage price of an equivalent forward.

With no costs or benefits of holding the asset,


f0(T) = S0 × (1 + Rf)T

With costs and/or benefits of holding the asset,


f0(T) = {S0 – [PV0(Ben) – PV0(Cost)]} × (1 + Rf)T

© Kaplan, Inc. 2

1
LOS b Explain Pricing and Valuation of Futures Contracts

Futures vs. Forward Prices


After initiation, forward price does not change. Value changes as
asset price changes (when there are no MTM cash flows)

Because futures have MTM cash flows, price resets to the


settlement price and value returns to zero daily as MTM gains
and losses are settled.

© Kaplan, Inc. 3

LOS b Explain Pricing and Valuation of Futures Contracts

Example: Futures Price and Value


Consider a long futures contract on 100 oz. gold initiated at
$1,870/oz.

The following illustrates mark-to-market cash flows and their


effects on futures price and value.

© Kaplan, Inc. 4

2
LOS b Explain Pricing and Valuation of Futures Contracts

Futures Price and Value


Day 0
Price = Settlement Price 1,870 MTM Value = 0

Day 1
Settlement Price = 1,875 MTM value = $500
$500 addition to margin
New futures price = 1,875 MTM value = 0

Day 2
Settlement price = 1,855 MTM value = –$2,000
$2,000 deduction from margin
New futures price = 1,855
© Kaplan, Inc.
MTM value = 0 5-2

LOS b Explain Pricing and Valuation of Futures Contracts

Forward Prices vs. Futures Prices


Because futures have daily MTM cash flows, if interest rates are
positively correlated with underlying asset value, a long futures
contract is preferred to a forward without MTM cash flows

Higher rate when “lending” than when “borrowing”

In practice, no significant difference in prices/values

© Kaplan, Inc. 6

3
LOS b Explain Pricing and Valuation of Futures Contracts

Forward Prices vs. Futures Prices


Consider a long future, $1mm on six-month MRR priced at 97.50 =
(1 – annualized MRR of 2.5%) × 100
Each basis point change in MRR changes the payoff by 0.0001 ൈ 6/12
ൈ 1mm = $50, payoff is linear
If MRR = 2.44% at settlement, futures price is 100 – 2.44
= 97.56, long receives payment(s) of (2.50% – 2.44%)
ൈ 6/12 ൈ 1mm = $300, the additional interest cost on a $1mm six-
month loan

© Kaplan, Inc. 7

LOS b Explain Pricing and Valuation of Futures Contracts

Convexity of Forward Payoffs


Consider an equivalent FRA:

At settlement with MRR = 2.51% payment to the long is


50  $49.3803
 0.0251 
1 
 2 
At settlement with MRR = 2.49% long pays Convexity

50  $49.3852
 0.0249 
1  2 

© Kaplan, Inc. 8

4
LOS b Explain Pricing and Valuation of Futures Contracts

Convexity of Forward Payoffs


The gain from an interest rate decrease is larger then the loss from an
interest rate increase.
Same as bond convexity, forward convexity bias has value to
investor.
Difference in payoffs is small for short-dated FRAs but significant for
long-dated FRAs.

© Kaplan, Inc. 9

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