TUTORIAL 2

Forward and Futures

Pricing
1. Futures quotes and contract specifications
• Position:
• Long: expect price of the underlying asset (S0) to rise → If Ft↑ → profit, Ft↓ → loss
• Short: expect price of the underlying asset (S0) to fall → If Ft↑ → loss, Ft↓ → profit
• Settlement price: the price just before the closing time each day. It is used for the
daily settlement process.
• Trading volume vs open interest (additional question 2.1)
• Closing out positions prior to the expiry date: by taking the opposite position to
the original one (offsetting).
• Closing out at the expiry date: physical delivery or cash settlement.
• Specifications: the underlying asset, contract size, delivery arrangements, delivery
months, price quotes, margin requirements
2. Futures daily settlement
Additional question 2.2: An investor takes a short position in two 3-month futures
contracts on a stock. The contract size is 100 shares, and the futures price is US$110 per
share. The initial margin requirement is US$500/contract. The maintenance margin is
US$250/contract. These contracts are closed out after 10 days at the price of $102 per
share. Given the information in the following table, please do the marking to market
process for this investor?
Answer:
• Initial margin = $500*2 = $1000
• Maintenance margin = $250*2 = $500
• Short at futures price of $110/share
→ If Ft increases on the next day → Short positions lose Ft – F(t-1) per share
If Ft decreases on the next day → Short positions gain Ft – F(t-1) per share
Day 1: Ft = $111 → daily loss = (Ft – Ft-1 )*size of contract x number of contracts
= (111– 110)*100*2 = $200
 Trade Price Settle Price Daily Gain Cumulative Margin Balance Margin
Day
($) ($) ($) Gain($) ($) Call ($)
1 110
111
112
113
115
110
109
107
105
100
2. Futures daily settlement
Trade Price Settle Price Daily Gain Cumulative Margin Balance Margin
Day
($) ($) ($) Gain($) ($) Call ($)
1 110 1000
1 111 -200 -200 800
2 112 -200 -400 600
3 113 -200 -600 400 600
4 115 -400 -1000 600
5 110 1000 0 1600
6 109 200 200 1800
7 107 400 600 2200
8 105 400 1000 2600
9 100 1000 2000 3600
10 102 -400 1600 3200
3. Pricing forward and futures
• Forward price calculation (no associated income & cost):

𝐹0 = S0 e rt (S0 e rt : no-arbitrage price)

• Assumptions:
• No transaction costs; Constant tax rate
• Borrowing rate = lending rate = risk-free rate of interest, expressed with continuous
compounding, for an investment maturing at the delivery date
• Arbitrage opportunities will be taken as they occur
• Notation:
• F0 : price of a forward contract, initiated at time t=0 and expiring at time T
• St: price of the underlying asset at time t (S0: current/spot price, price at time t=0)
• T: time when the forward contract matures (years)
3. Pricing forward and futures
• Arbitrage opportunity:

• If 𝐹0 (market price) > S0 e rt : the forward/futures is overpriced → Borrow S0 to buy

underlying assets and short forward at F0 . At maturity, sell assets at F0 and pay off the
loan S0 e rt --> gain = F0 - S0 e rt
• If 𝐹0 (market price) < S0 e rt : the forward/futures is underpriced → Long forward at F0;
short sell assets at S0 and lend S0 . At maturity, buy assets at F0 and receive S0 e rt from the
lending --> gain = S0 e rt - F0
3. Pricing forward and futures
• Income/costs associated with the underlying asset:
• Underlying assets with known income: I: income in $; q: % income yield
• Underlying assets with costs: storage cost U ($), u (%))

• Cost of carry (c): is the storage cost plus the interest costs less the income
earned (representing the difference between F0 and S0
a) For an investment asset F0 = S0ecT
b) For a consumption asset F0 ≤ S0ecT
With convenience yield (y): F0 = S0e(c-y)T
3. Pricing forward and futures
• Futures prices of stock indices:

• Index Arbitrage:
• When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index
and sells futures
• When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the
stocks underlying the index
3. Pricing forward and futures
• Price of foreign currency futures/forward:

• The underlying asset is one unit of the foreign currency.

• The price of one unit of the foreign currency is S0: the current exchange rate (direct
quote: the number of units of the domestic currency per unit of the foreign
currency)
• F0 : the forward exchange rate (direct quote) that is the forward price on the
foreign currency
• rf : the foreign risk-free interest rate
• r : the domestic risk-free rate
4. Valuing forward contract
• Value of the long forward contract:
ƒ = (F0 – K )e–rT = S0 – Ke-rT
• Value of the short forward contract:
ƒ = (K - F0)e–rT = Ke-rT - S0
• If the underlying asset has a known income I (dividends, coupons) → Value
of long position:

• If the underlying asset has a known yield q (dividend yield): → Value of

long position:
4. Interest SOFR futures
• The one-month SOFR futures is based on an arithmetic average of overnight rates
• The settlement at the end of a contract month = 100 minus the arithmetic average of SOFR one -
day rates during the month (e.g. futures quote = 99.95 → rate = 100 – 99.95 = 0.05 (%))
• A one-month SOFR is designed to hedge a $5 million position. → If the rate on the contract
changes by 1 basis point, the gain or loss will be $41.67. (=5,000,000*0.01%*1/12)
• The three-month SOFR futures is based on the result of compounding overnight rates.
• The 3-month SOFR futures for the same contract month is settled 3-months later on the third
Wednesday of the month
• Trade for March (settled in June), June, September and December contracts.
• Settlement price at the end of the 3 months = 100 – R, where R is the rate obtained from
compounding one day SOFR over 3 months.
• The contract is designed to hedge a $1 million position → When a quote changes by one basis
point the gain or loss per contract is $25 (=1,000,000*0.01%*3/12)
 Book Question 2.1.
Suppose that you enter into a short futures contract to sell July silver for $17.20 per
ounce. The size of the contract is 5,000 ounces. The initial margin is $4,000, and the
maintenance margin is $3,000. What change in the futures price will lead to a margin
call? What happens if you do not meet the margin call?
Answer:
• SHORT Fo = $17.2; size = 5000 ounce/contract; IM = $4000; MM = $3000
• Margin Call when margin account balance < MM
→Margin account falls by > $1000 (=4000 – 3000)
→ Futures price rises by 1,000/5,000 = $0.20
(OR: Change in price*contract size* [Link] contracts = 1000)
→ The price of silver must therefore rise to $17.40 (=17.2 + 0.2) per ounce for there to
be a margin call. If the margin call is not met, your broker closes out your position.
Book Question 5.2.

Suppose that you enter into a six-month forward contract on a non-dividend-paying

stock when the stock price is $30, and the risk-free interest rate (with continuous
compounding) is 5% per annum. What is the forward price?

Answer:
r = 5%; t = 0.5; So =$30
The forward price is: F0 = 30𝑒0.05×0.5 = $30.76
Book Question 5.3.
A stock index currently stands at 350. The risk-free interest rate is 4%
per annum (with continuous compounding) and the dividend yield on
the index is 3% per annum. What should the futures price for a four-
month contract be?
Answer:

The futures price is F0 = 350𝑒(0.04-0.03)×0.3333 = $351.17

Book Question 5.12
The two months interest rates in Switzerland and the US are 1% and 2%
respectively per annum with continuous compounding. The spot prices
of the Swiss Franc is $1.05. The futures price for a contact deliverable in
2 months is 1.05. What arbitrage opportunities does this create?
Answer:

We have: F0 = $1.05/SF < theoretical futures price = $1.0518/SF

→ Investors should sell Swiss franc for USD and long futures contract
on Swiss franc.
Book Question 5.13
The spot price of silver is $25 per ounce. The storage costs are $0.24
per ounce per year payable quarterly in advance. Assuming that the
interest rates are 5% per annum for all maturities. Calculate the future
price of silver for delivery in 9 months.
Answer:
S0 = $25/ounce; cost = $0.24/4 = $0.06/ounce/quarter; r = 5%

The futures price:

Additional Problem Ch 5 - 1
An investor considers a one-year forward contract on a non-dividend-
paying stock when the stock price is $40, and the risk-free rate of interest
is 10% per annum with continuous compounding.
a) What are the forward price and the initial value of the forward
contract?
Answer: S0 = $40; r = 10%
• F0 = 40*e0.1*1 = $44.21
• Initial value of the forward contract = 0
Additional Problem Ch 5 - 1
An investor considers a one-year forward contract on a non-dividend-paying stock when the
stock price is $40, and the risk-free rate of interest is 10% per annum with continuous
compounding.
b) Suppose that the investor enters into a long position in (buys) this forward contract, six
months later, the price of the stock is $45 and the risk-free interest rate is still 10%. What are
the forward price and the value of the forward contract? Does the investor gain or lose?
Answer:
• The delivery price of the forward contract K = $44.21
• After 6 months ( 6 months remaining): F0 = $45*e0.1*0.5 = $47.31
• Value of the forward contract: f = (F0 – K)*e-rT = (47.31 – 44.21)*e-0.1*0.5 = $2.95
or: f = S0 – Ke-rT = 45 – 44.21e-0.1*0.5
The investor gains $2.95
Additional Problem Ch 5 - 1
An investor considers a one-year forward contract on a non-dividend-paying stock when the
stock price is $40, and the risk-free rate of interest is 10% per annum with continuous
compounding.
c) Suppose that the investor enters into a short position in (sells) this forward contract, six
months later, the price of the stock is $43 and the risk-free interest rate is still 10%. What are
the forward price and the value of the forward contract? Does the investor gain or lose?
Answer:
• The delivery price of the forward contract K = $44.21
• After 6 months ( 6 months remaining): F0 = $43*e0.1*0.5 = $45.2
• Value of the forward contract: f = (K –F0)*e-rT = (44.21 – 45.2)*e-0.1*0.5 = -$0.95
or: f = Ke-rT – S0 = 44.21e-0.1*0.5 - 43
The investor loses $0.95
Additional Problem Ch 5 - 2
An investor considers a one-year forward contract on a non-dividend-
paying stock when the stock price is $50 and the risk-free rate of
interest is 10% per annum with continuous compounding.
a. What are the forward price and the initial value of the forward
contract?
Answer: S0 = $50, r = 10%
• The forward price: F0=S0erT=50*e0.1*1= $55.26
• The initial value of the forward contract is zero.
Additional Problem Ch 5 - 2
An investor considers a one-year forward contract on a non-dividend-paying stock when the
stock price is $50 and the risk-free rate of interest is 10% per annum with continuous
compounding.
b. If the market price of this forward contract is currently quoted at $60, what transactions
should the investor take today and in one year time in order to exploit this mispricing
situation?
Answer:
The market price of this forward contract is $60, which is higher than the theoretical price
$55.26. The contract is overpriced. The investor should:
Cashflow
Today • Sell/short one-year forward contract at $60 $0
• Borrow $50 for 1 year at 10% +$50
• Buy the stock at $50 -$50
In 1 year • Settle the short position → sell stock +$60
• Pay off the loan -50*e0.1*1 = -$55.26

Profit = 60 – 55.26 = $4.74

Additional Problem Ch 5 - 2
An investor considers a one-year forward contract on a non-dividend-paying stock when t-
the stock price is $50 and the risk-free rate of interest is 10% per annum with continuous
compounding.
c. If the market price of this forward contract is currently quoted at $48, what transactions
should the investor take today and in one year time in order to exploit this mispricing
situation?
Answer:
The market price of this forward contract is $48, which is lower than the theoretical price
$55.26. The contract is underpriced. The investor should:
Cashflow
Today • Buy one-year forward contract at $48 $0
• Short sell the stock at $50 +$50
• Lend $50 for 1 year at 10% -$50
In 1 year • Settle the long position → buy stock - $48
• Receive proceeds from lending + 50*e0.1*1 = +$55.26

Profit = 55.26 - 48 = $7.26

Additional problem Ch 5 - 3
A stock is expected to pay a dividend of $1 per share in two months and in
five months. The stock price is $50, and the risk-free rate of interest is 8%
per annum with continuous compounding for all maturities. An investor has
just taken a short position in a six-month forward contract on the stock.
a) What are the forward price and the initial value of the forward contract?
Answer:
• The present value, I , of the income from the security is given by:

• The forward price:

• The initial value of the forward contract is (by design) zero.
Additional problem Ch 5 - 3
A stock is expected to pay a dividend of $1 per share in two months and in five months.
The stock price is $50, and the risk-free rate of interest is 8% per annum with continuous
compounding for all maturities. An investor has just taken a short position in a six-month
forward contract on the stock.
b) Three months later, the price of the stock is $48 and the risk-free rate of interest is still
8% per annum. What are the forward price and the value of the short position in the
forward contract?
Answer: short forward with K = $50.01
• In 3 months, the present value of income:
• Value of the long position: f = S0 - I - Ke-rt
f = 48 – 0.9868 – 50.01*e-0.08*3/12 = -$2.01
→Value of the short position = $2.01
Forward price = (48 – 0.9868)*e0.08*3/12 = $47.96
Book Question 6.3
A three-month SOFR futures price changes from 96.76 to 96.82. What
is the gain or loss to a trader who is long two contracts?
Answer:
• Change in price = 96.82 – 96.76 = 0.06 = 6 bsps. (=0.06%)
→ The SOFR futures price has increased by 6 basis points.
• Long contracts and Futures quote rises (interest rate declines) → long
gain
• Gain = $25 × 6 × 2 = $300
Book Question 6.11
Suppose that the 9-month SOFR interest rate is 8% per annum and the 6-month SOFR interest
rate is 7.5% per annum (both with actual/365 and continuous compounding). Estimate the 3-
month SOFR futures price quote for a contract maturing in 6 months.
Answer:
• RF (6 to 9) = (8%*9/12 – 7.5%*6/12)/0.25 = 9% continuous compounding
• Quarterly compounding: RF (6 to 9) = 4*(e0.09/4 – 1) = 9.102% (actual/365)
• With the day count actual/360, the rate is: 9.102%*360/365 = 8.977%
• 3-month SOFR futures price quote for a contract maturing in 6 months = 100 - 8.977 = 91.02