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5.1
Basic formula
F0 = S0 erT
where
T
S0
F0
Equivalently
S0 = F0 erT .
Market dynamics
If F0 > S0 erT :
1. Buy the asset now (go long in the asset) at S0 .
2. Short forward contracts on the asset (promise to sell the asset in the
future at F0 ).
3. Profit at delivery date = F0 S0 erT .
If F0 < S0 erT :
1. Short the asset now (borrow the asset and sell it now for S0 ).
2. Go long on forward contracts on the asset (promise to buy the asset
in the future for F0 ).
3. Profit = S0 erT F0 .
Convergence
St = Ft er(T t)
ST = FT .
5.2
Modifications
S0 = F0 erT + I0 .
Intuition:
Let T = 0, then F is the spot price less income.
At time T , I will receive the asset minus the income stream.
qt
= assets yield
pt
= wealth at time t
dpt
.
dt
Arbitrage guarantees that the two strategies must have the same
payoff:
dpt
dt
rpt = qt pt +
dpt
(r qt )pt = 0
dt
rt+
Rt
0
qs ds
pT e
RT
0
qs ds
p0 = 0.
which gives
rT
pT = p0 e
RT
0
qs ds
rT T ( T1
= p0 e
RT
0
qs ds)
= p0 e(rq )T
where q
1
T
RT
0
= spot price S0
5.3
Basic formulae
Long contract: f = (F0 K)erT
Short contract: f = (K F0 )erT
Elaborations:
Simple asset:
F0 = S0 erT
f = S0 KerT
(long contract)
Known income:
F0 = (S0 I0 )erT
f = S0 I0 KerT
(long contract)
f = S0 eqT KerT
(long contract)
5.4
10
5.5
11
Forward on commodities
12
Borrow S0 + U at rate r
Buy one unit of the commodity and pay storage cost
Short a forward contract on one unit of the commidity.
Realize a profit of F0 (S0 + U )erT at time T .
13
14
F0 = (S0 + U )e(ry)T .
5.6
15
16
17
18
19
if
k>r
The excess of k over r represents the systematic risk asociated with the
asset.
[We will see more on this later, but k > r, k = r, k < r as the
correlation of ST with stock market is > 0, = 0, < 0 respectively.]
20
Short position
(a) Borrow E[ST ]ekT , buy the asset, and take a short futures position.
(b) At time T , sell the asset for F0 , and use the proceeds to repay the loan
plus interest E[ST ]e(rk)T .
(c) Zero profit: F0 = E[ST ]e(rk)T as before.