SS 16: Derivative Investments

Derivatives
Reading Assignments
Forward Markets and Contracts
Futures Markets and Contracts

Forward Markets and Contracts

Brush-Up: Forward Contracts

Forward contract is an agreement in which the buyer agrees
to purchase an asset or derivative from the seller at a preagreed price that is to be paid at a future date
Long = Buyer = Pays Cash/Receives Asset
Short = Seller = Delivers Asset/Receives Cash
Forwards provide a hedge against future increase or decrease
in prices price-lock

Brush-Up: Forward Contracts

Forward Contracts can be terminated prior to expiration
Party can enter into a new contract with opposite position to
offset the existing contract
Example: Long wishes to terminate its contract half-way into
it, so it decides to short another contract for the same asset
that expires at the same time
Prices can be different and long can even make a profit

Example: long could hold the first contract at $20 and short
the second one at $25, and pocket $5

Pricing a Forward Contract

Price of a Forward Contract is the pre-agreed price that the
buyer will pay the seller at a pre-determined date in the
future for the underlying asset or derivative

Denoted by F(0,T) where:

0 is time today
T is the pre-agreed delivery time or time of expiration of
the contract
Contracts can be terminated prior to T, and notation, t is
used to denote a point in time between 0 and T
t=0

t=t

t=T
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Pricing a Forward Contract

What is the PV Factor that we use?
PV Factor = (1 + r)T where r = risk-free rate
Also allows us to determine the price of the forward,

F(0,T) = S0(1 + r)T

This means that the spot price grows at the risk free rate
into the forward price = No-arbitrage principle
This enables us to set the initial = 0 so that:
No upfront payment is required by any party
No opportunity for arbitrage

Valuing a Forward Contract

Value of a Forward Contract is the Net Present

Value of its cash flows
Value at expiration: VT = ST F(0,T)
Example: A Forward Contract stipulates to deliver a ZeroCoupon Bond at $98 per $100 par after 6 months and
after this time period, the bond is trading at $98.25
Value = 98.25 98 = $0.25 to the long
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Value of Forward Contracts

Spot Price Notation

Means

So

Spot Price of Asset Today

St

Spot Price of Asset at time t

ST

Spot Price of Asset at Expiration

Forward Price Notation

F(0,T)

Value Notation

Means
Forward Price at t=0 (Always at
Expiration)
Means

Vo

Value of Forward Contract Today

Vt

Value of Contract at time t

VT

Value of Contract at Expiration

Value of Forward Contracts

Value of a Forward is the PV of all its future cash
flows (always remember TVM)
Value of Forward

In Words

0,
0 = 0
=0
1+

Spot Price Today PV of Forward Price

= No-Arbitrage

(0, )
=
(1 + )

Spot Price at t PV of Forward Price

computed at t

= (0, )

Spot Price at T Forward Price

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Value and Price of Equity Forwards

with Discrete Dividends
Interim cash flows on stocks = Dividends
Long = doesnt get the benefit of dividends during
the forward contract
Effect: Remove the effect of dividends from FP

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Value and Price of Equity Forwards

with Discrete Dividends
Price of Forward
0, = 0 () (1 + ) or 0 1 +

()

Value of Forward
0,
0 = 0 ()
=0
1+
(0, )
=
1 +
= (0, )

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Forwards on Equity: Example

FAM has asked Saeed Ahmed to look into forward contracts on equity
for Hamoodi Enterprises, a family owned business in UAE. The
company is anticipating funds transfer after 150 days. He has looked at
the stock of a pharmaceutical firm that is currently selling for AED
55.34 and will pay a dividend of AED 0.75 in 50 days and another AED
0.75 dividend in 140 days. The risk-free rate is 2.5%. He decides to
enter into a long forward contract.
1. Compute the forward price of this contract.
2. The company has run into some new drug development issues and
now, 55 days later, the stock price has plummeted to AED 45.32.
Determine the value of the forward contract at this point.
3. It is now the expiration day, and the stock price is AED 44.50.
Determine the value of the forward contract at this time.

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Forwards on Equity: Example

Solution (1)
F(0,T) = (Equity Spot Price Today PV of Discrete Dividends) * (FV
Factor)
PV of D1

= 0.75/1.025(50/365)

AED 0.7475

PV of D2

= 0.75/1.025(140/365)

AED 0.7429

Total PV(Div)

= 0.7457 + 0.7429

AED 1.4904

Hence, F(0,T)

= (55.34 - 1.4904) x (1.025)150/365

AED 54.3988

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Forwards on Equity: Example

Solution (2)
Vt = St PV of Dividends at t PV of F(0,T) at t
Since one dividend is already paid, and only one left, we compute PV(D2)
PV of D2

0.75/1.025(85/365)

AED 0.7457

PV of Forward

54.3988/1.025(95/365)

AED 54.0503

Value at t = 55

45.32 - 0.7457 - 54.05

-AED 9.4760

Solution (3)
VT = ST F(0,T)
VT = 44.50 54.40 = - AED 9.9 to long

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Price of Equity Forwards with

Continuous Dividends
Continuous Dividends are different in that they use a continuous
rate for compounding and discounting

0, = 0

= continuously compounded dividend yield

= continuously compounded risk free rate

= 1 +

FV factor

PV factor
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Price of Equity Forwards with

Continuous Dividends
Example: A fund manager had entered 2-year forward
contract on UKs FTSE 100 Index. Index Value is 2300,
continuously compounded dividend yield is 0.75% and
continuously compounded risk-free rate is 4.82%. Compute
the forward price

0, = 0

Forward Price = (2,300 x ) x

Forward Price = (2,300 x e

-0.0075*2

)x e

0.0482*2

= 2,495.05

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Value of Equity Forwards with

Continuous Dividends
0, =
Current
asset price

0,

PV of remaining
dividends

PV of Forward price

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Value and Price of Bond Forwards

Just like dividends, bonds have coupon payments
Forward Price of a Bond= (Bond Spot Price Today
PV of Coupon Payments) * (FV Factor)
0, = 0

1+

From the longs perspective, this means that we are

eliminating the effect of coupons since s/he does not
hold title to the asset until after expiration
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Value and Price of Bond Forwards

Price of Forward
0, = 0 1 + r

0 1 +

()

Value of Forward
0 = 0 ()

(0,)
=
1+

(0, )
=
1 +
= (0, )
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Value and Price of FRA

Forward contracts on interest rates are called Forward
Rate Agreements, FRA
Used to lock-in a future interest rate

Eurodollar is when dollars are borrowed and lent outside

of the US, usually in London (Euro simply means outside
the currencys own country)
LIBOR or the London Interbank Offer Rate is the interest
rate that banks use amongst themselves for borrowing
money (used for Eurodollars)
Euribor is the interest rate used for Euro-denominated
borrowings
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Value and Price of FRA

At expiration or contract termination, forward rates are
compared to a pre-agreed LIBOR rate
Think of LIBOR as the Spot Interest Rate (just as Spot Equity or
Bond prices)
Since FRAs are settled in net, LIBORs are compared to
Forward Rates
If LIBOR > Forward Rate = Long benefits
If LIBOR < Forward Rate = Short benefits

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Value and Price of FRA

Example: a 3 x 9 FRA is quoted at 5.5%
i.e. Forward Contract expires in 3 months and is based on 6
month LIBOR (loan term is 6 months), at expiration of FRA
Adjustments need to be made for add-on interest, i.e. implicit
assumption that the instrument accrues interest
To eliminate this effect, interest rates are used in the divisor
(Recall equity forward price with continuous dividend yield)

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Value and Price of FRA

Pricing FRA
=

1+ 360

1+ 360

360

Valuing FRA
1. Price the new FRA
2. Compare the payoff on the original FRA to the fixed rate on a new
FRA
3. Discount the payoff back to today

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FRA: Example
FAM is trading in interest rate futures in the Eurodollar market.
Aisha Al Abri is looking at hedging interest rate risk by going long
on a 1 x 7 FRA. She has the following interest rates: 30-day LIBOR
is 4.75% and 210-day LIBOR is 5.50%
1. Compute the price of the FRA
2. Assume it is now 20 days later and the new term structure is:
10-day LIBOR is 4.85% and 190-day LIBOR is 5.90%. Aisha is
hedging a principal amount of AED 2 million. What is the
value of the FRA at this point?
3. What is the value of the FRA at expiration if the 180-day
LIBOR then is 6%?
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FRA: Example
Solution (1)
=

1+ 360

1+ 360

360

Price of FRA = 1 + (0.055 x 210/360) - 1 x 360/180 = 0.05602 or 5.6%

1 + (0.0475 x 30/360)

Solution (2)
1.

Compute the New FRA

Price of FRA = 1 + (0.0590 x 190/360) - 1 x 360/180 = 0.05950 or 5.95%

1 + (0.0485 x 10/360)

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FRA: Example
Compare payoff of the old FRA to the new FRA & discount it until today
Compare pay-off = (0.05950 - 0.05602) x 180/360 = 0.00169 or AED 3,370.95
1 + (0.0590 x 190/360)

Solution (3)
Compare payoff of the original FRA to the new market LIBOR & discount it
until forward maturity (expiration)
Pay-off at Maturity = (0.06 - 0.05602) x 180/360 0.00193 or AED 3,860
1 + (0.06 x 180/360)

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Value and Price of Currency Forwards

Currency forwards are useful for companies such as
MNCs that expect large sums of foreign currency to
be exchanged into dollars at a later date
Interest Rate Parity is the relationship between the
spot and forward exchange rates after accounting for
different interest rates in the 2 countries

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Value and Price of Currency Forwards

Price of Forward

0, =

0
1 +

0, = (0

1+

Notes

0 = direct quote in units of

domestic currency per unit of the

asset or foreign currency
= Domestic Int. Rate
= Foreign Int. Rate

Value of Forward

0, =
1 +

0, =

()

(0, )

(1 + )()

(0, )

()

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Credit Risk in Forward Contracts

Credit Risk is the risk associated with large changes in market
value of the contract and the consequent possibility of default
from the party owing it
Value of Forward Contract represents market risk
Risk is faced by only party; i.e. that to which the market value
is owed
Credit Risk can be minimized by Marking to Market and
repricing the forward contract a new rate

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Futures Markets and Contracts

Differences: Futures v/s Forwards

Futures
Public transactions where the
counterparty is always the
clearinghouse
Standardized contracts

Forwards

Secondary Market Liquidity

No secondary market --> Way to exit is

to offset the contract with another one

Private transactions between two

parties
Customized Transactions

Regulated by law, (US: Commodities

No regulatory body
Futures Trading Commission)
Marked to Market Daily Lower
default risk

Credit Risk

Initial Margin deposited by both

parties (does not not affect V0 = 0)

None
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Futures Price and Spot Price

Futures are marked to market daily gains and
losses are adjusted against the account everyday
Contract is repriced daily
At expiration, futures price meets the spot price
fT(T) = ST
Rationale # 1: To avoid arbitrage opportunity
Rationale # 2: A futures price is created now and
expires right away
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Price of a Futures Contract

F0(T) = S0(1 + r)T

TVM again!
Futures price is the Spot Price Today compounded at
the risk-free rate

If this were not true, then there is an opportunity for

arbitrage (Recall examples from previous reading)

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Value of a Futures Contract

Vt = St - Ft
Marking to Market means that the futures contract
has a new value each day and a new futures price
each day
Futures is marked up or down to the spot value and
the gain/loss = value
Once marking to market is done, value = 0
contract priced at new futures value
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Forward and Futures Prices

Relationship between forward prices, futures prices and
interest rates
If interest rates and future prices are positive
correlation traders will prefer futures over forwards

Rationale: Marking to Market will generate gains which can

be reinvested for higher returns

If interest rates and future prices are negative

correlation traders will prefer forwards over futures
Rationale: Traders will not prefer futures, so forwards will
have a higher price

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Monetary and Non-Monetary

Benefits & Future Prices
Benefit/Cost
of Holding
Asset

Explanation

Effect on
Futures Price

Storage Cost

Depends on the asset, for e.g.

Oil, grains, live cattle have
storage costs

Increases the
Monetary Cost + FV(SC)
Future Price;

Cash Inflows

Depends on the asset, for e.g.

Stocks generate dividends and
bonds, coupons

Decreases the Monetary

Future Price; Benefit

Convenience
Yield

Associated with asset with short

Decreases the Non-Monetary
supply; holder of the asset has
- FV (CY)
Future Price; Benefit
an advantage of convenience

Net Costs

Increase/Decrease the Future

Calculated as Storage Cost Price depending on whether
Convenience Yield (Our Typical
+ FV(SC - CY)
costs outweigh the benefits &
Equation)
vice-versa

f = S0 (1 + r)T

- FV(CF)

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Backwardation and Contango

Terms used for assets with convenience yield
Think of Cost of Carry as the sum of explicit and
implicit cash flows, such as coupons, dividends,
storage costs, convenience yields
Contango: f0(T)> S0 ; when Cost + Interest > Benefits

Backwardation: f0(T) < S0; when Benefits > Cost +

Interest

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Futures Prices and Expected Spot

Prices
Sometimes, f0(T) E0 (ST) when its a mere transfer of risk from the asset
holder to the buyer of the future contract
E0 (ST) = S0(1+r)T + FV(Cost of Carry) + Risk Premium
If you are holding an asset today and wish to sell it in the future, you want
it to compensate you for
a.
b.
c.

Risk free rate

Storage Cost
Risk premium (since the asset bears the risk of future selling)

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Futures Prices and Expected Spot

Prices
f0(T) = E0 (ST) Risk Premium
Rationale: Futures Price < E(S0) by the Risk Premium because risk is being
transferred to the buyer of the futures contract he is not willing to pay
the spot price as well as accept risk! he will want to pay a value less
than the Spot Price for accepting risk
This situation is NORMAL BACKWARDATION
The situation which prevails most in the stock markets is where the
futures prices are biased predictors of spot and are typically in
backwardation
If Future Price > Expected Spot Prices Normal Contango

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Pricing Eurodollar Futures

Eurodollar futures are similar to FRA to lend USD 1,000,000
for 3 months on the contract settlement date
Buying Eurodollar Lending money
Selling Eurodollar Borrowing money

Spot Rate of Eurodollars is similar to FRAs add on yield

However, futures contracts on Eurodollars are structured like
T-Bills discounted basis
Thus, Eurodollar futures do not provide perfect hedge owing
to difference in structure between spot and forward pricing

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Pricing Eurodollar Futures

Pricing Eurodollar Futures is difficult
a.
b.
c.

do not quite use the Cost of Carry Model

have different structures for Spot Price and Futures
Price
Thus, leaving no opportunity for risk less arbitrage like
in T-bill or other futures discussed earlier

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Pricing Bonds Futures

Technicality exists in structure of Bond Futures
Futures are sold on an underlying bond that has:
Maturity of 15 Years
Coupon at any Rate

This means that the short can choose from a

large base of T-Bonds that s/he can deliver to
long at expiration
There can be so many bonds with different
coupon rates that all have a maturity of 15 years
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Pricing Bonds Futures

Disadvantages
Solution
Vague Underlying Bond Exchange standardizes the features of the
deliverable bond as Coupon Rate = 6%, and
Maturity = 15 Years
Short has an advantage This is offset by a Conversion Factor which is
a number that adjusts the futures price of
the bond that the short chooses to deliver
If Coupon > 6%, CF > 1, Price paid by long is
adjusted upwards
If Coupon < 6%, CF < 1, Price paid by long is
adjusted downwards
Ensures that short is unbiased about which
bond to choose at delivery
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Pricing Bonds Futures

Cheapest-to-Deliver: Short chooses to deliver a bond
at futures expiration, that is the Cheapest to Deliver
At expiration, if she were to buy the bond in the open
market and deliver it to the long, price of bond in the
open market > futures price (with CF) that short would
receive otherwise arbitrage would exist
Short would deliver the bond that is Cheapest-todeliver in terms of:

Minimizing such losses

Give short the highest rate of return if s/he were to buy it
and sell a futures contract
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Pricing Bonds Futures

If underlying bond is the only deliverable bond:
Price of Bond Futures
0 = 0
0 = 0 1 +

1+

In Words

(Spot Price Today PV of Coupons)

compounded at the risk-free rate
(Spot Price Today compounded at the
risk-free rate to give a FV from which FV
of coupons are deducted

This is similar to Forwards on Bonds

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Pricing Bonds Futures

If there are several deliverable bonds, then Conversion Factor
comes into play:
Price of Futures

0 1 +
0 =

Price of Futures
0 =

0 1 +

In Words

Spot Price Today less PV of

Coupons, compounded at the
risk-free rate, discounted at CF
In Words

Spot Price Today compounded at

the risk-free rate less FV of
Coupons, discounted at CF

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Bonds Futures: Example

Saeed Ahmed, who works for Furkan Asset Management, is
looking at bond futures for one of his clients. A bond with
semiannual coupon of 10% has a maturity of 5 years. The
face value is AED 1,000 and it is currently priced at AED
1,205.32. The risk-free rate is 2.5%.
1. Find the value of a one-year futures contract
2. Suppose the bond is one the many deliverable bonds.
Using a CF = 1.05, compute the futures price

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Bonds Futures: Example

Solution (1)
Price of the Futures = FV of Bond FV Coupons
FV of Coupons
= [50 x (1.0125)] + 50
= AED 100.63
Price of the Futures = [1205.32 x (1.025)] - 100.63 = AED 1,134.83

Solution (2)
Futures price = (FV of Bond FV Coupons)/ CF
f0(T) = [(1205.32 x (1.025)) - 100.63] / 1.05

= AED 1,080.79

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Pricing Stock Futures

Several formulae to compute futures price for stock (stock
index, portfolio)
Underlying rationale is the same as that for pricing equity
forwards
Price of Futures

0 = [0 ] 1 +
0 = 0 1 +
0 = 0

()

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Pricing Currency Futures

Price of Futures
0
0 =
1 +

(1 + )

0 = 0

Notes
Future Value Factor Using Domestic Int. Rate

Discount Factor Using Foreign Int. Rate

Spot Rate is compounded by the continuous
domestic rate and discounted by the cont.
foreign rate

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