Financial Derivatives

Jie Zhu

Shanghai University

September 2022

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Consumption and Investment Assets

Investment assets are assets held by signi…cant numbers of people

purely for investment purposes (Examples: gold, silver)
Consumption assets are assets held primarily for consumption
(Examples: copper, oil)

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Short Selling

Short selling involves selling securities you do not own

Your broker borrows the securities from another client and sells them
in the market in the usual way
At some stage you must buy the securities back so they can be
replaced in the account of the client
You must pay dividends and other bene…ts the owner of the securities
receives

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Notations and Assumptions

S0 : Spot price today

F0 : Futures or forward price today
T : Time until delivery date
r : Risk-free interest rate for maturity T . We assume it is continuously
compounding.
The market is frictionless
The underlying asset doesn’t provide any income during the contract
period.

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An Arbitrage Opportunity?

Suppose that:
1. The spot price of a non-dividend paying stock is $40
2. The 3-month forward price is $43
3. The 3-month US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

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Another Arbitrage Opportunity?

Suppose that:
1. The spot price of a non-dividend paying stock is $43
2. The 3-month forward price is $39
3. The 3-month US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

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The Forward Price

If the spot price of an investment asset is S0 and the futures price for
a contract deliverable in T years is F0 , then

F0 = S0 e rT ,

where r is the annual risk-free interest rate measured in continuous

compounding.
In the previous example, if S0 = 40, r = 5%, and T = 0.25, then

F0 = 40e 0.25 0.05

= 40.50.

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How to Derive the Forward Price?

We may consider the following trading strategy:

1. Short the assets today, obtain S0
2. Use the money to purchase the risk-free asset (treasury bond)
3. Enter a long position in the forward contract with the price F0
4. When the contract matures, sell the risk-free asset, and use the
money to buy the asset with the price F0 .
5. Return the asset to the lender
Such a strategy allows zero investment today, without arbitrage, the
future payo¤ must also be zero, thus we have

F0 = S0 e rT .

If short sales are not available: it still works for an investment asset
because investors who hold the asset will sell it and buy forward
contracts when the forward price is too low.

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Arbitrage Opportunity

If F0 > S0 e rT , we may borrow money (short the treasury bond), use

the money to buy the spot, and short the forward.
If F0 < S0 e rT , we may short the spot, invest the money into risk-free
asset (buy the treasury bond), and long the forward
The premium of the forward price on the spot price just re‡ects the
time value of money.
Example: Consider a 4-month forward contract to buy a zero-coupon
bond that will mature in 1 year from today. The current price of the
bond is $930. The 4-month risk-free interest rate is 6% per annum.
The forward price is given by

F0 = S0 e rT
= 930e 0.06 4/12

= $948.79.

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Known Income

Now consider the case that the underlying asset will provide a known
income during the forward contract.
Examples are stocks paying dividend or bonds paying interests.
Example 1: Consider a long forward contract to purchase a coupon
bond whose current price is $900. The forward contract will mature
in 9 months. Suppose a coupon payment of $40 is expected after 4
months. We assume the 4-month and 9-month interest rates are 3%
and 4% per annum, respectively.
1. Suppose the forward price is $910. Is there any arbitrage
opportunity?
2. Suppose the forward price is $870. Is there any arbitrage
opportunity?

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Known Income

In general, if the underlying asset will provide income with a present

value of I during the life of a forward contract, we have

F0 = ( S0 I )e rT

In the previous example,

S0 = 900, I = 40e 3% 4/12 = 39.60, r = 4%, and T = 0.75, thus

F0 = (900 39.6)e 4% 0.75

= 886.60.

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Known Income

Example 2: Consider a 10-month forward contract on a stock with a

price of $50. The risk-free interest rate is 8% per annum for all
maturities. The dividends of $0.75 are expected after 3 months, 6
months, and 9 months. What is the forward price?
We …rst calculate the present value of the dividends
0.08 3/12 0.08 6/12 0.08 9/12
I = 0.75e + 0.75e + 0.75e = 2.162

Thus the forward price is given by

F0 = ( S0 I )e rT = (50 2.162)e 0.08 10/12

= $51.14.

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Known Yield

Sometimes the underlying asset will provide a known yield rather than
a known cash income.
Suppose that an asset is expected to provide a yield of 5% per annum.
This could mean that income is paid once a year and is equal to 5%
of the asset price at the time it is paid.
In this case, the yield of 5% is with annual compounding.
For simplicity, assume that q is the average yield during the life of the
contract (expressed with continuous compounding), then

F0 = S0 e ( r q )T
.

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Valuing a Forward Contract

The value of a forward contract is zero when it is …rst entered into.

As time goes by, it may have a positive or negative value.
It is important for banks and other …nancial institutions to value the
contract every day (marking to market).

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Valuing a Forward Contract

De…ne
1. f : value of forward contract today
2. K : delivery price in a forward contract
3. F0 : forward price that would apply to the contract today
4. T : remaing time of the forward contract from today
The value of a long forward contract is
rT
f = ( F0 K )e

Similaryly, the value of a short forward contract is

rT
f = (K F0 ) e

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Valuing a Forward Contract

Since F0 = S0 e rT , the above equation can also be expressed as

rT
f = S0 Ke , for a long position, and
rT
f = Ke S0 , for a short position.

For assets providing known income

rT
f = S0 I Ke .

For assets providing known yield

qT rT
f = S0 e Ke .

Note both equations are for a long forward contract.

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Valuing a Forward Contract

We may also derive these equations from risk neutral pricing.

Suppose a forward contract has a remaing life of T , the delivery price
is K . For a long position, when the contract matures, the payo¤ is

ST K

We may estimate the expected value of this payo¤ in a risk neutral

world and then discount it to present using the risk-free rate as the
discount rate
f = e rT E Q [ST K ].
In a risk neutral world, the stock price will grow at the risk-free rate,
thus
E Q [ST ] = S0 e rT
Again we …nd that
rT
f = S0 Ke .
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Forward vs Futures Prices

We know that futures are settled daily, while forwards are settled at
maturity.
Forward and futures prices are usually assumed to be the same.
This is true when interest rates are deterministic function of time.
When interest rates are random, forward and futures prices are
slightly di¤erent:
1. A strong positive correlation between interest rates and the asset
price implies the futures price is slightly higher than the forward price
2. A strong negative correlation implies the reverse

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Stock Index Futures

Stock Index can be viewed as an investment asset paying a dividend

yield
The futures price and spot price relationship is therefore

F0 = S0 e ( r q )T
,

where q is the average dividend yield on the portfolio represented by

the index during life of contract
Example: Consider a 3-month futures contract on the S&P 500 index.
Suppose that the stocks underlyig the index provide a dividend yield
of 1% per annum, the current level of the index is 800, the risk-free
interest rate is 6% per annum. The futures price is given by

F0 = S0 e ( r q )T

= 800e (0.06 0.01 ) 0.25

= 810.06.
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Index Arbitrage

When F0 > S0 e (r q )T , an arbitrageur buys the stocks underlying the

index and shorts futures
When F0 < S0 e (r q )T , an arbitrageur shorts the stocks underlying
the index and longs futures
Index arbitrage involves simultaneous trades in futures and many
di¤erent stocks
Very often a computer is used to generate the trades
Occasionally simultaneous trades are not possible and the theoretical
no-arbitrage relationship between F0 and S0 does not hold (e.g. Black
Monday on October 19, 1987)

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Futures and Forwards on Currencies

Note: we always refer to direct quotation in the following calculations.

A foreign currency is analogous to a security providing a dividend yield
The continuous dividend yield is the foreign risk-free interest rate
It follows that if rf is the foreign risk-free interest rate, then

F0 = S0 e ( r r f )T
,

where S0 is the spot exchange rate, r is interest rate for domestic

currency, and T is the maturity.
This equation is called interest rate parity.

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Futures and Forwards on Currencies

For example, suppose the 2-year interest rates in Australia and U.S.
are 5% and 7%, respectively, and the spot exchange rate is 0.62. The
2-year forward exchange rate should be

F0 = S0 e ( r r f )T

= 0.62e (0.07 0.05 ) 2

= 0.6453.

Now suppose the forward exchange rate is 0.63. How to do the

arbitrage?

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Futures and Forwards on Currencies

1000 units of
foreign currency
at time zero

rf T
1000 e 1000S0 dollars
units of foreign at time zero
currency at time T

rf T
1000 F0 e 1000 S 0 e rT
dollars at time T dollars at time T

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Storage Costs

Some underlying assets may incur storage costs, such as crude oil.
Storage costs can be treated as negaive income. Let U be the present
value of all storage costs during the life of a forward contract, then

F0 = (S0 + U )e rT .

If the storage cost, u, is represented as a percent of the asset value

F0 = S0 e ( r + u ) T .

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Forwards for Consumption Assets

When we derive the forward price for investment assets, we assume

that
1. when F0 > S0 e rT , investors can buy the spot and short the forward
2. when F0 < S0 e rT , investors can short the spot and long the
forward
For consumption assets, individuals and companies would like to keep
such an asset in their inventory because of its consumption value.
They are reluctant to sell the commodity and long the forward,
because forward cannot be consumed now.
It is possible that the following relation holds for consumption assets

F0 < (S0 + U )e rT , or
F0 < S 0 e ( r + u ) T

where U or u is the present value of storage costs.

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Convenience Yield

Convenience yield measures the bene…ts from holding the physical

asset:

F0 e yT = (S0 + U )e rT , or
F0 e yT = S0 e ( r + u ) T .

The convenience yield re‡ects the market’s expectation concerning

the future availability of the commodity.

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Cost of Carry

The relationship between forward and spot prices can be summarized

in terms of the cost of carry.
De…ne the cost of carry as c.
For an investment asset
F0 = S0 e cT .
For a consumption asset

F0 = S0 e ( c y )T
.

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Futures Prices and Expected Future Spot Prices

Suppose k is the expected return required by investors on an asset

We can invest F0 e rT at the risk-free rate and enter into a long
futures contract so that there is a cash in‡ow of ST at maturity
This shows that
rT kT
F0 e e = E (ST ), or
F0 = E ( S T ) e ( r k )T

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Futures Prices and Expected Future Spot Prices

If the asset has

1. no systematic risk, then k = r and F0 is an unbiased estimate of
ST
2. positive systematic risk, then k > r and F0 < E (ST )
3. negative systematic risk, then k < r and F0 > E (ST )

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