Determination of Forward and

Futures Prices
RAVICHANDRAN
 Forward / Futures Prices
• we will examine how forward prices and
futures prices are related to the spot price
of the underlying asset.
• Forward contracts are easier to analyse
than futures contracts because there is no
daily settlement—only a single payment at
maturity.
 ASSUMPTIONS AND
NOTATION
1. The market participants are subject to no
transaction costs when they trade.
2. The market participants are subject to the
same tax rate on all net trading profits.
3. The market participants can borrow
money at the same risk-free rate of interest
as they can lend money.
4. The market participants take advantage of
arbitrage opportunities as they occur.
 Assumption and Notation

﹡NOTATION:
S0: Price of the asset underlying the
forward or futures contract today
F0: Futures or forward price today

T: Time until delivery date

r: Risk-free interest rate for maturity T

 Recap on Forwards
• Forward contracts are agreements to
buy/sell an asset at a future date at a price
agreed on today.
• No money changes hands at the start of
either transaction.
• Forward contracts are far less visible
segment of the financial markets.
• Forward Contracts commit both the parties
to a future transaction.
 General characteristics of forward
contracts:
1. They are private contract between two parties
2. They are customized (i.e. not standardized)
where parties customize the size and maturity of
contract.
3. There is no clearing house involved between
parties and therefore there is some credit risk
4. They usually have one specified delivery date
5. They are settled at end of contract (either cash
settlement or physical delivery)
 Some Important points
• Essence of pricing a forward or futures
contract (swap), - Observed Spot price and
adjusting it for time.
• Delivery Price / Contract Price for a
forward / futures contact is the fixed price at
which long party commits to buy and the
short party commits to sell at some time in
the future.
• The essence is to determine the delivery price.
 Some Important points
• In a forward contract the sole objective of
each party is to lock in a price for a future
transaction, neither party wants to pay any
more than the other.
• Forward contract is zero-sum game, with one
party gain offset by the other’s pain.
• The delivery price of a new zero-value
forward contract is known as a forward price.
• Its analogy for Futures is the futures price.
 Some Important points
• Both Forward futures and Futures price are
calculated intuitively in the same way and
• to simplify whenever you read forward
price , you can safely assume it applies to
futures price too. (Technically subtle
difference is in Futures the daily settlement)
• Forward Price by adjusting a spot price for
the costs and benefits of waiting for a
delivery date, known collectively as Costs of
Carry.
Some more points for digression
Value of a forward – the present value of
difference between its delivery price ( strike
price) and the current forward price.
Value of futures contract – is the difference
between the current futures price for the
contract and the previous day’s closing
futures price.
Forward Contract value and Futures contract
value differ due to daily settlement.
COST OF CARRY
 Costs of Carry Explained
• Consider the value of a forward upon delivery.
• It is the difference between spot price and the delivery price.
• Example : A tortilla maker with a long forward to buy 1000
bushels of wheat of corn at $25.
• The spot price on the delivery date was $28 for a valuation
($28-$25) *1000 or $3000. (ST - F0)
• Value of a forward on some date before delivery?
Two Basic Components –
• (1) Spot – Delivery difference
• (Spot Price changes over the life of the forward but the
delivery price does not)
• (2) Cost of Carry
 Costs of Carry
• (1) Cost of maintaining or carrying a
forward position over the time.
• Consider Storage if the underlier is a
commodity. Storage Costs money.
• Who pays this cost ?
• the short party, incur the cost, which will
affect the value of forward contract.
 Costs of Carry
• (2) Another Cost of Carry is Interest –
Interest cost is simply the cost of
borrowing money , or put another way ,
the payment for loaning or investing it.
• For the long party, it is actually a benefit,
since the money has not changed hands,
for the short party, interest cost is a truly a
cost of carry, thus incurring an opportunity
cost.
 Costs of Carry
• (3) Others- Costs (Benefits) include Dividend /
income paid to the holder of the underlier, such
as dividend of a stock .
• Also tangible as convenience yield (benefit of
possessing the underlier – such as an ability to
survive a shortage)
Cost of Carry – Encompasses
1. Storage Cost
2. Interest Charges
3. Benefit of Convenience
 Convenience Yield
• The extra gain that an investor (short party who
is holding the asset) receives for holding a
commodity rather than an option or futures
contract on that commodity.
• Because of the uncertainty of future events, the
convenience yield can be (though is not always)
quite high.
• For example, if one holds so many barrels of oil
and there is a sudden disruption in a major
pipeline, the value of the physical barrel will
increase while the value of a futures contract on
oil likely will decrease.
 Convenience yield

• Users of a Consumption asset may obtain a

benefit from physically holding the asset (as
inventory) prior to T (maturity) which is not
obtained from holding the futures contract.

• These benefits include the ability to profit from

temporary shortages, and the ability to keep a
production process running.
 Convenience yield

• The convenience yield is inversely related to

inventory levels.

• Sometimes, due to irregular market movements

such as an inverted market, the holding of an
underlying good or security may become more
profitable than owning the contract or derivative
instrument, due to its relative scarcity versus high
demand. 
The Idea behind a forward price
• Value of a forward at any time is basically the
sum of two things : the difference between
ever changing spot price and never
changing delivery price , and the cost of
carry (which can be positive or negative
value).
• Forward Value LONG = (Spot-Price –Delivery Price) + Carry
• Forward Value SHORT = (Delivery-Price – Spot- Price) + Carry
• Rearranging the above,
• V = (S+C)-F
( Spot price + Carry price) – Forward Price
The Idea behind a forward price contd.
At inception, Value of forward contract is zero
0 = (S+C)- F
FLONG = S + C
Hence the forward price is just spot plus cost of carry.
Cost means, cost to the short party.
If it is a benefit to the short party , we subtract it.
Let us make the equation of cost of carry as:
C = c – b (‘c’ – cost & ‘b’ benefit to short party)
Flong = s + c – b
S – spot price
c – cost of carry to short party
b – benefit to short party
The Idea behind a forward price contd.

Illustration : Consider a one year forward on a barrel oil whose

spot price upon execution $100.
By going on a forward contract, the long party is obliged by
buy one barrel oil in one year. If they have bought today, they
would have spent $100 today.
Say if they have put $100 for interest @6% , annual
compounding , they would have got $106, assume 6% interest
is risk free. Upon execution forward, the long party pay $100
and earn $6 risk free rate.
For the short party, since it is obliged to sell, looses the
opportunity to invest $100 and earn $6 (Opportunity Cost).
So the fair delivery price for this deal is spot adjusted for
interest – that is $106
The Idea behind a forward price contd.

Illustration : Since oil is a physical good, that

must be stored, storage costs money.
The short party does bear the cost.
If the annual cost of storage of one barrel is $7
Now the fair price of the forward :
$100 + $6 + $7 = $113
 Risk free rate in Derivatives
• For all derivative calculations , we use a
risk free interest rate for discounting.
• The risk-free or reference rate is
essentially a guaranteed rate of return on
an investment with no risk of loss.
 1/Forward Price Formulas
Basic Forward (With out known income)
• The simplest underlier which requires no
storage cost and generates no income
(dividends). The cost of carry is only
interest.
• The forward price of the underlier is just
future value of the underlier given a spot
price S, interest rate r (continuous
compounding), and time period t.
• F = S * ert
 Forward Price Example
• You agree to buy from your brother 100 shares stock of
X company in 6 months. Assume X pays no dividends
and is now trading at for 15.50. The risk free rate is 2
percent. What is the fair market forward price ?
• S = 15.50 *100 = 1550
• R = 0.02
• T = 0.5 (6 months)
• F = S * ert = 1550 * e0.02 *0.5
• F = 1550 * 1.01005 = 1565.58
• The fair market delivery price for this contract is
$1565.58 or $15.66 per share.
 2/ Forward with Storage (fixed
cost)
• When an underlier incurs a fixed cost, the
forward price is
• future value of sum of two things, spot S
plus the present value of storage U.
• F = (S + U ) * ert
Forward with Storage - example
• Company X agrees to buy from Company
Y 5000 barrels of crude oil one year
forward.
• The oil is settling on the spot market at $32
per barrel.
• The cost of storing this kind of oil is $1.5
per barrel per quarter, payable at the
beginning of each quarter.
• The risk free rate is 3 percent. What is the
Correct forward price for this deal?
Forward with Storage – example
• Let us look handle the storage.
• Arrive at the Present Value of storage costs, from
this, we will calculate the future value of over the
life of forward,
• there will be 4 payments for storage made at the
start of each quarter in the amount of $7500 (ie)
5000 barrels at $1.50 each) one occurs now at the
execution of the contract, one in 3 months, one in
6 and 9 months.
• We need to calculate the PV of each of the four
cash flows and add up the results.
Forward with Storage – example
• Pvstorage = cf0 + cf3m+ cf6m + cf9m
• PVSt = 7500 + 7500*e -0.3(0.25) + 7500*e -0.3(0.5) + 7500*e -0.3(0.75)
• PVSt = 7500 + 7443.96 + 7388.34+ 7333.13
• PVSt = 29,665.43 =U
• Now we have present value of Storage cost
• Spot S = 32 * 5000 = 160,000 (spot price * 5000 barrels)
• U = 29,665.43
• r = 0.03 ; t = 1 (one year)
• Putting altogether , F= (S + U) *ert
• F = (160,000 + 29,665.43) * e 0.03(1)
• F = 195,441.60
• The fair market delivery price for this contract is $195,441.60 or just
about $39 per barrel. (195,441.60/5000)
 3/ Forward Price ->Storage Cost when change with the
spot price of the underlier
–> Proportional Storage Costs.

• The forward price of an underlier with

proportional storage cost, then is , the
futures value of the undrlier given a spot
price S, annual int. rate r, and time t, with
interest rate “adjusted” by the proportional
storage cost u.
• Formula : F = S* e(r+u)t
 Forward Price - Proportional Storage-
Example
X agrees to buy 1000 bushels of apples from apple grower
Y in 3 months. Y knows from experience apple stored lose 2
percent of their values to bugs, mice and rot. Apples are
currently selling wholesale for $ 6 per bushel. The risk free
interest rate is 4 per cent.
Pre-calculation :
S = 1000 * 6 = 6000
U = 0.02 r =0.04 t=0.25
Putting altogether : F = S * e (r+u)t
F = 6000 * e (0.04+0.02)(0.25) : F = 6000 * e0.15
F = 6090.68
The fair market delivery price for this contract $6090.68
 4/Forward with Income
• Income such as dividends on a stock
underlier, are like storage cost in reverse.
They represents benefits to the short party.
• Now the Forward price is just the value of
spot S less the present value of income I.
• Formula
• F = (S-I)*ert
 Forward with Income Example
• X agrees to buy from Y 400 shares of stock
in Acme industries in 1 year. Acme is
currently trading at $ 36.00 per share.
Acme pays quarterly dividend to its
shareholders; The expected dividend is
$0.25 cents per share.(at the end of each
quarter)
• The risk free rate is 2 percent. What is Fair
market forward price?
Forward with Income Example contd.

• As with storage , we need PV of income.

Over the life of this forward, there will be
four dividend payments (cash flows) made
at the end of each quarter for $100 (ie 400
shares at 0.25). One occur in 3 months,
the next in 6, 9 and 12.
• To calculate the present value of storage,
we just calculate the PV of each of the 4
cash flows.
Forward with Income Example contd.
• Pvincome = div3m + div6m + div9m+ div12m
• PV = 100e-0.02(0.25) + 100e-0.02(0.5) + 100e-0.02(0.75) + 100e-0.02(1)
• PV = 99.50 + 99.01 + 98.51 + 98.02
• PV = 395.04
• Putting all together
• S = 36 * 400 = 14,400
• I = 395.04
• r = 0.02
• t=1
• F=(S-I) *ert
• F= (14,400 -395.04) * e0.02(1)
• The fair market delivery price for this contract is $14,287.88
5/Forward with income Proportional to
Spot price
• Some times underlier income is propotional to
its spot price. Dividend could be expected as
proportion of price of underlier.
Example :
• X agrees to buy from Y 200 shares of ABC
stock index in one year.
• Currently trading at $54.00 per share. ABC is
expected pay an annual dividend equal to
0.5% (0.005) of its share price. The risk free
interest rate is 3 percent.
Forward with income Proportional to
Spot price – contd. example
• S = 200 * 54 = 10,800
• r =.0.03 i =0.005 t=1
• Putting all together we have:
• F = S * e(r-i)t
• F = 10,800 * e(0.03-0.005)(1)
• F = 10,800 * e0.025(1)
• F = 11,073.40
• The fair market delivery price for this
contract is $11,073.40
 6/Forward with Convenience Yield
• Holding an underlier can have a less tangible benefit than
income, known as a convenience yield.
• For example if there is a shortage on a good, it can be good to
have it on hand.
• Dealing with this convenience yield is simiar to dealing with
proportional income.
• Just substitute the convenience yield for the income rate.

• F = S * e(r-y)t
• Incidentally, convenience yields are often implied from, or
backed out of observed market prices and not explicitly entered
in to a formula like other factors. They are something of a “fudge
factor” to make the equality between forward prices and their
other input factors hold true.
 Futures Prices Of 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
 Futures Prices Of Stock Index
• F0 = S0e(r-q)T
q:The dividend yield

Example:
r = 0.05 S0 = 1,300 T = 3/12 (0.25) q = 0.01

F0 = 1,300e(0.05-0.01)x0.25 = $1,313.07
 Forward price of currency
• When the underlier is a foreign currency,
we consider the domestic interest rate but
also the foreign rate.(rf)
• Foreign interest rate represents income to
short party and is just proportional income.
• F = S *e(rh-rf)t
Forward price of currency - example
• X agrees to buy 5000 Tuluvian Krinkets from a
currency dealer Y in 9 months. Krinklets are
currently trading for $0.55. (when dealing foreign
currency, just think of each unit of other currency
as a share of stock, which is bought with some
amount of local currency)
• The risk free int. rate in Tuluvia is 2 percent.. The
risk free int. rate at home is 6 per cent.
• This is exactly a forward underlier with
proportional income, replacing I with rf(foreign
rate). Here’s what we got:
Forward price of currency - example
• S = 5000 * 0.35 = 1750
• r = 0.06
• rf = 0.02
• t=0.75
• Putting all together we have
• F = S* e(r-rf)t
• F = 1750 * e(0.06-0.02)(0.75)
• F = 1750* e0.03
• F = 1803.30
• The fair –market delivery price for this contract is
$1803.30
 Forward Price Summary
Description Forward Price formula
Basic Forward Price F = S* ert 

With Fixed Storage F= (S + U) *ert

With Proportional
F = S * e (r+U)t
Storage
With Fixed Income F= (S-I) * ert 
With Proportional
F= S* e(r-i)t 
Income
With Convenience
F = S * e (i-y)t 
Yield
Foreign Currency
F = S * e(r-rf)t 
Forward
 Forward Price - together
• Putting these all together:
• Forward Price = (S + U - I)* e(r+ u –i-y-rf)t
• Where S = Spot price , U –Fixed storage
cost
• I – Fixed Income, r – risk-free interest rate
• u- proportional storage cost ,
• i - proportional income, y - convenience
yield, rf – foreign interest rate
 Forward vs Futures Prices
• A strong positive correlation between interest
rates and the asset price implies the futures price
is slightly higher than the forward price
• A strong negative correlation implies the reverse
• Last only a few months are in most circumstances
sufficiently small to be ignored
• Forward and futures prices are usually assumed
to be the same. When interest rates are uncertain
they are, in theory, slightly different