C09 FORWARD & FUTURES PRICES

INVESTMENT & CONSUMPTION ASSET #

• INVESTMENT ASSET: Held for the purpose of investment.
• CONSUMPTION ASSET: Held for the purpose of consumption.

SHORT SELLING & SHORT SQUEEZE #

Short selling is the sale of a security that is not owned by the seller. Short seller-

1. Simultaneously borrows & sells securities through a broker.
2. Must return the securities at the request of the lender or when the short sales is closed out.
3. Must keep the proceeds of the short sale on deposit with the broker.

Short squeeze is the situation where short seller is forced to close his position when the borrower runs out of securities to borrow.

DIFF & SIMILARITIES BETWEEN FORWARD & FUTURES #

SIMILARITIES: Forward & futures contracts:

• Can be either deliverable or cash settlement contract.
• Priced to have zero value when investor enters the contract.

DIFFERENCE:

FORWARD PRICING #

Assumptions in forward prices:

No transaction cost or short sale restrictions.

Same tax rates.

Borrowing & lending at risk free rate.

Arbitrage opportunities are exploited.

Forward price F0 = S0erT

F0 = (S0 – I)erT           =                          with carrying cost

F0 = S0e(r – q)T          =                          with dividend

Where    S0= Spot price

T= Time to maturity

r= risk-free rate

I = carrying cost

q = dividend

CURRENCY FUTURES #

INTEREST RATE PARITY: Forward exchange rate , F₀ must be related to the spot exchange rate S₀ & to the interest rate between the domestic & the foreign currency.

F₀= S₀ e ^{(r – rf)T}

Where, r  = risk free rate in domestic country

rf= risk free rate in foreign country

 COMMODITY FUTURES #

1. Income & storage cost: underlying is a consumption asset having actual storage cost.

F₀ = S₀ e ^{( r + u)T}

2. Convenience yield: A convenience yield is an implied return on holding inventories.

F₀ = S₀ e ^{( r + u – y)T}

DELIVERY OPTIONS IN THE FUTURE MARKET #

Delivery options on what, where, when to deliver, choice of bonds that are acceptable to deliver are given to the “short”.

If cost of carrying asset is greater than convenience yield than it is ideal for the “short” to deliver early.

FUTURES & EXPECTED FUTURE SPOT PRICES #

Expectations model: Current futures price for delivery at time T is equal to the expected spot price at time T. If the futures price is less than the expected price, aggressive buying of the futures would push up the futures price. If the futures price is greater than the expected spot rate, aggressive selling of the futures would lead to lower the futures price.

CONTANGO & BACKWARDATION #

• CONTANGO: Situation where the future price is above the spot price. Benefit in holding the asset.
• BACKWARDATION: Future price is below the spot price. No benefit in holding the asset.