CHAPTER 2.

FUTURES MARKET AND PRICES

20

Chapter 2

Futures market and prices

2.1

Warming up

2.1.1

What is a risk-free interest rate?

Let us consider the following four portfolios of securities:

1. A portfolio of Treasury bills, i.e., United States government debt securities
maturing in less than 1 year
2. A portfolio of long-term United States government bonds
3. A portfolio of long-term corporate bonds
4. S&P500, i.e., Standard and Poors Composite Index, which represents a
portfolio of common stocks of 500 large firms
The portfolios offer different degrees of risk. Treasury bills are about as safe
as an investment as you can make. There is no risk of default, and their short
maturity means that the prices of Treasury bills are relatively stable. In fact,
an investor who wishes to lend money for, say, 3 months can achieve a perfectly
certain payoff by purchasing a Treasury bill maturing in 3 months.
By switching to long-term government bonds, the investor acquires an asset
whose prices fluctuate as interest rates vary. An investor who switches from

CHAPTER 2. FUTURES MARKET AND PRICES

21

Table 2.1: Average rates of return (ARR) and Average risk premium, 1926-1988
(figures in % per year).
Portfolio

Average ARR

Average Risk Premium

Treasury bills

3.6

Government bonds

4.7

1.1

Corporate bonds

5.3

1.7

S&P500

12.1

8.4

government to corporate bonds accepts an additional default risk. An investor

who shifts from corporate bonds to stocks has a direct share in the risks of the
enterprise.
In the study of financial mathematics, we normally assume that we can borrow
and save money at the risk-free rate of interest.1 This assumption is not valid for
an individual but for a large investment house.

2.1.2

Continuous compounding

For the study of pricing derivatives, the continuously compound interest rates
are used.
There are two types of interests: simple and compound. Interest is said to be
simple if it is withdrawn at the end of each interest period so that the value of
the investment remains the same no matter how long the period for which it is
1

What is the risk-free interest rate? Is it the long-term government bond rate, the London

interbank rate or the Bank of England base rate? Well, it may depend on the context. Any of
these rates may be considered to be the risk-free rate and, in fact, they differ only very slightly.
Another question is Is the risk-free rate really risk-free and does not change at all?. The Bank
of England base rate changed from 6% at the begining of 2001 to 4% at the end of the year.
However, in this module we do not really worry about these problems. Despite the problems,
it is reasonably fair to assume for the study of options and forwards that the risk-free interest
rate is stable for the life time of these derivatives which is relatively short.

CHAPTER 2. FUTURES MARKET AND PRICES

22

invested. With compound interest, on the other hand, the interest is added to
the investment at the end of each period (is compounded) so that the value of the
investment increases steadily.
Assume the interest rate per annum is R and the value of the initial investment
is So . If the rate is compounded m times a year then after n years, the value Sm
of the investment is

R mn
Sm = So 1 +
.
m
If it is compounded continuously, the value Sc of the investment is


Sc = So lim

1+

R
m

mn

(2.1)

(2.2)

Using the definition of the exponent, we find

Sc = So eRn .

(2.3)

mn

(2.4)

We can easily prove that

R
1+
m

< eRn .

To find the compatibility of the annual interest rates, suppose that Rc is a rate
of interest with continuous compounding and Rm is the equivalent rate with
compounding m times per annum. Assuming Sc = Sm , we get
mn

(2.5)

(2.6)

Rm = m(eRc /m 1).

(2.7)

So e

Rc n

= So

Rm
1+
m

which gives the following relation

Rm
Rc = m ln 1 +
m


and

In the world of finance, R is normally an annual rate and T is counted in year.

For example, the initial investment of So becomes
S = So e0.050.25

(2.8)

by the three-month risk-free investment at the interest rate of 5% per annum.

CHAPTER 2. FUTURES MARKET AND PRICES

2.2

23

What is a bond?

When you own a bond, you receive a fixed set of cash payoffs. Each year until
the bond matures, you get an interest payment and then at maturity you also
get back the face value of the bond. The face value of the bond is known as the
principal. The interest payment is called coupon payment. Bond investors would
say, for example, that this bond has a 5% coupon.
Sometimes bonds are sold at a discount on their face value, so that investors
receive a significant part of their return in the form of capital appreciation. The
ultimate is the zero coupon bond, which pays no interest at all; in this case all
the return consists of price appreciation.

2.3

Forward pricing

We consider forward pricing for there to be no arbitrage opportunities.

2.3.1

On an asset without income/cost

Examples: Non-dividend-paying stocks and zero coupon bonds.

The price G of the forward on an asset whose spot price is S must be
G = Ser(T t)

(2.9)

where r is the risk-free interest rate, T the time for the forward contract to mature
and t the current time. The duration of time T t is counted by years.
If G > Ser(T t) , profits can be made by buying the underlying stocks (this is
financed by borrowing S pounds at the risk-free rate) and shorting forward contracts. If G < Ser(T t) , profits can be made by shorting or selling the underlying
stocks and taking a long position in forward contracts. However, the arbitrage
chance does not last long because, for example, if G > Ser(T t) everybody will
rush to buy the underlying stock and S will increase in due course.
We consider the following two portfolios for formal arguments (G: delivery
price, f : value of a long forward contract):

CHAPTER 2. FUTURES MARKET AND PRICES

24

Portfolio A: a long position of one unit of forward contract and an amount

of cash equal to Ger(T t)
Portfolio B: a long position of one unit of the underlying asset.
It is easily seen that the two portfolios have the same value. Thus
f + Ger(T t) = S.

(2.10)

We know that when the forward contract is to enter, its value is zero and the
delivery price is the same as the forward price. Otherwise there should be an
arbitrage chance. Taking f = 0, Eq.(2.9) is recovered:
Ger(T t) = S.

(2.11)

G is the price of the forward and f is its value.

2.3.2

On an asset which provides known cash income

Examples: Stocks paying known dividends and coupon-bearing bonds.

Assuming I as the present value of income to be received during the life of the
forward contract, the relationship between G and S is
G = (S I)er(T t) .

(2.12)

Example
Consider a 9-month forward contract on a stock with a price of 30. We
know that dividends of 50p and 80p per share will be paid after 3 months and 6
months respectively. We assume that the risk-free compound interest rate is 6%
per annum. The present value of the dividends is
I = 0.50 e0.060.25 + 0.80 e0.060.5 = 1.268.
The forward price is
G = (30 1.268)e0.060.75 = 30.05(pounds).

CHAPTER 2. FUTURES MARKET AND PRICES

2.3.3

25

On an asset with continuous income

Example: Index portfolio

Assuming a continuous income at the rate q per annum, S I in Eq.(2.12) is
the same as Seq(T t) and
G = Se(rq)(T t) .

2.3.4

(2.13)

On an asset with a cost to store

Examples: gold, vegetables and grains

If the present value of the storage cost is U , the spot price S has to be substituted by S + U in Eq.(2.9). If the storage cost per unit is a constant proportion,
u, of the spot price, the spot price S is substituted by Seu(T t) .
G = (S + U )er(T t)

G = Se(r+u)(T t) .

(2.14)

NB: For some commodities, the forward price is not determined by the equation
above. Even when G < Se(r+u)(T t) , some asset holders are reluctant to short
the asset when they do not hold them for investment reasons.
As an example, consider a one-year forward contract on gold. It costs $1
semiannually per ounce to store gold. Suppose the payment is made in advance
every 0.5 year. Assume that the spot price is $450 and the risk-free rate is 7%
per annum for all maturities. What is the forward price?
U = 1 + 1 e0.070.5 = 1.9656
and the futures price
G = (450 + 1.9656)e0.07 = 487.74.
When G > (S + U )er(T t) , an arbitrage profit is earned by borrowing S + U
at the risk-free rate to purchase the commodity and shorting a forward on the
commodity. When G < (S + U )er(T t) , an arbitrage profit is earned by selling
the commodity at S + U and longing a forward. But who wants to buy the

CHAPTER 2. FUTURES MARKET AND PRICES

26

commodity at S + U when its price is S? So, sell the commodity at S and save U
and long a forward to get a profit. More precisely, G (S + U )er(T t) because
there are some owners who keep the commodity due to its consumption value.

2.3.5

Interest rate parity relation

Example: Foreign currencies

Assume that the value of the underlying asset S is the current price in the
domestic currency of one unit of the foreign currency. The foreign currency
considered as an asset has the property that the holder of the asset can earn
interest at the foreign risk-free interest rate rf . The price of a forward contract
on a foreign currency is given by
G = Se(rrf )(T t) .

(2.15)

For example, the risk-free interest rate in the UK is 6% per annum while
in the US is 4%.

The US$ forward price for one-year delivery is $amount

e0.02 =$amount1.02.

2.3.6

Cost of carry

The relationship between forward prices and spot prices can be summarised in
terms of the cost of carry, c:
G = Sec(T t) .

2.4

(2.16)

Marking to market the account

Forward contracts and futures are much alike, except that the former are private
contract between two parties and the latter are traded over-the-counter. To
minimise the contract defaults, an investor who buys a futures is requested to
deposit funds in a margin account. The margin account is there to safeguard
against the possibility of default.

CHAPTER 2. FUTURES MARKET AND PRICES

27

The following is the contract specification for the corn futures at CBOT (Chicago
Board of Trade) on 15 January 2004.
$ Corn Contract
Maintenance Margin: $ 400 per contract
Initial Margin: $ 540 (initial margin mark up percentage = 135%)
Contract Size: 5,000 bushels
Deliverable Grades: No. 2 Yellow at par and substitutions at differentials
established by the exchange
Delivery Months: March, May, July, September, December
Minimum Tick (Size/Value): 1/4 cent per bushel ($12.50/contract)
Daily Price Limit: 20 cents/bu ($1,000/contract) above or below the previous
days settlement price.
Last Trading Day: The business day prior to the 15th calendar day of the
contract month.
Last Delivery Day: Second business day following the last trading day of the
delivery month.
Let us consider the following transaction in the CBOT.
Day 0 A customer longs two corn futures contracts (March delivery) at the closing price of $2.07 per bushel. Initial margin: 2 $540 = $1, 080
Day 1 Closing futures price of day 1: $2.05 per bushel
Change in futures price: $2.05 - $2.07 = -$0.02 per bushel
Investors loss: 2 5, 000 ($0.02) = $200
Margin Account Balance: $1, 080 $200 = $880
Day 2 The price of the corn futures falls to $2.04 per bushel.
Change in futures price: $2.04 - $2.05 = -$0.01 per bushel
Investors loss: 2 5, 000 ($0.01) = $100
Margin Account Balance: $880 $100 = $780.
$780 is less than the maintenance margin by $20 so the customer receives a

CHAPTER 2. FUTURES MARKET AND PRICES

28

margin call. He will have to pay the variation margin $1, 080 $780 = $300. If
not, the customers position is closed.
Day 3 The price of the corn futures rises to $2.08 per bushel.
Change in futures price: $2.08 - $2.04 = $0.04 per bushel
Investors gain: 2 5, 000 $0.04 = $400
Margin Account Balance: $1, 080 + $400 = $1, 480
$400 is more than the initial margin so the customer can take out $400.
The effect of the marking to market is that a futures contract is settled daily
rather than all at the end of its life.
It is straightforward to prove that the margin account payment becomes the
futures payment at maturity without considering an interest on the margin account.
proof
Denote the initial margin by I, the maintenance margin by M and the futures
price on day i by Fi . On day 0, the initial margin I is paid into the margin
account. On day 1, I + (F1 F0 ) is in the margin account. On day 2, I + (F1
F0 ) + (F2 F1 ) = I + (F2 F0 ) is in the margin account. Likewise, on day 3,
I + (F1 F0 ) + (F2 F1 ) + (F3 F2 ) = I + (F3 F0 ) is in the margin account.
On day i, there is I + (Fi F0 ) in the margin account. If this sum is smaller than
the maintenance margin then the investor gets a call and has to put the amount
of F0 Fi into the margin account. Thus, till the maturity (day n), the margin
account payment will be F0 Fn . As the futures price at maturity is the same as
the spot price on the day, Sn , the payment is F0 Sn which is exactly the futures
payment which is the difference between the futures price F0 on day 0 and the
spot price Sn at maturity.

2.5

Relation between forward price and futures price

We can prove that when the risk-free interest rate is constant, the forward price
is the same as the futures price for a contract when their delivery dates are same.

CHAPTER 2. FUTURES MARKET AND PRICES

29

Proof
Assume that the delivery date of a futures and a forward contract is n days
away. Let Fi and Gi denote respectively the futures and forward prices at the end
of the ith day, 0 i n. The current forward and futures prices are respectively
Go and Fo and the forward price and futures price on maturity have to be the
same as the spot price, Sn , on the day; Fn = Gn = Sn .
Suppose an investors portfolio:
Start a long position in e at the end of day 0
Increase the long position to e2 at the end of day 1
Increase the long position to e3 at the end of day 2
.
When her(his) position of futures contracts is changed everyday, the value of the
entire investment at the end of day n is
n
X

ai (Fi Fi1 )e(ni)

(2.17)

i=1

where
: Risk-free interest rate per day
ai : Number of futures contracts at the i 1th day
ai (Fi Fi1 ) : Profit or loss from the position on day i
ai (Fi Fi1 ) earns the risk-free interest till the end of the futures life in the case
of profit. In the case of loss, the investor has to borrow ai |Fi Fi1 | from a
bank and has to repay the loan and the interest. This is why we have e(ni) in
Eq.(2.17).
For the investors portfolio, ai is ei so that Eq.(2.17) becomes
n
X
i=1

(Fi Fi1 )en = (Fn Fo )en .

(2.18)

CHAPTER 2. FUTURES MARKET AND PRICES

30

We know that the futures price at its maturity must be the spot price, Sn , for
the underlying asset. So the value of the investment (2.18) becomes
(Sn Fo )en

(2.19)

Let us consider an investor who has the above portfolio and the initial cash Fo
in the risk-free account. His(Her) money grows to Fo en in n days. Thus his(her)
portfolio is worth
(Sn Fo )en + Fo en = Sn en
on Day n.
Let us consider another investor who is in a long position of en underlying
assets. On Day n, the asset price is Sn so his(her) portfolio is worth Sn en . We
realise that the two portfolios bear the same value on Day n thus they should
have the same value at any time. Therefore,
So en = Fo .
The Left-hand side is the forward price. We have proved that the forward price
is the same as the futures price.

2.6

Hedging using futures

Let us consider an airline company which knows that it will buy 2 million gallons
of jet fuel in three months. The fuel price is not stable and the company does not
want to expose to the risk. However, unfortunately, there is no jet fuel futures
contract. The company tries to hedge the risk by the futures contracts on heating
oil. How many oil futures contracts would you recommend it to buy to hedge the
risk?
The company is short the fuel which is hedged by creating a long position in
oil futures. Buying h numbers of futures contracts, the change in the value of
companys position is
= S + hF

(2.20)

CHAPTER 2. FUTURES MARKET AND PRICES

31

where S is the change in spot price, S, and F the change in futures price. For
example, suppose S = 203 at t0 , S = 205 at t1 , and S = 200 at t2 then
S = 2 between t0 and t1 and S = 5 between t1 and t2 .
Any price change happens in a random manner. For the random
price change of S we define the mean as follows
= hSi =
S

pi Si

where pi is the probability of Si . The mean value (or average

value) is sometimes called the expectation value and denoted by
E(S). The standard deviation tells us the size of the fluctuation
in the price change:
S =

sX
i

2=
pi (Si S)

sX

pi Si2 (

pi Si )2 .

Another term very often used is the variance. The variance is the
square of the standard deviation. One more thing which appears
often in the study of statistics is marginal. Let us assume we
have more than one random variables. In this case, the marginal
mean value for variable 1, for example, is to consider the mean
value for variable 1 regardless of other variables.

We know that S and F are correlated random variables. By hedging we

want to minimise the variance of the companys hedging position. To do it, the
company has to decide how many futures contracts it ought to buy. How?
Step 1
Find the correlation between S and F .

CHAPTER 2. FUTURES MARKET AND PRICES

32

Step 2
Find the variance of the change in the value of the hedged position.
Step 3
Find the minimum point of the variance with regard to the number of
futures contracts
To do the step 1, we have to know how the correlation between two random
variables is defined.

Characterisations of correlation between two random variables

1. Definition
Take a set of two random variables X = (X1 , X2 ), the covariance between
the two variables is defined by
12 (X) = E[(X1 X1 )(X2 X2 )].

(2.21)

2. Definition
For X = (X1 , X2 ), its correlation coefficient is defined by
(X) = E

"

X1 X1
1

X2 X2
2

!#

12 (X)
.
1 2

(2.22)

where 1 and 2 are the standard deviations of X1 and X2 . The correlation

coefficient has upper and lower bounds of 0 and 1: If the two are perfectly
correlated, = 1 and if the two are totally independent, = 0.
The variance Y2 of a random variable Y = a1 X1 + a2 X2 is
2
2
Y2 = a21 X
+ a22 X
+ 2a1 a2 (X1 , X2 )X1 X2
1
2

(2.23)

where ? is the standard deviation of the variable ?.

Assuming the coefficient of correlation between S and F , we find the vari2 , of the change of the hedged position
ance hdg
2
2
2

= S
+ h2 F
2hS F .

(2.24)

CHAPTER 2. FUTURES MARKET AND PRICES

33

This is a quadratic equation with regard to h which is represented by a concave

parabola. Its derivative with regard to h is zero when
h=

S
F

(2.25)

2 . This makes a very good sense as h is larger when the two

which minimises

prices are more correlated, i.e. larger, the asset price fluctuates more, i.e. S
larger, and the futures price fluctuates less, i.e. F smaller.
example
An airliner will need 2,000,000 gallons of jet fuel in the future. The standard
deviations for the fluctuations of jet fuel price and heating oil price are respectively S = 0.3 and F = 0.2 and their correlation coefficient is = 0.8 then
h = 1.2. If a futures contract is on 1,000 gallons of heating oils we need to take
a long position on
1.2

2, 000, 000
= 2, 400
1, 000

number of futures contracts.

Rolling the hedge forward

Let us consider the following example. In February, a company realised that
it would need 10,000 ounces of gold in July. The company decided to buy futures contracts on gold to hedge its risk. The company longs June contracts in
February. In May, it rolls the hedge forward into September contracts.
The price of gold is 180 in February and rises to 230 in July. The June
futures price rises from 190 in February to 210 in May. The September futures
price rises from 215 in May to 233 in July. With the hedging, how much cash
does the company need for the purchase of 10,000 ounces of gold?

2.7

Hedging using index futures

Let us assume that a portfolio is composed of shares of a few companies. To

hedge the portfolio we can either buy forward contracts of each share or buy

CHAPTER 2. FUTURES MARKET AND PRICES

34

stock index futures. We can calculate how many stock index futures we have to
buy to optimise the hedging.