Uday Damodaran
XLRI Jamshedpur
Session 3:
General Framework for
Pricing Any Forward Contract
XLRI 17-19: O&F
Session 3 1
Uday Damodaran
XLRI Jamshedpur
From the specific to the general…
We have seen the pricing framework for a specific type of
derivative: a foreign exchange (FX) forward contract…
…Let us move on to developing general frameworks for
pricing forward contracts
Chapter 5:
Determination
of Forward and
Futures Prices
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Uday Damodaran
XLRI Jamshedpur
Forward Price for an Investment Asset
What would be the forward price for an investment asset that
provides no income (not our forex contracts!)
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Uday Damodaran
XLRI Jamshedpur
“Investment assets”…
Versus consumption assets
Examples of consumption assets?
Laptops, for example (JR Varma, Chapter 3)
‘Derivatives and Risk Management’: JR
Varma.. A good book for this topic..
basically section 3.1
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Uday Damodaran
XLRI Jamshedpur
Forward Price for an Investment Asset
What would be the forward price for an investment asset that
provides no income (not our forex contracts!)
Examples of such assets?
Non-financial?
Financial?
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Uday Damodaran
XLRI Jamshedpur
Forward Price for an Investment Asset
For an investment asset that provides no income
Non-dividend paying stocks
Zero coupon bonds
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Uday Damodaran
XLRI Jamshedpur
Forward Price for an Investment Asset
For an investment asset that provides no income
Intuitively, how can
the price be
determined?
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Uday Damodaran
XLRI Jamshedpur
Example, p.126
Non-dividend paying stock, current stock price $40
3-month forward contract on this stock: what do you need to
know to price this?
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Uday Damodaran
XLRI Jamshedpur
Example, p.126
Non-dividend paying stock, current stock price $40
3-month forward contract on this stock $43
Is this fairly priced? What do you need to know?
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Uday Damodaran
XLRI Jamshedpur
Example, p.126
Non-dividend paying stock, current stock price $40
3-month forward contract on this stock $43
3-month risk-free continuously compounded interest rate =
5%p.a.
What should be done?
40 * e0.05*(3/12) = 40.50
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Uday Damodaran
XLRI Jamshedpur
Forward Price
Of an investment asset that provides no income
Relationship in symbols?
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Uday Damodaran
XLRI Jamshedpur
Forward Price
Of an investment asset that provides no income
F0 = S0 erT
Price of forward
contract today Price of underlying Time until delivery date
asset today
Zero coupon risk-free
rate of interest, per
annum, expressed with
continuous
compounding
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Uday Damodaran
XLRI Jamshedpur
Forward Price
So, notice.. Whether it be our FX or stocks, to price the
derivative (in this case, forwards) we do not need to know
anything about the fundamentals of the underlying; we need
not have a view on the underlying !!
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Uday Damodaran
XLRI Jamshedpur
Forward Price
Of an investment asset that provides no income
F0 = S0 erT
Or equivalently:
S0 = F0 e-rT
Interpretation?
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Uday Damodaran
XLRI Jamshedpur
Forward Price
Of an investment asset that provides no income
F0 = S0 erT
Or equivalently:
S0 = F0 e-rT
“the spot price should equal the present value of the future
cash flow F0 that is known with certainty”
Warning: note that the discounting is done at the risk free
rate; therefore the forward price is not equal to the
expected spot price at maturity!
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Uday Damodaran
XLRI Jamshedpur
Forward Price
Of an investment asset that provides no income
F0 = S0 erT
Or equivalently:
S0 = F0 e-rT
“the spot price should equal the present value of the future
cash flow F0 that is known with certainty”
Not applicable for consumption assets..for example PV of
laptop is not determined by expected value at the end of
the year!
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Uday Damodaran
XLRI Jamshedpur
‘Support Systems’!
Read Business Snapshot 5.1: Kidder Peabody’s Embarrassing
Mistake
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Uday Damodaran
XLRI Jamshedpur
Read…
Chapter 5- read Business Snapshot 5.1 (Kidder Peabody’s
Embarrassing Mistake)
Brian: Middle Office/ Front Office
Support - Help the traders in
Importance of the PL keeping track of corporate actions,
function! in booking trades, verification of
traders claims of P&L (very
important to be in their good books
for traders!)
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Uday Damodaran
XLRI Jamshedpur
Think!
What about our forex forward? What kind of an investment
asset is currency?
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Uday Damodaran
XLRI Jamshedpur
Forward Price: Known Income
What would be the forward price of investment assets that
provide predictable cash incomes?
What are examples of such assets?
Is our FX an example of this?
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Uday Damodaran
XLRI Jamshedpur
Forward Price: Known Income
What would be the forward price of investment assets that
provide predictable cash incomes?
(What are examples of such assets?)
Coupon bearing bonds
Stocks paying known dividends
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Uday Damodaran
XLRI Jamshedpur
Example, p.130
Coupon bearing bond with current price of $900
Coupon of $40 after 4 months
What will be the price of a 9-month forward contract on
this bond? What other information would you require?
4 month continuously compounded risk-free rate = 3% p.a.
9 month continuously compounded risk-free rate = 4% p.a.
Assume that the forward contract is trading at $910. What
would you do?
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Uday Damodaran
XLRI Jamshedpur
Actions
Buy the bond with borrowed money
But known income of $40 after 4 months. So borrow
40e -.03*(4/12) = $39.60 for 4 months
Borrow $860.40 for 9 months resulting in outflow of
860.4 e .04*(9/12) = $886.60
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Uday Damodaran
XLRI Jamshedpur
Forward Price
Forward Price for an investment asset with known income:
What would be the relationship in symbols?
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Uday Damodaran
XLRI Jamshedpur
Forward Price
Forward Price for an investment asset with known income:
F0 = (S0 – I) e rT where I is?
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Uday Damodaran
XLRI Jamshedpur
Forward Price: Known Yield
Situation where the asset underlying a forward contract
provides a known yield rather than a known cash income
Ah! This seems to be our currency forward (or is it?)
What will be the equilibrium forward price?
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Uday Damodaran
XLRI Jamshedpur
Forward Price: Known Yield
F0 = S0 e (r-q)T
Where q is the average continuously compounded yield per
annum on the underlying asset during the life of the forward
contract
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Uday Damodaran
XLRI Jamshedpur
In summary: Forward Price
No- Income Asset: F0 = S0 erT
Known- Income Asset: F0 = (S0 – I) e rT
Known- Yield Asset: F0 = S0 e (r-q)T
In non-continuous compounding language?
Have we seen
this before?
Verify!
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Uday Damodaran
XLRI Jamshedpur
Strategies Using Forwards
Considering an asset with no income
If F0 > S0 erT
What will you do?
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Uday Damodaran
XLRI Jamshedpur
Strategies Using Forwards
Considering an asset with no income
If F0 > S0 erT
Short the forward and buy the asset with borrowed funds
‘Cash and carry arbitrage’
Concept of
‘carry’ so
ubiquitous in the
markets: Real
estate?
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Uday Damodaran
XLRI Jamshedpur
Cash and Carry Arbitrage
Through a cash and carry arbitrage you are locking into a
certain payoff at a particular point of time in the future
Therefore a long position in the asset and a short position
in the forward can be called a Synthetic T-Bill
The numbers
Non-dividend paying stock, current stock price $40
3-month forward contract on this stock $43
3-month risk-free continuously compounded interest rate = 5%p.a.
What should be done?
40 e0.05*(3/12) = 40.50
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Uday Damodaran
XLRI Jamshedpur
Identity
Therefore symbolically:
A long position in the asset and a short position in the
forward can be called a Synthetic T-Bill
Spot – Forward = Synthetic T-Bill
‘With a natural position in any two of three assets we can
create a synthetic position in the third
How will you create a synthetic long position in a forward
contract, using this symbolic logic?
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Uday Damodaran
XLRI Jamshedpur
Identity
Therefore symbolically:
Spot – Forward = Synthetic T-Bill
‘With a natural position in any two of three assets we can
create a synthetic position in the third
How will you create a synthetic long position in a forward
contract, using this symbolic logic?
S-F = Rf
Synthetic Forward = S – Rf
And a synthetic spot??
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Uday Damodaran
XLRI Jamshedpur
Reverse Cash and Carry Arbitrage
What would that be?
What structure does it look like, and what can we call it?
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Uday Damodaran
XLRI Jamshedpur
Reverse Cash and Carry Arbitrage
What would that be?
F0 < S0 erT
Short the asset, invest proceeds, long the forward
In symbols: -S+F = -Rf
What structure does it look like, and what can we call it?
‘Implied Repo Rate’
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Uday Damodaran
XLRI Jamshedpur
Session 3
What have we done till now?
Looked at three general approaches to pricing of forwards
Looked at strategies to benefit from mispricing
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Uday Damodaran
XLRI Jamshedpur
In summary: Forward Price
No- Income Asset: F0 = S0 erT
Known- Income Asset: F0 = (S0 – I) e rT
Known- Yield Asset: F0 = S0 e (r-q)T
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