Lecture 2 – Pricing Futures and Forwards There is a fundamental assumption when seeking to price forwards and futures: a) No Arbitrage – Markets are efficient & arbitrage cannot persist There is also a guiding principle: b) Replication – The payoffs of the derivative product are determined by price movements in underlying assets. The derivative can be “replicated” by using the underlying assets. An investor needs to ensure that they have a given asset at a set point in time. a) They could (Long) buy a forward at Delivery Price b) They could buy a unit of Asset now (at T=0) and hold it Either of these strategies deliver equivalent results for the investor at Time = T the investor has his asset. In a perfect market with no transaction, holding or delivery costs, the present value of each strategy should be the same. Assumptions made using this approach: - - No transaction costs No restrictions on Short Sales (Short Sales are possible and therefore the full proceeds from short sales are available immediately, but issues arise with this assumption e.g. cost to hold is too expensive) The rates of interest are the same for borrowing and lending This looks appealing but the model makes no allowances for: - Delivery Options Margining Transaction Costs Restrictions on Short Sales Different rates of interest for borrowing and lending The issue with this is that mid-term the contract cannot be changed, the market has moved. a) There may be an asset and delivery mismatch The assets underlying the original contract may not be available, there may be similar assets but what is the difference in value? b) Margining for futures contracts would have to be considered It may be impossible to absolutely match the delivery criteria of the original contract in a market that has changed. Given that futures contracts generally favour the short position and therefore favour supply over demand, futures contracts will, ceteris paribus, be cheaper than forwards contracts. Hedging Strategies using Forwards Hedges are a way of protecting oneself against financial loss or other adverse circumstances. Long Hedge – An attempt to manage risk using an agreement to buy assets in the future - Used when investor needs assets in the future and believes the price of it will rise over time Short Hedge – An attempt to manage risk using an agreement to sell assets in the future - Used when the investor already owns an asset, wants to sell it at some point in the future or believes the price of the asset may fall over time Long Hedge Short Hedge
