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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Chapter 8: Principles of Pricing Forwards, Futures, and Options on Futures To know value is to know the meaning of the market. Charles Dow Money Talks (by Rosalie Maggio), 1998, p. 23 Important Concepts in Chapter 9 Price and value of forward and futures contracts Relationship between forward and futures prices Determination of the spot price of an asset Cost of carry model for theoretical fair price Contango, backwardation, and convenience yield Futures prices and risk premiums Futures spread pricing Pricing options on futures Some Properties of Forward and Futures Prices The Concept of Price Versus Value Normally in an efficient market, price = value. For futures or forward, price is the contracted rate of future purchase. Value is something different. At the beginning of a contract, value = 0 for both futures and forwards. Notation Vt(0,T), F(0,T), vt(T), ft(T) are values and prices of forward and futures contracts created at time 0 and expiring at time T. Some Properties of Forward and Futures Prices (continued) The Value of a Forward Contract Forward price at expiration: F(T,T) = ST. That is, the price of an expiring forward contract is the spot price. Value of forward contract at expiration: VT(0,T) = ST - F(0,T). An expiring forward contract allows you to buy the asset, worth ST, at the forward price F(0,T). The value to the short party is -1 times this. Some Properties of Forward and Futures Prices (continued) The Value of a Forward Contract (continued) The Value of a Forward Contract Prior to Expiration A: Go long forward contract at price F(0,T) at time 0. B: At t go long the asset and take out a loan promising to pay F(0,T) at T At time T, A and B are worth the same, ST – F(0,T). Thus, they must both be worth the same prior to t. So Vt(0,T) = St – F(0,T)-(T-t) See Table 9.1, p. 306. Example: Go long 45 day contract at F(0,T) = $100. Risk-free rate = .10. 20 days l