Determination of Forward and Futures Prices in Financial Market

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Determination of Forward and Future Prices

Financial Risk Manager (FRM®) Part I of the FRM Exam covers the fundamental tools and techniques used in risk management and the theories that underlie their use.

Forward and Futures Prices

Welcome to the session on pricing of futures and forwards. When we started the module on “Financial Markets and Products,” we introduced you to the concept of forwards and futures, both of which are contracts to sell or purchase an asset on a future date. In this session, we will discuss how to find the value of these contracts. We will apply the concept of arbitrage in finding the value of the forward.

Agenda

The main agenda of our discussion will be finding out the expression for the price of forwards and futures. We will learn to apply the expression to find the prices of different types of futures including stock futures, currency futures and commodity futures. We will learn about consumption commodities and convenience yield while dealing with commodity futures. We will also compare the pricing of forwards and futures. We will then discuss the expected spot prices of the futures. Finally, we will end the session with a brief discussion on contango (or backwardation) that shows the trend of movement of futures prices.

Asset Types

Investment assets are assets that are held for the purpose of investing. For example different investors hold stocks, bonds etc. for the sake of investment. Consumption assets are assets that are held for the purpose of consumption. Example of consumption assets include commodities such as oil and natural gas.

Short sales are orders to sell securities that the seller does not own. For a short sale, the short seller

  • Simultaneously borrows and sells securities through a broker
  • Must return the securities at the request of the lender or when the short sale is closed out
  • Must keep a portion of the short sale proceeds on deposit with the broker 

The short seller may be forced to close his position if the broker runs out of securities to borrow. This is known as short squeeze and the short seller will need to close his short position immediately at a loss, when the price is high.

Pricing Concept

In an earlier session, we have introduced you to the concept of absence of arbitrage in efficient markets; i.e., similar assets cannot be sold at different prices. Otherwise, the arbitrageurs will sell the higher priced asset and buy the cheaper one at the same time and earn instantaneous riskless profit. We have also introduced the concept of time value of money in the previous session.


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