PPT 1 - 1.1 1 FORWARD CONTRACTS Reading Luenberger Chapter...

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1. FORWARD CONTRACTS
Reading: Luenberger Chapter 10
Prerequisite: Interest rates. Read (review)
Luenberger Chapter 4.
1.1

§੿ A Forward Contract is an agreement between two parties
to buy/sell an asset at an agreed upon price at an agreed
upon time in the future
.
– Long position : agrees to buy the asset
– Short position : agrees to sell the asset
– Spot price : price of the asset today
– Delivery price : price agreed upon in forward contract.
Example: Buy 100,000 pounds of sugar at 12 cents per pound one
year from today . The buyer is long 100,000 pounds; the seller is
short 100,000 pounds. 12 cents is the delivery price or sometimes
called the forward price F.
Question: Is F=12 cents a fair price if the spot price is 10 cents ?
1.1 Forward Contracts
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1.2

§੿ Example : Suppose the interest rate is 5% and
the spot price of oil is $100/barrel. An oil refiner
enters into a forward contract to purchase 1000
barrels of oil to be delivered in one year.
§੿ Assume no storage costs for the asset
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1.3

What if the delivery price is $110? One trading strategy is:
§੿ Borrow $100,000 today for one year at 5% interest.
§੿ Purchase today 1000 barrels of oil, and store them for
one year.
§੿ Enter into a short forward contract to sell the oil for
$110,000 in one year.
§੿ After one year the trader sells the oil for $110,000,
repays the loan (principle and interest) for $105,000, and
makes a $5,000 profit.
– A sure future profit without any investment!
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1.4

What if the delivery price is $90? One trading strategy for a
market participant who owns oil is:
§੿ Sell 1000 barrels of oil today, for $100,000.
§੿ Invest the $100,000 at 5% interest.
§੿ Enter into a long forward contract today to purchase the
oil for $90,000 in one year.
§੿ After one year the trader has $105,000, uses $90,000 to
repurchase the oil, and is left with a $15,000
The preceding two trading strategies are examples of
arbitrage , a trade that takes advantage of the relative mis-
pricing of two or more assets. An arbitrage opportunity is a
trade that locks in a risk free profit.
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1.5

Arbitrage and No-Arbitrage
• Arbitrage
– Opportunity for a riskless profit*
• No-Arbitrage Hypothesis
– There is never a scenario in which a selection of