Forwards Futures L2

Section: Forwards and Futures — Level 2 Estimated study time: 60 minutes Content: Forwards and futures are linear derivatives where the payoff is proportional to the difference between the underlying asset price at expiration and the agreed forward price. At CFA Level 2, the analytical focus is on no-arbitrage pricing, basis risk, and the use of futures for hedging and portfolio management. A forward contract obligates the buyer to purchase and the seller to deliver a specified asset at a specified price (the forward price) on a future date. Futures contracts are standardized exchange-traded equivalents with daily mark-to-market (variation margin) and clearing house interposition. The futures price is not the same as the expected future spot price — it is determined by no-arbitrage conditions from the current spot price. The cost of carry model determines the no-arbitrage forward price. For an asset with no income and no carrying costs: F_0 = S_0 * (1 + r)^T (discrete) or F_0 = S_0 * e^(rT) (continuous). For assets with cash income (dividend yield q for equities or coupon yield for bonds): F_0 = (S_0 - PV of cash income) * (1 + r)^T, or using yield: F_0 = S_0 * e^((r-q)T). For assets with storage costs (commodities): F_0 = (S_0 + PV of storage costs) * (1 + r)^T. For currency forwards (covered interest rate parity): F_0 = S_0 * ((1 + r_d) / (1 + r_f))^T. If the actual forward price differs from the theoretical no-arbitrage price, cash-and-carry arbitrage (buy spot, sell forward) or reverse cash-and-carry (sell spot, buy forward) can be executed until prices converge. Futures pricing includes an additional adjustment for the daily mark-to-market feature. The futures price…