- CFA Exams
- 2025 Level II
- Topic 7. Derivatives
- Learning Module 31. Pricing and Valuation of Forward Commitments
- Subject 3. Pricing Equity Forwards and Futures

### Why should I choose AnalystNotes?

Simply put: AnalystNotes offers the **best value**
and the **best product** available to help you pass your exams.

##### Subject 3. Pricing Equity Forwards and Futures PDF Download

Equity forward contracts are priced and valued much like the generic contracts described earlier, with one important additional feature: many stocks pay dividends, and the effects of these dividends must be incorporated into the pricing and valuation process.PV(D, 0, T) = ∑[D F(0, T) = [S F(0, T) = S F V

Given a series of dividends of D

_{1}, D_{2}, ...D_{n}, whose values are known, that occur at times t_{1}, t_{2}, ... t_{n}, the present value is defined as PV(D, 0, T) and computed as:

_{i}/(1 + r)

^{ti}] (i is from 1 to n).

An equity forward contract is priced by taking the stock price, subtracting the present value of the dividends over the life of the contract, and then compounding this amount at the risk-free rate to the expiration date of the contract.

_{0}- PV(D, 0, T)] (1 + r)

^{T}

Note that the dividends reduce the forward price, a reflection of the fact that holders of long positions in forward contracts do not benefit from dividends in comparison to holders of long positions in the underlying stock.

Another approach to incorporating the dividends is to use their future value. An equity forward can be priced by compounding the stock price to the expiration date and then subtracting the future value of the dividends at the expiration date.

_{0}(1 + r)

^{T}- FV(D, 0, T)

*Example 1*Let's consider a stock priced at $50, which pays a dividend of $4 in 60 days. The risk-free rate is 5.5%. A forward contract expiring in three months (T = 0.25) would have a price of

- F
_{0}(T) = F_{0}(0.25) = [50 - 4/(1.055)^{60/365}] 1.055^{0.25}= $46.66, or - F
_{0}(T) = 50 (1 + 0.055)^{0.25}- 4 x 1.055^{30/365}= $46.66.

Unsurprisingly, the two formulas give the same answer.

If the stock has more than one dividend, we would simply subtract the present (or future) value of all dividends over the life of the contract from the stock price (or future value of the stock price).

Alternatively, we can express dividends as a fixed percentage of the stock price. If we assume that the stock, portfolio, or index pays dividends continuously at a rate of δ, we then allow the dividends to be uncertain and completely determined by the stock price at the time the dividends are being paid.

Because we pay dividends continuously, for consistency we must also compound the interest continuously. The continuously compounded equivalent of the discrete risk-free rate r is denoted as

*r*, and found as_{c}*r*= ln(1 + r). The future value of $1 at time T is e(_{c}*r** T). The forward price is then:_{c}

_{0}(T) = S

_{0}* e

^{(rc -δ) * T}

- S
_{0}* e^{-δ * T}is the stock price discounted at the dividend yield rate (the stock price minus the present value of the dividends). - The value is then compounded at the risk-free rate over the life of the contract.

*Example 2*France's CAC 40 index is at 5475. The continuously compounded dividend yield is 1.5%. The continuously compounded risk-free interest rate is 4.625%. The contract life is two years. With T = 2, the contract price is: F

_{0}(T) = F_{0}(2) = 5475 * e^{(0.04625 - 0.015) * 2}= 5828.11.Regardless of how the dividend is specified or even whether the underlying stock, portfolio, or index pays dividends, the value of an equity forward contract is the stock price minus the present value of the dividends, minus the present value of the forward price that will be paid at expiration.

_{t}(T) = S

_{t}- PV(D, t, T) - PV[F

_{0}(T)]

Note that the forward price should not be interpreted as a forecast of the future price of the underlying. If the forward price is higher than the spot price, it merely indicates that the effect of the risk-free rate is greater than the effect of the dividends. In fact, such is usually the case with equity forwards: interest rates are usually greater than dividend yields.

###
**User Contributed Comments**
6

User |
Comment |
---|---|

americade |
i think a better way to work it is to adjust the spot to the forward price then compare the forward price for value rather than discounting the forward price back |

americade |
since you are compounding the spot at a higher rate than discounting the spot (at the div rate) it usually will accentuate the spot equity rate over the forward and exacerbates over longer time periods. |

tushi123 |
When the dividends are discrete, we are subtracting their PV from the spot price to arrive at the forward price, but when they are continuously compounded we are multiplying their exponential with the spot price, what is the explanation? |

rascallian |
as with tushi123's question, anyone with an idea of how to solve St-PV(D,t,T) = St*e^d(T-t)? |

czar |
tushi123 - its negative dividend -d * rt , to use the exponent (e) it is multiplied, but in effect negated due to -d (theta) |

CFAJ |
Just to clarify, the move straight from a dividend on one stock to talking about all the dividends received from an index. I cannot understand what they mean when they say "because we pay dividends continuously", but I assume that they are trying to explain that all the dividends from an index are coming in essentially continuously. So anyway, you continuously compound the dividends ON AN INDEX FUTURE, because compounding them individually isn't realistic. |

You have a wonderful website and definitely should take some credit for your members' outstanding grades.