Futures pricing is associated with the price of the underlying assets attached to it. The price may move in the direction of an asset’s price (spot price).
An increase in an asset’s price may lead to an increase in the price of futures and vice versa. However, futures pricing may not follow the asset’s price trajectory. The difference between them is due to spot-future parity. In addition, future pricing and spot pricing may follow different trajectories due to dividends, interest, and expiry dates.
Calculation of futures price is based on a simple mathematical formula that equates underlying asset price and futures price.
The formula for futures pricing is given below:
Futures price = Spot price*(1+rf) – d
Where rf is the risk-free rate and d is the dividend
Here rf is the interest rate that one can earn throughout the year in normal circumstances. However, traders can adjust it proportionately for one, two or three months depending on the expiry of the contract. The adjusted formula looks like this:
Future price = Spot price*[1+rf(X/365)-d]
Here X denotes the number of days to expiry.
Divergence in futures price and spot price is mainly due to interest rates and expiry dates. This variance between these two forms the ‘basis of spread’. The spread is the maximum at the start of the series but gradually converges as the settlement date nears. Here spread refers to the difference between the spot and the futures price.
The spot price and futures price are almost equal on the expiration date.
Here are certain aspects that individuals should understand regarding futures pricing:
Contracts are legal agreements between a buyer and a seller. For example, a buyer may take a long position in future, whereas a seller may take a short position.
Margin is the amount of money deposited by both parties with stockbrokers at the beginning of a trade. It acts as an assurance that both parties will honour their commitments on contract expiry. If the initial amount falls below the maintenance amount, the parties may receive a margin call.
Mark to market is a process to settle futures prices daily. Futures’ prices may see a rise or fall in their value due to active trading throughout the day. Mark to market calculations is done daily after the closing of trading hours. Clearinghouses pay the price differences daily. The P&L account is credited and debited with the differential amount from the margin deposited with clearinghouses on the same day.
Two types of future pricing models are given below:
It assumes that markets are perfectly efficient. This means no difference between spot and futures prices, and it thereby eliminates any chance of arbitrage. Arbitrage is a process by which traders take advantage of a price difference in two markets.
Under this model, traders are indifferent towards both markets as their earnings are the same from both. Futures price will be equal to spot price plus the net cost of carrying the assets till expiry.
Therefore, Futures pricing = Spot pricing + (Carry cost – Carrying return)
Here carrying costs may include storage costs, interest paid to acquire assets or financing costs. Carrying returns will include any income earned with these assets, like dividends and bonuses. The net of these is the net carrying cost.
This model is based on expected pricing trends. Futures pricing of an asset is what the expected spot price will be in future. Futures prices will be positive if markets are bullish, whereas pricing will be negative if markets exhibit bearish sentiments. In this model only, the expected future spot price is taken into consideration.
Futures pricing is dependent on various factors like interest, returns, and financing costs. One should understand how futures pricing works to plan their position in markets more efficiently.