BAJAJ BROKING
November 02, 2023
5 mins read
When you trade futures, understanding how the pricing works can help you make smarter decisions. Futures pricing reflects the expected future value of an asset, factoring in several variables. These include interest rates, time until the contract expires, storage costs, dividends, and the current spot price of the asset.
One of the key influencers is the cost of carry, which is the total cost of holding the asset until the futures contract’s maturity. If you're investing in commodities like oil or gold, storage costs and insurance also come into play. For financial assets like stocks, dividends affect the pricing—higher dividends often lower futures prices. Interest rates influence both positively and negatively depending on whether you're long or short. Time to expiration also matters—the further out the contract, the more sensitive it is to changes in these factors.
Ultimately, you’re looking at how much the future delivery of an asset is worth today, adjusted for all associated costs. That’s how futures prices are derived.
The future pricing formula helps determine the fair value of a futures contract based on the current spot price, interest rates, and time to maturity. It ensures pricing reflects opportunity costs, carrying costs, and dividends (for assets like stocks). The formula assumes no arbitrage opportunities exist in the market.
If you’re trying to calculate the futures price of an asset, there's a widely used formula to guide you. The formula accounts for the current market price and the total cost of holding the asset until contract expiry. This method is known as the cost of carry model.
The basic formula is:
F = S × e^(r − d) × t
Where:
F = Futures price
S = Spot price
e = Exponential function
r = Risk-free interest rate
d = Dividend yield (if any)
t = Time to expiration in years
You use this to estimate what the asset should cost in the future, considering the risks and returns. It helps you assess whether the current futures market is fairly priced or not. When you apply it correctly, it offers a clearer picture for decision-making.
The pricing of a futures contract is a critical aspect of financial markets. It involves determining the cost at which a standardised quantity of an underlying asset can be bought or sold at a specified date in the future. Futures prices are influenced by various factors, including the current spot price of the underlying asset, interest rates, dividends, carrying costs, and market expectations. These prices are not only essential for hedgers and speculators but also play a fundamental role in maintaining market stability. A deep understanding of futures contract pricing is crucial for investors and market participants, as it can impact trading strategies, risk management, and decision-making in a wide range of industries, from agriculture and energy to finance and beyond.
The futures contract price is calculated using the cost-of-carry model, which factors in the spot price of the asset, interest rates, dividends (if any), and time to maturity. It ensures no arbitrage conditions are met. The model reflects the real economic cost of holding the underlying asset over time.
The calculation is most accurate in efficient markets where liquidity is high, such as NSE’s derivative segment. For instance, if a stock trades at Rs.1,000 and the interest rate is 5%, the futures price for a 3-month contract would be higher than the spot, assuming no dividend payout. This pricing reflects both market expectations and economic variables.
The determination of a futures contract’s price relies on a straightforward mathematical equation that equates the underlying asset’s price to the futures price. This formula for futures pricing is as follows:
Futures Price = Spot Price * (1 + rf) – d
In this equation, rf represents the risk-free rate, and d stands for the dividend. The rf value corresponds to the interest rate that one can typically earn over the course of a year in standard conditions. Nevertheless, traders can proportionally adjust it for contracts with different expirations, such as one, two, or three months. The adjusted formula takes the following form:
Future Price = Spot Price * [1 + rf * (X/365) – d]
Here, X represents the number of days until the contract’s expiration.
Also Read: Swaps in Derivatives
Futures prices are determined by several variables, and understanding these factors is essential for successful trading. Here are the main components that influence futures prices:
The current market price of the underlying asset (e.g., a stock, commodity, or currency) significantly impacts futures prices. If the spot price changes, it directly affects the corresponding futures price.
The risk-free rate represents the interest rate that can be earned throughout the year under normal circumstances. It accounts for the time value of money and reflects market expectations. The futures pricing formula includes this interest rate.
Dividends paid by the underlying asset also play a role in futures pricing. If an asset pays dividends during the contract period, it affects the futures price.
For commodities like oil or grains, storage costs impact futures prices. These costs include expenses related to storing and maintaining physical inventory.
This concept applies mainly to commodities. Convenience yield represents the benefits or advantages gained from holding the physical commodity rather than a futures contract. It affects futures pricing.
The futures pricing formula is given by:
Futures Price = Spot Price * e^(rT)
Where:
Read Also: Difference Between Forward and Futures Contract
Futures pricing can feel complex at first, but it gets easier once you understand the moving parts. You’re essentially working with today’s price plus future expectations and associated costs. Let’s break it down in simple points for better clarity.
The current market price of the asset is your starting point for all futures calculations.
This includes interest rates, storage, and insurance that you’d incur while holding the asset until the future date.
For financial assets like stocks or indexes, expected dividends reduce the future price.
The longer the time left for the contract to expire, the more uncertain and volatile the futures price may become.
Sudden changes in demand, supply, or investor expectations can affect futures pricing even if spot prices remain unchanged.
Understanding futures pricing involves several key elements:
Futures contracts represent legal agreements between a buyer and a seller. Buyers typically take long positions, while sellers assume short positions, reflecting their expectations for the underlying asset’s future price movement.
Margin is the initial deposit made by both parties with their respective stockbrokers at the outset of a trade. It serves as collateral to ensure that both parties fulfil their contractual obligations upon contract expiration. If the initial margin falls below a specified maintenance level, parties may receive a margin call, requiring additional funds to meet the margin requirement.
Mark-to-market is a daily process to determine the current value of futures contracts. These contracts can experience price fluctuations throughout the trading day. Mark-to-market calculations are conducted at the close of each trading day. Clearinghouses facilitate these calculations and adjust the margin accounts to account for price differences.
Daily price differentials from the mark-to-market process are credited or debited to the P&L accounts of the involved parties. These adjustments reflect gains or losses based on the fluctuating values of their futures contracts and are settled daily using the margin funds deposited with clearinghouses.
Also Read: OTM Call Options
There’s more than one way to understand how futures are priced. You’ve got a few models, each suited to different asset types and market conditions. Let’s explore the main ones.
This is the most common, accounting for interest rates, storage, and income like dividends.
Assumes that futures prices reflect the expected spot price at the contract’s expiration, often used for commodities.
These are based on market sentiment. Backwardation means futures prices are lower than spot prices; contango is the opposite.
Ensures futures are priced fairly by checking if arbitrage opportunities exist between spot and futures markets.
Used in commodity markets, this considers the non-monetary benefits of holding the physical asset.
Arbitrage in futures involves profiting from the price difference between the futures and spot markets without taking on significant risk. Traders exploit inefficiencies when the futures price deviates from its theoretical value. This ensures both markets eventually converge, maintaining fair pricing and liquidity.
For example, if the futures price of a stock is higher than the cost-of-carry-adjusted spot price, a trader may short the futures and buy the stock simultaneously. Once prices converge, the position is squared off, capturing the price differential. Such strategies
Futures contracts are integral to the efficient functioning of the commodities market. These contracts enable buyers and sellers to secure prices ahead of time, providing stability for farmers, miners, manufacturers, and various market participants who can then focus on their operations without being constantly affected by daily market fluctuations.
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Future pricing refers to determining the expected price of an asset for a future date based on current spot prices, interest rates, and time to maturity. It reflects the asset’s carrying cost and anticipated changes over time. This pricing helps traders and investors plan trades in futures markets.
F&O (Futures and Options) price is calculated using models like the futures pricing formula for futures and the Black-Scholes model for options. For futures, use: F = S × e^(rt), where S is the spot price, r is the interest rate, and t is time till expiry.
Examples of futures include equity futures (e.g., Nifty 50 futures), commodity futures (e.g., crude oil, gold), and currency futures (e.g., USD-INR). These contracts allow buyers and sellers to lock in a price for a specific asset to be delivered or settled at a later date.
Futures prices are determined by market participants on exchanges based on supply and demand. They reflect expectations of the future value of the underlying asset. Pricing aligns with theoretical models but fluctuates with real-time news, interest rates, and economic indicators.
Futures are bought and sold by hedgers, speculators, and arbitrageurs. Hedgers use them to protect against price risk, speculators aim to profit from price changes, and arbitrageurs exploit price inefficiencies. All transactions occur through organised exchanges like NSE or MCX, ensuring transparency and regulation.
If the spot price of gold is Rs. 60,000 per 10g and the futures price for delivery in two months is Rs. 61,000, then Rs. 61,000 is the future price. It includes carrying costs and market expectations.
Futures model pricing refers to theoretical models like the cost of carry model or expectations model used to determine what a futures contract should be priced at, based on spot price, interest rates, dividends, and time.
Futures prices are calculated using the formula F = S × e^(r − d) × t, where S is spot price, r is interest rate, d is dividend yield, and t is time to expiry. It adjusts the spot price based on holding costs.
Futures pricing is the process of determining what an asset is worth at a future date based on today’s value, interest rates, dividends, storage, and time. It reflects expectations of future supply, demand, and costs involved in holding the asset.
Futures prices offer more transparency and help in managing risk through hedging. They’re often more forward-looking than spot prices. You can also use them to gain exposure to assets without full ownership.
Disclaimer :
The information on this website is provided on "AS IS" basis. Bajaj Broking (BFSL) does not warrant the accuracy of the information given herein, either expressly or impliedly, for any particular purpose and expressly disclaims any warranties of merchantability or suitability for any particular purpose. While BFSL strives to ensure accuracy, it does not guarantee the completeness, reliability, or timeliness of the information. Users are advised to independently verify details and stay updated with any changes.
The information provided on this website is for general informational purposes only and is subject to change without prior notice. BFSL shall not be responsible for any consequences arising from reliance on the information provided herein and shall not be held responsible for all or any actions that may subsequently result in any loss, damage and or liability. Interest rates, fees, and charges etc., are revised from time to time, for the latest details please refer to our Pricing page.
Neither the information, nor any opinion contained in this website constitutes a solicitation or offer by BFSL or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service.
BFSL is acting as distributor for non-broking products/ services such as IPO, Mutual Fund, Insurance, PMS, and NPS. These are not Exchange Traded Products. For more details on risk factors, terms and conditions please read the sales brochure carefully before investing.
Investments in the securities market are subject to market risk, read all related documents carefully before investing. This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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