November 02, 2023
5 mins read
This blog explains futures pricing and how futures contract prices are calculated using practical models like cost of carry and arbitrage pricing. It covers pricing formulas, key influencing factors, market mechanisms, and different pricing models, helping traders and investors understand fair value, manage risk, and make informed futures trading decisions.
Future pricing is the way to figure out the fair value of a futures contract, which is a deal to purchase or sell an underlying asset at a fixed price on a set date in the future. The current spot price of the asset is not the only thing that determines the price of a futures contract. Instead, it is figured out by adding the cost of storing or carrying the item until the end of the period.
This cost can include interest, storage, and other costs. Futures pricing commonly uses a cost-of-carry framework: carrying costs (e.g., financing, storage where applicable) are added, and known income/yield (e.g., expected dividends, convenience yield as applicable) is adjusted, consistent with no-arbitrage logic. The no-arbitrage concept is the main notion underpinning futures pricing. This means that there shouldn't be a way to make money without taking any risks between the spot and futures markets. Arbitrageurs are traders who make transactions to bring prices back to normal if there is a price discrepancy.
Futures pricing makes sure that everyone knows what the prices are, helps traders set price expectations, and makes all financial markets the same. It is very significant for hedging, speculating, and risk management, especially when it comes to equities, commodities, and currency futures.
The price of a futures contract is generally calculated using the cost-of-carry model, which establishes the fair value of a futures contract by considering both the current market price of the underlying asset and the cost or benefit of holding it until the expiry date. In simple terms, the futures price reflects what the asset should logically be worth on the settlement day if there are no risk-free profit opportunities in the market. The formula commonly used is:
Futures Price = Spot Price × (1 + Risk-Free Interest Rate × Time to Expiry) – Expected Income or Yield. A common representation is F = S × e^{(r + carrying costs − income/yield)T}; the exact form depends on the asset and assumptions (discrete/continuous compounding).
Here, the spot price refers to the current market price of the asset. The risk-free interest rate typically represents the return on government-backed securities for the same time period, and the time to expiry is measured in days, months, or years, depending on the contract. The expected income or yield may include dividends in the case of equity futures or benefits arising from holding certain commodities.
The result of this calculation is known as the theoretical price, which acts as a benchmark. However, the actual market price may differ due to factors such as market speculation, transaction costs, liquidity, demand-supply changes, and investor sentiment.
When a noticeable difference arises between the theoretical and market prices, traders may execute arbitrage strategies to benefit from the price gap, helping the market return to equilibrium. Therefore, while the formula provides a structured and logical valuation, real-world pricing also reflects behavioural and market-driven influences.
When evaluating futures pricing, it is important to understand several influencing factors beyond the basic formula. The most common concept is the basis, which is the difference between the spot price and the futures price.
This difference can widen or narrow depending on interest rates, carrying costs, and time left until expiry. As the expiry date approaches, convergence normally occurs, meaning the futures price tends to move closer to the spot price. Traders should also consider market liquidity, volatility, and expected returns while analysing price behaviour, as these elements can cause short-term deviations from the theoretical value.
Margin Requirement: When trading futures, you don’t have to pay the full price of the contract. You only pay a small amount, margin call, as a security deposit.
Mark-to-Market (MTM): Every day, your profit or loss is calculated based on how the price moves. If the price goes your way, you earn money. You lose money if it goes against you. This cycle continues until you close the trade or it expires.
Convergence Principle: As the expiry date comes closer, the futures price slowly moves closer to the actual market price of the asset. By the expiry date, both prices usually become almost the same.
Assumptions vs Reality: The formula for pricing assumes that markets are perfect, cheap to trade in, and without easy profit tricks. But real markets can change due to news, demand, supply, and investor mood.
Also Read: OTM Call Options
There are mainly two commonly discussed models for pricing futures contracts: the cost-of-carry model and the expectancy model.
The cost-of-Carry Model is the most widely used. It explains that the futures price should be equal to the current market (spot) price plus the cost of holding or carrying the asset until the contract expires. These carrying costs may include interest, storage, insurance, or other expenses. If the asset provides any benefit, such as dividends or yield, that value is subtracted. This model is based on the idea that no trader should be able to make a risk-free profit, so spot and futures prices must stay logically linked.
The Expectancy Model, however, is based on traders' beliefs about the asset's price at expiry. Here, the futures price reflects market expectations and sentiment rather than only cost calculations, making it more market-driven and speculative.
Buy the underlying asset in the spot market.
Simultaneously sell an equivalent futures contract.
Hold until expiry, incurring carry costs (like interest).
Arbitrage seeks to capture pricing discrepancies; actual outcomes depend on transaction costs, funding, execution, and settlement factors
Futures pricing is grounded in the cost-of-carry model: you calculate what it would cost to hold the asset (borrowing cost, storage, etc.) and subtract expected benefits like dividends. This is a fair theoretical price, but real-world futures often deviate from this because of transaction costs, trader expectations, and margin requirements. Arbitrage helps bring futures prices back in line, but it’s rarely frictionless. Understanding these forces equips you to trade futures more intelligently and spot potential mispricings.
Share this article: 
No Data Found
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 :
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.
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 securities are quoted as an example and not as a recommendation. Past performance is not necessarily a guide to future performance.
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.
Content Partner - Dalal Street Investment Journal Wealth Advisory Private Limited
This article is for educational purposes only and should not be considered investment advice. Market investments are subject to risks. DSIJ Wealth Advisory Private Limited is a SEBI-registered Research Analyst (Reg. No: INH000006396) and Investment Adviser (Reg. No: INA000001142). Please consult your financial adviser before investing.
For more disclaimer, check here : https://www.bajajbroking.in/disclaimer
Level up your stock market experience: Download the Bajaj Broking App for effortless investing and trading
Open Your Free Demat Account
Enjoy low brokerage on delivery trades
|
Please Enter Mobile Number
Open Your Free Demat Account
Enjoy low brokerage on delivery trades
|
