The notion of futures pricing is essential; nevertheless, many investors do not have the opportunity to learn about it. This is because most futures traders are conducted using research and analysis, which does not need prior knowledge of the price of futures contracts.
However, a different kind of trader in the futures market employs quantitative trading tactics. These traders are known as algorithmic traders. Examples of this tactics category include calendar spread and index arbitrage, among others. In such instances, having some knowledge of the system used to determine prices might be beneficial, which can be achieved by using certain formulae.
Futures trading that is formula-based adheres to a trading strategy known as “calculated risk,” even though trading generally involves some degree of uncertainty due to the very nature of the activity.
The Futures prices can be calculated using the future pricing formula, which is an essential part of futures trading. To know more about this formula and what it is all about, continue reading below. A comprehensive description of everything about this formula is provided below to help you understand and develop a better understanding of this formula.
Before you know about the future pricing formula, it is essential that you have a clear understanding of futures trading.
To comprehend the futures pricing formula and its significance to futures trading, you must first understand its meaning.
In its most basic terms, a futures contract is a commitment to sell or purchase an asset at an agreed-upon price at a future date, and trading of such assets is known as futures trading.
Typically, futures contracts include exchange-based trading in which one party commits to acquiring a set quantity of a commodity or securities on a specified date. The party that is the seller undertakes to deliver the commodity or securities on the specified date.
Now that you know what future trading is, you might be wondering what the future pricing formula is and how it relates to future trading.
As mentioned earlier, future trading is done when the asset is traded on a future date, and the price of that contract at that time would be known as the future price.
Futures prices are decided by the underlying asset’s price and fluctuate in tandem.
Futures prices will increase if the underlying price rises and decrease if it declines. However, it is not necessarily equivalent to its underlying asset’s worth. They may be exchanged on the market at various rates.
For instance, an item’s spot price and future price may vary, and this price disparity is known as the Spot-Future parity. So, why do prices fluctuate throughout various periods? Interest rates, dividends, and time to maturity are three factors that influence the value of a bond, and these elements are included in the futures pricing formula.
As said previously, the formula for futures price is a mathematical depiction of how the price of futures changes in response to a change in any market variable. The expression is given as follows:
The Future Price = Spot Price × (1+ rf -d )
Where
rf stands for the risk-free rate.
d stands for the dividend.
The above mathematical expression is the Futures pricing formula and can be used to calculate the futures prices.
In a risk-free environment, you may earn a risk-free rate throughout the year. Treasury bills are an excellent illustration of a risk-free rate, and one may change it proportionally for two or three months till the futures contract expires.
With this modification, the Theoretical future pricing formula becomes
The Future Price = Spot price × [1 + rf × (x/365)-d]
Where
x indicates the number of days till expiration.
Let’s illustrate using an instance. To help facilitate computation, the following values are assumed.
The spot cost of ABC company is Rs. 2,380.5.
The risk-free rate is 8.3528 per cent.
Days till expiration = 7
The Futures Price = 2380.5 x [1+8.3528 (7/365)] – 0
We have assumed that the corporation is not paying a dividend on it and thus deemed it zero. However, dividends paid will also be included in the calculation.
This futures pricing algorithm yields the so-called “fair value.” The discrepancy between the fair value and the market price is due to taxes, transaction fees, margin, and other factors. Using the above theoretical future pricing formula, you may compute a fair value for any expiry days.
Now that you know the future price formula, you might be curious to see how the future pricing formula is determined. To know that continue reading below.
The future pricing formula is determined by considering various factors. The factors used to determine the futures pricing formula are:
Other than that, future prices are also dependent on the spot price. So, you might think, how is the future price different from the spot price?
It may seem strange that a product may have two prices simultaneously, but it is relatively frequent in the commodities trading industry. Every commodity is valued in two ways: its spot price and its futures prices. A commodity is an essential category of natural or agricultural commodities in their natural form, such as gold, oil, wheat, and meat.
Spot prices and futures prices are both quotations for a purchase contract, which is the agreed-upon price of the commodity between the buyer and seller. The transaction’s time and the commodity’s maturity date differentiate them. One relates to an agreement that will be implemented immediately; the other to a deal that will occur in the future, often a few months from now.
The futures price pertains to a transaction involving the commodity that will occur in the future—a purchaser of commodities futures locks in a price for anticipated delivery.
The futures price of a commodity is based on its current spot price plus the cost of carrying it till delivery. Carry cost refers to the cost of storing the commodity, which includes interest, insurance, and other incidental charges.
The spot price is the current market price at which a security, commodity, or currency may be purchased or sold for immediate delivery. A futures price is the price agreed upon in a contract between two parties for the sale and delivery of an item at a future date and time.
Now that you know how the future pricing is done and what affects the future price, you should also thoroughly understand the future pricing method.
There are two kinds of future pricing models:
It presupposes complete market efficiency. This indicates no difference between the spot and futures prices, which removes the possibility of arbitrage. Arbitrage is the method through which traders profit from a price disparity between two marketplaces. Under this concept, traders are indifferent to both markets because their profits are the same. Futures prices will equal spot prices plus the net cost of holding assets until expiration.
Futures price equals spot pricing plus (carry cost). Here, carrying costs may include storage fees, interest paid to buy assets, or financing expenses. Carrying returns will consist of any dividends and bonuses received with these investments, and the sum of these components is the net carrying cost.
This model is based on anticipated price movements. Futures pricing of an asset represents the predicted future spot price, and futures prices will be favourable when market sentiment is bullish and negative when market sentiment is bearish. Only in this model is the anticipated future spot price taken into account.
Futures exchanges serve as marketplaces for buyers and sellers of contracts. Contract buyers are known as long position holders, while sellers are known as short positions. The contract may require both parties to deposit a portion of the contract’s worth with a mutually trusted third party as a kind of security if the price goes against them. The margin in gold futures trading may range from 2% to 20%, depending on the volatility of the spot market.
Futures contracts on the value of a particular stock market index are known as stock futures.
Futures contracts on stocks are a high-risk investment. Futures contracts on stock market indexes are also used to gauge the market mood. The stock market futures pricing formula is
Futures Price = Stock Price × (1 + Risk-Free Interest Rate – Dividend Yield).
Futures are inherently priced based on their spot value; similarly, stocks follow a similar pattern when being priced.
With its focus on a later date, futures contracts are designed to reduce the risk of default by one or both parties during the interim period. This is why the futures market asks for a performance bond or margin from buyers and sellers. Margins must be maintained throughout the contract’s life to ensure the agreement since supply and demand might modify the contract’s price, resulting in one party losing money at the cost of the other.
The product is marked to market daily so that the gap between its agreed-upon price and the actual daily futures price is re-evaluated. This helps to limit the risk of default.
The futures exchange will pull money from the losing party’s margin account and deposit it into the account of the winning party, ensuring that the right loss or profit is shown each day. This is known as the variation margin. A margin call is issued whenever the account’s margin account falls below a certain threshold established by the exchange.
Since any gain or loss has already been resolved by marking to market, the amount exchanged on the delivery date is not the contract price but the spot value.
That leads us to an essential part of future pricing: the arbitrage of future pricing and how it is involved with the Stock index futures pricing formula.
Arbitrage is an trading method in which a trader simultaneously purchases and sells an asset on separate marketplaces to benefit from a price discrepancy. Even though pricing variations are often tiny and transient, the returns may be substantial when compounded by a high volume.
Hedge funds and other sophisticated investors often leverage arbitrage. Arbitrage is a trading method used by traders all over the globe due to the absence of risk for the arbitrager.
Let us consider an ABC Company situation:
Spot-Price Given Rs.1280
Risk-Free Rate (Rf) = 6.68 per cent
Days till expiration (x) = 22
Dividend = 0
Using the pricing formula for futures, the value is
Futures price = 1280*(1+6.68 per cent (22/365)) – 0
Futures price = 1285.15
According to the Stock index futures pricing formula, the futures price would only increase by Rs 5.
Arbitrage becomes possible if a significant price differential occurs due to an imbalance between supply and demand.
The realisation of profits is the most crucial aspect of an arbitrage deal. You have secured a risk-free arbitrage return, but how can you realise your earnings? On the cash market, selling shares might generate money. There are two methods to realise the lock-in profit on an arbitrage transaction in the arbitrage market.
You may realise the advantage of arbitrage by closing your transaction, which involves closing your long equities position and short futures position.
Or depending on the spread, you may keep your cash market position in your portfolio, but you may roll over your futures position to the next contract.
This is all you need to know about the arbitrage of future pricing and how it can affect future trading.
Conclusion
Futures trading requires knowledge and experience. Several factors impact future pricing on the market. Future pricing is affected by numerous variables and characteristics, especially the interest and financial costs,
However, mastering the futures pricing formula is an excellent beginning, and it will assist you in better comprehending future quotes and preparing your strategy. Hopefully, the above article gave you a thorough and clear understanding of futures trading and its most crucial aspect, the future pricing formula.
Here are a few characteristics of futures pricing that you should understand:
The purchase and sale of futures contracts
Legal arrangements between a buyer and a seller are contracts. A buyer may take a long position in the future, while a seller would take a short post.
Margin
The margin is the money both parties deposit with their stockbrokers at the outset of a deal. It guarantees that both parties will fulfil their contractual obligations upon contract expiration. A margin call may be issued if the original amount falls below the maintenance amount.
Mark to market
Mark to market is a method for settling daily futures prices. Due to active trading throughout the day, futures prices may increase or decrease in value. Mark to market computations are performed daily after the end of trading hours. Clearing houses pay every day for pricing disparities. On the same day, the P&L account is credited and debited with the difference between the margin amount deposited with clearinghouses and the amount owed.
Knowing the above definitions can better help you in understanding future pricing.
A spot commodity is sold to be delivered to the buyer within a short period, either immediately or within a few days. Contrast a spot commodity with commodity futures, where the buyer obtains delivery of the commodity at a future point in time.
There are two fundamental methods to price commodities: the spot price and the futures price.
The spot price, also known as the cash or market price, indicates the commodity's current market or exchange price. It would be the cost of the commodity if you purchased it today for immediate delivery.
In contrast, the futures price is specified in a futures contract, an agreement between two parties to purchase or sell a commodity at a fixed price on a future delivery date.
Supply and demand have a significant impact on the spot price of commodities. In turn, the spot price is the foundation for the futures price. The futures price is also affected by the expectation for supply and demand of the commodity and the cost of keeping it until it is sold.
Futures contracts are a kind of investment that allows the purchaser to speculate on the future price of a commodity or other asset.
Numerous kinds of futures contracts are available. These may be backed by commodities, stock market indexes, currencies, or agricultural goods.
Futures contracts, as opposed to forwarding contracts, which are tailored between the parties involved, are traded on structured exchanges such as those run by CME Group Inc. (CME). Futures contracts are popular with traders who want to benefit from price fluctuations and business clients who desire to hedge their risks.
Futures contracts are a derivative product, yes. Crude oil futures are derivatives since their value is dependent on the importance of an underlying asset, such as oil. Like many other derivatives, futures are leveraged financial products with the potential for enormous profits or losses. As such, they are often regarded as sophisticated trading products and are typically traded exclusively by institutions and experienced investors.
Traders that hold futures contracts until expiry often settle their positions with cash. In other words, the trader will pay or get a cash settlement based on whether the underlying asset rose or fell over the holding term.
However, futures contracts may sometimes necessitate physical delivery. In this case, the contract holder would receive possession of the underlying asset upon expiry. They would be liable for the products and the fees associated with material handling, physical storage, and insurance.
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