by A futures contract is nothing more than a standardized forwards contract. The price of a futures contract is determined by the spot price of the underlying asset, adjusted for time and dividend accrued till the expiry of the contract. When the futures contract is initially agreed to, the net present value must be equal for both the buyer and the seller else there would be no consensus between the two. This difference in price between the futures price and the spot price is called the “basis or spread”.
The futures pricing formula is used to determine the price of the futures contract and it is the main reason for the difference in price between the spot and the futures market. The spread between the two is the maximum at the start of the series and tends to converge as the settlement date approaches. The price of the futures contract and its underlying asset must necessarily converge on the expiry date.
The spot future parity i.e. difference between the spot and futures price arises due to variables such as interest rates, dividends, time to expiry, etc. It is a mathematical expression to equate the underlying price and its corresponding futures price.
According to the futures pricing formula:
Futures price = (Spot Price*(1+rf))- Div)
Where,
Spot Price is the price of the stock in the cash market.
rf = Risk free rate (T Bill/ Government securities)
d: Dividend paid by the company
A key point to take note of is ‘r’ is the risk free interest that we can earn for the entire year but since the future contracts expires in 1, 2 or 3 months, we require to adjust the formula proportionately.
Futures price = Spot price * [1+ rf*(x/365) – d]
x = number of days to expiry
One can take the RBI’s 91 or 182 days Treasury bill as a proxy for the short term risk free rate. The ongoing rate can be referred from RBI’s website. The prevailing rate in the market for 91 and 182 day t bill is ~6.68% and ~6.92% respectively.
Buying vs. selling futures contracts: Futures are a standardized legal agreements. The buyer has a long position, and a seller has a short position in the futures.
Clearing house: Futures are traded in an active market through an exchange, also called a clearing house. In India, the National Stock Exchange of India Limited (NSE) partakes in futures trading through futures index.
Margin requirement: Margin is the amount deposited in the clearing house by the parties. It acts as an assurance that parties will honor the contract when the time comes. Both parties need to deposit a margin at the beginning of the trade. Due to marking to market process, if the initial margin falls below the maintenance amount, the party receives a margin call.
Marking to market: It is a process to settle future prices daily. The futures price rise or fall daily because of active trading. Clearing houses have adopted a means to pay the price difference after each trading by debiting and crediting the differential amount from the margin amount deposited by the parties.
Expected Spot Price
The market’s average opinion about what the spot price of an asset will be at a specific time in the future. This is usually based on the returns investors require on an investment in the asset underlying a futures contract. In turn, these returns depend on the systematic risk of an investment. When the return from the underlying asset is uncorrelated with the broader stock market, the futures price can be viewed as an unbiased estimate of the expected future spot price. If the return is positively correlated with the broader market, the asset underlying the futures contract has positive systematic risk, and the futures price is lower than the expected future spot price. This situation is known as normal backwardation.
However, if the return from the asset is negatively correlated with the broader market, then the asset underlying the futures contract has negative systematic risk, and the futures price is higher than the expected future spot price. This situation is known as contango.
