FUTURES PRICING

THEORIES &
CHARACTERISTICS
Futures Trading is an important economic
activity for the development of any Economy. It is
the first form of Derivatives Trading.


Being a specialized field, to be a successful market
operator (Speculator, Arbitrageur, Trader, Investor or
Hedger) one must have professional expertise and
sound knowledge of the functioning of the Futures
Markets.
Futures Prices
In this chapter, we discuss how futures
contracts are priced. This chapter is organized
into the following sections:
1. Reading Futures Prices
2. The Basis and Spreads
3. Models of Futures Prices


READING THE
FUTURES PRICES
Futures prices are published in
all important Magazines, News
Papers and Journals.
These prices are reported
in Standardized Format.
FUTURES NEWSPAPER QUOTES
(sample)
Open High Low Settle Change High Low
Open
Interest
GOLD
Aug 293 294 292.45 Xxxxxx Xxxxx xxxxx Xxxxx Xxxxxx
Sep 296 297 296 Xxxxxx Xxxxx xxxxx Xxxxx Xxxxxx
Oct 300 302.5 299.5 Xxxxxx Xxxxx xxxxx xxxxx Xxxxxx
Nov 304 306.55 303.55 Xxxxxx Xxxxx xxxxx xxxxx Xxxxxx
Dec 307 309.55 306 xxxxxx Xxxxx xxxxx xxxxx Xxxxxx
Terminology
Expiry Cycle : This appears in the first column on
the left side of the table. Every contract is given an
expiry cycle by the Exchange on the Contract that is
traded. When the delivery date is reached, the
Contract is dropped from the table.
Open : The Open Column refers to the price at which
the first contract of the day was transacted or in other
words the price for the days first trade which
occurs during the designated time period is the
Open Price.
High : The Highest price of the contract recorded
during the day.
Low : The Lowest Price of the contract recorded
during the day.
TERMINOLOGY
Settlement Price : Settlement price is the
price that contracts are traded at the end of
the trading day.
Trading Session Settlement Price :New
term used to reflect round-the-clock trading.
Open Interest : Open interest is the number
of futures contracts for which delivery is
currently obligated.
BASIS
The Basis is an important term in Futures Trading.
The Basis is the difference between the
Current/Cash/Spot Price and the Futures Price of a
particular asset at a Specified Location.
The Futures prices are different from places to
places. Therefore Basis refers to the difference
between the Cash Price and the nearby Futures price
of the Contract.
When the Futures Contract is at Expiration, the
Futures Price and the Spot Price of an Asset becomes
the SAME. This behaviour of the Basis over the time is
known as CONVERGENCE.
Spreads
Where
F
0,t
= The current futures price for delivery of the product
at time t.
This might be the price of a futures contract
on wheat for delivery in 3 months.
F
0,t+k
= The current futures price for delivery of the
product at time t +k.
This might be the price of a futures contract
for wheat for delivery in 6 months.
Spread relationships are important to speculators.
t k t F F Spread , 0 , 0 = +
Spread
A spread is the difference in price between two futures contracts on
the same commodity for two different maturity dates:
Spreads
Suppose that the price of a futures contract on wheat for
delivery in 3 months is Rs. 4000 per Quintal
Suppose further that the price of a futures contract on
wheat for delivery in 6 months is Rs.4500 per Quintal.
What is the spread?





t F k t F Spread , 0 , 0 + =
500 . 4000 . 4500 . Rs Rs Rs Spread = =
Repo Rate
Repo Rate
The repo rate is the finance charges faced by
traders. The repo rate is the interest rate on
repurchase agreements.
A Repurchase Agreement
An agreement where a person sells securities
at one point in time with the understanding
that he/she will repurchase the security at a
certain price at a later time.

Example: Pawn Shop.

Models of Futures Prices
Cost-of-Carry Model
The common way to value a futures contract is by using the Cost-
of-Carry Model. The Cost-of-Carry Model says that the futures
price should depend upon two things:
The current spot price.
The cost of carrying or storing the underlying good from
now until the futures contract matures.
Assumptions:
There are no transaction costs or margin requirements.
There are no restrictions on short selling.
Investors can borrow and lend at the same rate of interest.
CARRYING COSTS
Storage Costs
Insurance Costs
Transportation Costs
Financing Costs.
Cash-and-Carry Arbitrage
A cash-and-carry arbitrage occurs when a
trader borrows money, buys the goods today
for cash and carries the goods to the expiration
of the futures contract. Then, delivers the
commodity against a futures contract and
pays off the loan. Any profit from this strategy
would be an arbitrage profit.


0 1
1. Borrow money
2. Sell futures contract
3. Buy commodity
4. Deliver the commodity
against the futures contract
5. Recover money & payoff
loan
Reverse Cash-and-Carry Arbitrage
A reverse cash-and-carry arbitrage occurs when a
trader sells short a physical asset. The trader
purchases a futures contract, which will be used to
honor the short sale commitment. Then the trader
lends the proceeds at an established rate of interest.
In the future, the trader accepts delivery against the
futures contract and uses the commodity received to
cover the short position. Any profit from this strategy
would be an arbitrage profit.
0 1
1. Sell short the commodity
2. Lend money received
from short sale
3. Buy futures contract
4. Accept delivery from futures
contract
5. Use commodity received
to cover the short sale
Arbitrage Strategies
Table 3.5
Transactions for Arbitrage Strategies
Market

Cash-and-Carry

Reverse Cash-and-
Carry
Debt

Borrow funds

Lend short sale
proceeds
Physical

Buy asset and
store; deliver
against futures

Sell asset short;
secure
proceeds from
short sale
Futures

Sell futures

Buy futures; accept
delivery; return
physical asset to
honor short sale
commitment


Cost-of-Carry Model
) , 0 1 ( 0 , 0 t C S t F + =
Where:
S
0
= the current spot price
F
0,t
= the current futures price for delivery of
the product at time t.
C
0,t
= the percentage cost required to store (or carry) the
commodity from today until time t.
The cost of carrying or storing includes:
1. Storage costs
2. Insurance costs
3. Transportation costs
4. Financing costs

The Cost-of-Carry Model can be expressed as:
Cost-of-Carry Rule 1
The futures price must be less than or equal to the spot price of
the commodity plus the carrying charges necessary to carry the
spot commodity forward to delivery.


Cash-and-Carry Gold Arbitrage Transactions

Prices for the Analysis:

Spot price of gold
$400
Future price of gold (for delivery in one year) $450
Interest rate 10%
Transaction

Cash Flow
t = 0 Borrow $400 for one year at 10%.
Buy 1 ounce of gold in the spot market for
$400.
Sell a futures contract for $450 for deliv-
ery of one ounce in one year.

+$400
- 400
0

Total Cash Flow
$0
t = 1 Remove the gold from storage.
Deliver the ounce of gold against the futu-
res
contract.
Repay loan, including interest.

$0
+450

-440
Total Cash Flow
+$10


) 1 ( , 0 0 , 0 t t C S F + s
Cost-of-Carry Rule 1
0 1
1. Borrow $400
2. Buy 1 oz gold
3. Sell futures contract
4. Deliver gold against
futures contract
5. Repay loan
The Cost-of-Carry Rule 2
Since the futures price must be either less than or equal to the
spot price plus the cost of carrying the commodity forward by rule
And the futures price must be greater than or equal to the spot
price plus the cost of carrying the commodity forward by rule .
The only way that these two rules can reconciled so there is no
arbitrage opportunity is by the cost of carry rule .
Rule #2: the futures price must be equal to the spot price plus the
cost of carrying the commodity forward to the delivery date of the
futures contract.


) 1 ( , 0 0 , 0 t t C S F + =
If prices were not to conform to cost of carry rule #2, a cash-and carry
arbitrage profit could be earned.

Recall that we have assumed away transaction costs, margin
requirements, and restrictions against short selling.
Spreads and The Cost-of-Carry
As we have just seen, there must be a relationship
between the futures price and the spot price on the
same commodity.
Similarly, there must be a relationship between the
futures prices on the same commodity with differing
times to maturity.
The following rules address these relationships:
Cost-of-Carry Rule 3
Cost-of-Carry Rule 4
Cost-of-Carry Rule 5


The Cost-of-Carry Rule 3
The distant futures price must be less than or equal to the nearby
futures price plus the cost of carrying the commodity from the
nearby delivery date to the distant delivery date.


) 1 ( , , 0 , 0 d n n d C F F + s
where d > n
F
0,d
= the futures price at t=0 for the distant delivery
contract maturing at t=d.

F
o,n
= the futures price at t=0 for the nearby delivery contract
maturing at t=n.

C
n,d
= the percentage cost of carrying the good from t=n
to t=d.

If prices were not to conform to cost of carry rule # 3, a cash-and-carry
arbitrage profit could be earned.
Spreads and the Cost-of-Carry

Table 3.6
Gold Forward Cash-and-Carry Arbitrage

Prices for the Analysis

Futures price for gold expiring in 1 year $400
Futures price for gold expiring in 2 years $450
Interest rate (to cover from year 1 to year 2) 10%
Transaction

Cash Flow
t = 0 Buy the futures expiring in 1 year.
Sell the futures expiring in 2 years.
Contract to borrow $400 at 10% for year
1 to year 2.



+$0
0
0

Total Cash Flow
$0
t = 1 Borrow $400 for 1 year at 10% as
contracted at
t = 0.
Take delivery on the futures contract.
Begin to store gold for one year.



+$400

- 400
0
Total Cash Flow
$0

t = 2 Deliver gold to honor futures contract.
Repay loan ($400 x 1.1)



+$450
- 440

Total Cash Flow +
$10


Table 3.6 shows that the spread between two futures contracts
can not exceed the cost of carrying the good from one delivery
date forward to the next, as required by the cost-of-carry rule #3.
The Cost-of-Carry Rule 3
0 1
1. Buy futures contract w/exp
in 1 yrs.
2. Sell futures contract w/exp
in 2 years
3. Contract to borrow $400
from yr 1-2
7. Remove gold from storage
8. Deliver gold against 2 yr. futures contract
9. Pay back loan
2
4. Borrow $400
5. Take delivery on 1 yr to exp
futures contract.
6. Place the gold in storage for one
yr.
The Cost-of-Carry Rule 4
The nearby futures price plus the cost of carrying the
commodity from the nearby delivery date to the distant
delivery date cannot exceed the distant futures price.
Or alternatively, the distant futures price must be greater
than or equal to the nearby futures price plus the cost of
carrying the commodity from the nearby futures date to
the distant futures date.
If prices were not to conform to cost of carry rule # 4, a
reverse cash-and-carry arbitrage profit could be earned.
( )
d n n d
C F F
, , 0 , 0
1+ >
The Cost-of-Carry Rule 4
Table 3.7 illustrates what happens if the nearby futures
price is too high relative to the distant futures price. When
this is the case, a forward reverse cash-and-carry arbitrage
is possible.

Table 3.7
Gold Forward Reverse Cash-and-Carry Arbitrage

Prices for the Analysis:

Futures price for gold expiring in 1 year $440
Futures price for gold expiring in 2 years $450
Interest rate (to cover from year 1 to year 2) 10%

Transaction

Cash Flow

t = 0 Sell the futures expiring in one year.
Buy the futures expiring in two years.
Contract to lend $440 at 10% from year 1
to
year 2.


+$0
0
0

Total Cash Flow
$0

t = 1 Borrow 1 ounce of gold for one year.
Deliver gold against the expiring futures.
Invest proceeds from delivery for one
year.



$0
+ 440
- 440

Total Cash Flow
$0

t = 2 Accept delivery on expiring futures.
Repay 1 ounce of borrowed gold.
Collect on loan of $440 made at t = 1.


- $450
0
+ 484

Total Cash Flow +
$34


The Cost-of-Carry Rule 4
0 1
1. Sell futures contract
w/exp in 1 yrs.
2. Buy futures contract
w/exp in 2 years
3. Contract to lend
$400 from yr 1-2
7. Accept delivery
on exp 2 yr
futures contract
8. Repay 1 oz.
borrowed gold.
9. Collect $400
loan
2
4. Borrow 1 oz. gold
5. Deliver gold on 1
yr to exp futures
contract.
6. Invest proceeds
from delivery for
one yr.
Cost-of-Carry Rule 5
Since the distant futures price must be either less than or equal to
the nearby futures price plus the cost of carrying the commodity
from the nearby delivery date to the distant delivery date by rule
#3.

And the nearby futures price plus the cost of carrying the
commodity from the nearby delivery date to the distant delivery
date can not exceed the distant futures price by rule #4.

The only way that rules 3 and 4 can be reconciled so there is no
arbitrage opportunity is by cost of carry rule #5.

Cost-of-Carry Rule 5
The distant futures price must equal the nearby
futures price plus the cost of carrying the
commodity from the nearby to the distant
delivery date.
If prices were not to conform to cost of carry rule
#5, a cash-and-carry arbitrage profit or reverse
cash-and-carry arbitrage profit could be earned.

Recall that we have assumed away transaction costs,
margin requirements, and restrictions against short
selling.
) 1 ( , , 0 , 0 d n n d C F F + =
Implied Repo Rates
If we solve for C
0,t
in the above equation, and assume that
financing costs are the only costs associated with holding an
asset, the implied cost of carrying the asset from one time point
to another can be estimated. This rate is called the implied repo
rate.
The Cost-of-Carry model gives us:
t C , 0 Solving for
And
) 1 ( , 0 0 , 0 t t C S F + =
) 1 ( , 0
0
, 0
t
t
C
S
F
+ =
t
t
C
S
F
, 0
0
, 0
1=
Implied Repo Rates
Example: cash price is $3.45 and the futures price is
$3.75. The implied repo rate is?

086956 . 0 1
45 . 3 $
75 . 3 $
=
That is, the cost of carrying the asset from today until the expiration
of the futures contract is 8.6956%.

t
t
C
S
F
, 0
0
, 0
1=
The Cost-of-Carry Model in
Imperfect Markets
In real markets, no less than four factors
complicate the Cost-of-Carry Model:
1. Direct transactions costs
2. Unequal borrowing and lending rates
3. Margin and restrictions on short selling
4. Limitations to storage



Transaction Costs
Transaction Costs
Traders generally are faced with transaction costs when
they trade. In this case, the profit on arbitrage
transactions might be reduced or disappear altogether.
Types of Transaction Costs:
Brokerage fees to have their orders executed
A bid ask spread
A market maker on the floor of the exchange needs
to make a profit. He/She does so by paying one
price (the bid price) for a product and selling it for a
higher price (the ask price).

Unequal Borrowing & Lending
Rates
Thus far we have assumed that investors can
borrow and lend at the same rate of interest.
Anyone going to a bank knows that this
possibility generally does not exist.
Incorporating differential borrowing and lending
rates into the Cost-of-Carry Model gives us:
Where:
C
L
= lending rate
C
B
= borrowing rate
) 1 )( 1 ( ) 1 )( 1 ( 0 , 0
0 B
t
L
C T S F C T S + + s s +
Unequal Borrowing & Lending Rates

Table 3.11
Illustration of No-Arbitrage Bounds
with Differential Borrowing and Lending Rates

Prices for the Analysis:

Spot price of gold


$400
Interest rate (borrowing)


12%
Interest rate (lending)


8%
Transaction costs (T )


3%

Upper No-Arbitrage Bound with Transaction Costs and a Borrowing Rate

F0,t < S0(1 + T )(1 + CB ) = $400(1.03)(1.12) = $461.44

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate

F0,t > S0(1 BT )(1 + CL ) = $400(.97)(1.08) = $419.04


Restrictions on Short Selling
Thus far we have assumed that arbitrageurs can sell short
commodities and have unlimited use of the proceeds.
There are two limitations to this in the real world:

It is difficult to sell some commodities short.

Investors are generally not allowed to use all
proceeds from the short sale.

How do limitations on the use of funds from a short sale
affect the Cost-of-Carry Model?
We can examine this by editing our transaction cost and
differential borrowing Cost-of-Carry Model as follows:
Restrictions on Short Selling
The transaction cost and differential cost of borrowing
model is as follows:
We modify this by recognizing that you will not get all of
the proceeds from the short sale. You will get some
portion of the proceeds.
) 1 )( 1 ( ) 1 )( 1 ( 0 , 0 0
B
t
L
C T S F fC T S + + s s +
) 1 )( 1 ( ) 1 )( 1 ( 0 , 0
0 B
t
L
C T S F C T S + + s s +
Where:
= the proportion of funds received
Restrictions on Short Selling
Table 3.12 illustrates the effect of limitations on the use of short
sale proceeds.
Table 3.12
Illustration of No-Arbitrage Bounds
with Various Short Selling Restrictions

Prices for the Analysis:

Spot price of gold
$400
Interest rate (borrowing)


12%
Interest rate (lending)


8%
Transaction costs (T )


3%

Upper No-Arbitrage Bound with Transaction Costs and a Borrowing Rate

F0,t < S0(1 + T )(1 + CB ) = $400(1.03)(1.12) = $461.44

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 1.0

F0,t > S0(1 BT )(1 + fCL ) = $400(.97)[1 + (1.0)(.08)] = $419.04

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 0.75

F0,t > S0(1 B T)(1 + fCL ) = $400(.97)[1 + (.75)(.08)] = $411.28

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 0.5

F0,t > S0(1 BT )(1 + f CL ) = $400(.97)[1 + (0.5)(.08)] = $403.52

Restrictions on Short Selling
The effect of the proceed use limitation is to
widen the no-arbitrage trading bands.
Futures Price
Time
$403.52
$461.44
Limitations on Storage
The ability to undertake certain arbitrage transactions
requires storing the product. Some items are easier to
store than others.
Gold is very easy to store. You simply rent a safe deposit
box at the bank and place your gold there for safekeeping.
Wheat is moderately easy to store.
How about milk or eggs?
They can be stored, but not for long periods of time.
To the extent that a commodity can not be stored, or has
limited storage life, the Cost-of-Carry Model may not hold.
How Traders Deal with Market Imperfections
The costs associated with carrying commodities forward
vary widely among traders.
If you are a floor trader, your transaction costs will be very
low. If you are a farmer with unused grain storage on your
farm, your cost of storage will be very low.
Individuals with lowest trading costs (storage costs, and
cost of borrowing) will have the most profitable arbitrage
opportunities.
The ability to sell short varies between traders.

Convenience Yield
When there is a return for holding a
physical asset, we say there is a
convenience yield.
A convenience yield can cause futures
prices to be below full carry.
In extreme cases, the cash price can
exceed the futures price.
When the cash price exceeds the futures
price, the market is said to be in
backwardation.
Futures Prices and
Expectations
If futures contracts are priced appropriately, the current futures
price should tell us something about what the spot price will be
at some point in the future.
There are four theories about futures prices and future spot
prices:
Expectations or Risk Neutral Theory
Normal Backwardation
Contango
Capital Asset Pricing Model (CAPM)

Speculators play an important role in the futures market, they
ensure that futures prices approximately equal the expected
future spot price.

Expectations or Risk Neutral
Theory

The Expectations Theory says that the futures price equals
the expected future spot price.

Where
=the expected future spot price
) ( 0 , 0 S E F t =
) ( 0 S E
Normal Backwardation

The Normal Backwardation Theory says that futures markets are
primarily driven by hedgers who hold short positions. For
example, farmers who have sold futures contracts to reduce their
price risk.
The hedgers must pay speculators a premium in order to assume
the price risk that the farmer wishes to get rid of.
So speculators take long positions to assume this price risk.
They are rewarded for assuming this price risk when the futures
price increases to match the spot price at maturity.
So this theory implies that the futures price is less than the
expected future spot price.
) ( 0 , 0 S E F t <
Contango

The Contango Theory says that futures markets are
primarily driven by hedgers who hold long positions. For
example, grain millers who have purchased futures
contracts to reduce their price risk.
The hedgers must pay speculators a premium in order to
assume the price risk that the grain miller wishes to get
rid of.
So speculators take short positions to assume this price
risk. They are rewarded for assuming this price risk when
the futures price declines to match the spot price at
maturity.
So this theory implies that the futures price is greater
than the expected future spot price.
) ( 0 , 0 S E F t >
Capital Asset Pricing Model
(CAPM)

The CAPM Theory is consistent with the Normal
Backwardation Theory, the Contango Theory, and the
Expectations Theories.
This model is applied to all kinds of financial
instruments. In general Higher the Risk, Higher will be the
expected return.
The CAPM model leads to the conclusion that there are two
types of Risks SYSTEMATIC & UNSYSTEMATIC
Unsystematic Risk can be eliminated by holding a well
diversified Portfolio. Systematic Risk cannot be diversified
away.
So as per this model, the investors should be compensated
only for Systematic Risk.