How Is the Price of a Futures Contract Determined?
Traders often use futures contracts to speculate prices of underlying assets and profit from their movements. So, if you are a trader who wants to learn how futures prices are determined, give this blog a read. You will get a clear understanding of how things work.
What Are Futures Contracts?
Futures contracts are legal agreements between two parties to buy or sell a particular underlying asset at a prefixed time and expiry date. You can trade them on the National Stock Exchange (NSE), Bombay Stock Exchange (BSE), National Spot Exchange, etc.
They are standardised derivatives trading options that eliminate possibilities of counterparty risks. The reason being exchange clearing houses make a guarantee that the parties involved will honour the contract terms.
A futures contract generally has two kinds of market participants – hedgers and speculators. Hedgers are generally buyers or commodity producers who aim to protect themselves from market fluctuations by taking another contrarian trade along with primary position. Inversely, speculators are traders or portfolio managers who want to predict the price movements of a particular asset.
How Do Futures Contracts Work? – Example
Suppose Ajay, a wheat merchant wants to sell his produce to a company called AK Agro Limited. Now, the wheat merchant is concerned about the fluctuation of commodity values in the coming months when he is supposed to reap his harvest.
How Are Futures Contract Prices Determined?
A futures contract’s value depends on its underlying asset’s market value. Thus, the agreement’s value will change with fluctuations in the asset’s price.
An asset’s spot and future price generally move in the same direction; however, they are not always the same. The difference between these two values is known as Spot-Futures parity, and several factors affect this, like margins, transaction charges, taxes, etc.
Here is a formula that can help you calculate futures prices:
Futures Prices = Spot Price * [1 + RF * (X/365)] – D
Here, RF stands for rate of risk-free return, X is the number of days remaining till expiry and D denotes dividends paid by the company till expiration.
To understand how this formula works, let’s take the help as an example.
Suppose Stock R’s spot price is ₹2,000, RF is 7% and days till expiry(X) is 23. Now, the company declares a dividend (D) of ₹2 that needs to be paid before the contract expires.
Thus, the calculation will be,
= ₹2,000 * [1 + 0.07 * (23/365)] – 2
= ₹2,000 * [1 + 0.07 * 0.063] – 2
So, the futures price will be higher by ₹6.82.
The concepts of premiums and discounts come into play due to the gap between the spot and future prices. When the futures price is higher than the spot price, the futures are considered to be trading at a premium. Alternatively, if the futures price is less than the spot price, they are said to be trading at a discount. However, the parity decreases as the expiry nears.
Now, take a look at the futures and spot price movements:
- When the contract starts, the difference between the spot and future prices is high.
- Sometimes, due to short-term imbalances of demand and supply, future prices can be lower than the spot price. In these situations, it can be said that the futures are trading at a discount.
- The spot and futures prices converge on the expiry date, whether they are trading at a premium or discount. Their gap or time value becomes zero. If you do not square off your position on the expiry date, the exchange will square it off on your behalf. The settlement price will be equal to the spot price as of expiry, and both spot and futures prices are the same.
Now that you know the price movements, it’s time to gain insight into the strategies you can use to get the maximum profits.
Things to Keep in Mind About Futures Contracts Pricing
Here are a few things to understand about pricing of futures contracts:
Before entering a futures contract, you and the other parties involved must deposit a margin amount with a broker. This assures that both parties will honour their part of the bargain upon contract expiry. The parties concerned may also receive a margin call if the initial deposit falls below the maintenance amount.
- Mark to Market
Mark to market is a procedure that regularly settles the prices of futures contracts. These calculations are generally conducted daily after the stock market closes, and clearing houses pay the price differences. The differential amount is adjusted in the Profit and Loss Account from the deposited margin on a daily basis.
What Are the Different Futures Pricing Models?
Here are two common futures pricing models that most traders use:
- Expectancy Model
In this model, an asset’s futures pricing depends on its future spot price trends. So, this prediction will be positive in case market predictions are bullish and negative if the outlook is bearish.
- Cost-carry Model
The Cost-carry model assumes that the market is performing efficiently, i.e., there will not be any gap between spot and future prices. This also eliminates any chances of arbitrage. Thus, traders are indifferent towards both markets as they will earn the same from both.
So, the futures price will be equal to the sum of the spot price and carrying costs after deducting the carrying return.
Futures price = Spot price + (Carry cost – Carrying return)
The expenses associated with holding assets, such as storage costs and interest paid for acquisition or financing, are referred to as carrying costs. On the other hand, any income generated by these assets, such as dividends and bonuses, is considered carrying returns. The difference between the two is the net carrying cost.
Traders determine the prices of futures contracts using a lot of analytics. They also depend upon several aspects like financing costs, returns and interest. Thus, if you want to use futures, a thorough study on this aspect is crucial. Moreover, you can seek guidance from veteran traders for clearer insight.
Do futures prices affect stock prices?
Futures is a derivative instrument, where its price is derived from the underlying movements. However, it can be useful before opening of market hours to determine the opening price. Also, this is mainly applicable to index futures, as they are traded globally and globally futures markets rarely close. Stock futures can’t help predict spot prices.
Can I lose more than my initial investment while trading futures?
There is always a chance of losing more than your initial investment in the case of futures trading. This is because futures are traded on a margin which can be 15-20% of the total cost price of the underlying as per the lot size. Hence if the underlying falls more than 15%-20%, your initial investment will be eroded and also you may be required to provide additional margin.