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Futures Pricing Formula - 5paisa - 5pschool PDF
Futures Pricing Formula - 5paisa - 5pschool PDF
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Chapter 10 Futures
Pricing Formula
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.
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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.
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.
We will calculate the futures price of ITC through the pricing formula and compare it with the
current futures price in the market.
The stock has not declared any dividend in the current August series.
There are 22 days for expiry 30-9 (taking both the days into consideration)
Solving the above equation, we obtain the futures price of 303.7, which is called its fair value.
However, the actual price in the market, of ITC Aug Futures is 303.5, which is called its market price.
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The price difference between the fair value and prevailing market price occurs due to supply
/demand, liquidity as well as factors such as transaction charges, taxes and margins. But on most
occasions, the theoretical future price would match the market price.
Similarly, we could determine the future price for the mid month and far month contracts.
Div =0
Days to expiry =22+28 (22 days of Aug series +28 days of Sep series)
= 305.4
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Div =0
Days to expiry =22+28 +28 (22 days of Aug series +28 days of Sep series+28 days of October Series)
= 307.04
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There is a difference of Rs. 2.66 between the fair value and the market price. This is due to the low
liquidity that is present. There are hardly any contracts of ITC October Futures which are traded in
the market, hence the premium.
Premium /Discount
If the price of the security is trading higher in the futures market vs. spot price (which is usually the
case) then the futures price is said to be at a premium. While it is said to be trading at a discount if
the futures price is less vs. the spot price. We will now see how a trader can bene t if there is a major
difference in the price of security in the cash and futures market.
Arbitrage
Here we will see how arbitrage strategies can be made use of when there is a difference in price
between the spot market and the futures market.
It is considered a riskless strategy as the gains are locked right at the start and thereafter, it does not
matter in which direction the asset moves.
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But what if Infosys Aug Futures is trading at 1410 drastically deviating from its theoretical price.
According to the formula there should ideally be only a Rs5 difference between the spot and future
price. But if a huge gap is witnessed due to supply demand imbalances, an arbitrage opportunity
arises.
Clearly Infosys is trading above its fair value, and according the arbitrage strategy, we sell the
expensive asset and purchase the cheaper one. In this case, we will sell Infosys futures and purchase
the same quantity of shares in the cash market, knowing that by the end of the series the price of
the futures and spot will converge.
Open Demat
Sell Infosys Account
Futures at in 5 Minutes Mobile Number
1410
I prefer South Indian language.
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Since the lot size of Infosys is 600 we purchase 600 shares of Infosys in the cash market at 1380.
Once we have executed the trade at the expected price you have locked in the spread. So
irrespective of where the market goes by expiry, pro t is guaranteed. The strategy requires us to
square off our positions before expiry i.e. we would have to buy Infosys in the futures market and sell
the 600 shares in the cash market.
This arbitrage strategy between the spot and futures market is known as cash and carry arbitrage.
Expiry Value Spot Trade P&L (Long) Futures Trade P&L (Short) Net P&L
Similarly, if the stock is trading at discount in the futures market compared to its spot price, we can
implement the reverse cash and carry arbitrage strategy. In this strategy it is required that the
trader already has shares in his DP equal to or more than the lot size or its multiple.
Here the trader purchases the future contract and sells the stock in the cash market. At the time of
expiry, a reverse trade has to be executed, as we had seen in the cash and carry arbitrage.
Clearly, the stock is trading at a discount to its fair value, which has been calculated through the
mathematical formula and which had come up to 1385.
Hence, in order to take bene t of the situation, the trader sells 600 shares of Infosys (or multiples of
600 lot size) in the cash market and purchase the proportionate quantity of Infosys in futures
market. In this strategy too, the spread is locked right at the start, and hence, it does not matter at
what price the stock ends on expiry.
Expiry Value Spot Trade P&L (Short) Futures Trade P&L (Long) Net P&L
Through these two examples we see how a trader can bene t if there is a price difference in the spot
and futures market.
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