BEEGUM HAFNA M HAFEES

M.COM F&A( S3)

Roll no 11
 PRICING OF FUTURES

UNDERSTANDING THE DYNAMICS OF

FUTURE CONTRACT PRICING
 TITLE
1. BASIC DIMENTIONS
 FUTURE CONTRACT
 INVESTMENT ASSET &CONSUMTION ASSET
 CONCEPT OF SHORT SALE

2. PRICING OF FUTURES
ANS PLZ
PRICING OF
FUTURES
 Pricing of future contract
 FUTURE CONTRACT
BASIS
COST OF CARRY
CONTANGO MARKET
BACKWARDATION MARKET
CONCEPT OF CONVERGENCE
FUTURE PRICE UNDER COST OF CARRY MODEL
The cost-of-carry model in for futures/ forward
• This is also called as Theoretical minimum price or arbitrage free
price
• Future price = Spot price + Carrying cost – Returns (dividends, etc).
• Example 1
The price of ACC stock on 31 December 2010 was ` 220 and the
futures price on the same stock on the same date, i.e., 31 December
2010 for March 2011 was ` 230. Other features of the contract and
related information are as follows:
Time to expiration - 3 months (0.25 year)
Borrowing rate - 15% p.a.
Annual Dividend on the stock - 25% payable before 31.03. 2011
Face Value of the Stock - ` 10
Based on the above information, determine the futures price for ACC
stock on 31 December 2010
How Will the Arbitrager Act?
Example 1 based question
He will buy the ACC stock at ` 220 by borrowing
the amount @ 15 % for a period of 3 months and
at the same time sell the March 2011 futures on
ACC stock. By 31st March 2011, he will receive
the dividend of ` 2.50 per share. On the expiry
date of 31st March, he will deliver the ACC stock
against the March futures contract sales.
 In case of compounding
• simple example
of a fixed deposit in the bank. ` 100 deposited in the bank at a rate of interest of 10% would be
come ` 110 after one year. Based on annual compounding, the amount will become ` 121 after two
years. Thus, we can say that the forward price of the fixed deposit of ` 100 is ` 110 after one year
and ` 121 after two years.

• In terms of the annual compounding, the forward price can be computed through the following
formula:
A = P (1+r/100)t
• in case there are multiple compounding in a year, say n times per annum, then the above
formula will read as follows:
A = P (1+r/n)nt
• in case the compounding becomes continuous, i.e., more than daily compounding, the above
formula can be simplified mathematically and rewritten as follows:
A = Pert
• Where
e = Called epsilon, is a mathematical constant and has a value of - 2.718.
r = Risk- free Rate of Interest
t = Time Period
Example
Consider a 3-month maturity forward contract on a non-dividend
paying stock. The stock is available for ` 200. With compounded
continuously risk-free rate of interest (CCRRI) of 10 % per annum,
the price of the forward contract would be:
A = 200 x e(0.25)(0.10) = ` 205.06

In case there is cash income accruing to the security like dividends,

the above formula will read as follows:
A = (P-I)ert
Where I is the present value of the income flow during the tenure
of the contract
Example
Consider a 4-month forward contract on 500 shares with each
share priced at ` 75. Dividend @ `2.50 per share is expected to
accrue to the shares in a period of 3 months. The CCRRI is 10% p.a.
Then value of the forward contract will be ?