All You Need to Know about Futures Pricing

Things to Consider in Futures Pricing

Divergence in futures price and spot price is mainly due to interest rates and expiry dates. This variance between these two forms the ‘basis of spread’. The spread is the maximum at the start of the series but gradually converges as the settlement date nears. Here spread refers to the difference between the spot and the futures price.

The spot price and futures price are almost equal on the expiration date. 

Things to Understand in Futures Pricing

Here are certain aspects that individuals should understand regarding futures pricing:

• Buying and Selling Futures Contracts

Contracts are legal agreements between a buyer and a seller. For example, a buyer may take a long position in future, whereas a seller may take a short position.

• Margin 

Margin is the amount of money deposited by both parties with stockbrokers at the beginning of a trade. It acts as an assurance that both parties will honour their commitments on contract expiry. If the initial amount falls below the maintenance amount, the parties may receive a margin call.

Also read How to Trade in Futures and Options

• Mark to Market

Mark to market is a process to settle futures prices daily. Futures’ prices may see a rise or fall in their value due to active trading throughout the day. Mark to market calculations is done daily after the closing of trading hours. Clearinghouses pay the price differences daily.

The P&L account is credited and debited with the differential amount from the margin deposited with clearinghouses on the same day. 

Different Future Pricing Models 

Two types of future pricing models are given below:

• Cost-carry Model

It assumes that markets are perfectly efficient. This means no difference between spot and futures prices, and it thereby eliminates any chance of arbitrage. Arbitrage is a process by which traders take advantage of a price difference in two markets.

Under this model, traders are indifferent towards both markets as their earnings are the same from both. Futures price will be equal to spot price plus the net cost of carrying the assets till expiry.

Therefore, Futures pricing = Spot pricing + (Carry cost – Carrying return)

Here carrying costs may include storage costs, interest paid to acquire assets or financing costs. Carrying returns will include any income earned with these assets, like dividends and bonuses. The net of these is the net carrying cost.  

• Expectancy Model

This model is based on expected pricing trends. Futures pricing of an asset is what the expected spot price will be in future. Futures prices will be positive if markets are bullish, whereas pricing will be negative if markets exhibit bearish sentiments. In this model only, the expected future spot price is taken into consideration. 

Final Word 

Futures pricing is dependent on various factors like interest, returns, and financing costs. One should understand how futures pricing works to plan their position in markets more efficiently.

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