Assignment

Pricing of financial futures (Cost of carry model)

Department of Commerce, Delhi School of Economics Session: 2021-23

MBA – International Business

In Partial fulfilment of the requirement for the Master degree in

International Business

Submitted By: Submitted To:

Kasi Deepthi Priya Prof. Amit Kumar Singh
 Financial Futures

Financial futures are contracts that allow investors to buy or sell a specific asset at a predetermined
price and date in the future. These contracts are used to hedge against price volatility or to
speculate on the future price movements of the underlying asset. One of the most common
methods used to price financial futures contracts is the cost of carry model.

A quick history

In 1972, the post-WWII Bretton Woods agreement – which attempted to peg the world’s currencies
against the U.S. dollar – had failed. Financial futures in foreign currencies were introduced to help
resolve the crisis, introducing the first non-commodity-based contracts. These innovations are now
among the most vital and actively traded futures in today’s markets.

Three types of Financial Fututures Markets

1. THE FOREIGN CURRENCY MARKET
If you buy products or services in other countries, you must manage the risk of fluctuations
in foreign exchange rates.

EXAMPLE 1

You’re planning a European vacation for your family. The exchange rate you pay when you
convert your money is shaped by euro futures .
2. THE INTEREST RATE MARKET
If you lend or borrow money, you must manage the risk of shifting interest rates to ensure a
steady level of access to your capital .
EXAMPLE 1
You are financing a new car. The interest rate you pay on your loan is stabilized by interest
rate swap futures.

3. THE EQUITY INDEX MARKET

If you invest in stocks, you may want to manage the risk of price changes reflected in
underlying equity indexes such as the S&P 500 and the Dow Jones Industrial Average.
EXAMPLE 1

You contribute to a company-sponsored 401k. The investment manager in charge of the

program uses equity index futures to balance your portfolio, and protect it against sudden
drops in the major stock indexes.
 The cost of carry model

The model assumes that the price of the futures contract will be equal to the sum of the spot price of
the underlying asset, plus the cost of carrying the asset until the delivery date.

The cost of carry model is based on three main components: interest rates, storage costs, and
opportunity costs. Let's take a closer look at each of these components:

Interest Rates:

The interest rate represents the cost of financing the purchase of the underlying asset until the
delivery date of the futures contract. If interest rates are high, then the cost of carrying the asset will
be higher, which will increase the price of the futures contract.

Storage Costs:
Storage costs are expenses associated with holding the underlying asset until the delivery date of the
futures contract. For example, if the underlying asset is a commodity such as oil, then storage costs
may include the cost of renting or leasing storage facilities. Storage costs are typically higher for assets
that are expensive to store or require specialized storage facilities.

Opportunity Costs:
Opportunity costs represent the return that could be earned by investing the money that would be
used to buy the underlying asset. For example, if an investor chooses to buy a futures contract for
gold, then they are foregoing the opportunity to invest that money in another asset that may generate
a higher return. Opportunity costs are typically higher for assets that have lower expected returns.

To calculate the price of a financial futures contract using the cost of carry model, we use the following
formula:

F = S x (1 + r)^T + C - D

Where:

F is the futures price

S is the spot price of the underlying asset

r is the interest rate

T is the time until the delivery date of the futures contract

C is the storage cost

D is any dividends or income earned on the underlying asset

The cost of carry model assumes that the futures price will be equal to the spot price of the underlying
asset (S) plus the cost of carrying the asset until the delivery date, which is represented by (1 + r)^T +
C - D.

Let's say, for example, that an investor wants to buy a futures contract for oil that will be delivered in
six months. The spot price of oil is $60 per barrel, the interest rate is 3%, storage costs are $1 per
barrel per month, and there are no dividends or income earned on the underlying asset. Using the
cost of carry model, we can calculate the price of the futures contract as follows:

F = $60 x (1 + 0.03)^0.5 + $1 x 6 = $63.62

This means that the theoretical price of the futures contract should be $63.62 per barrel.

In conclusion, the cost of carry model is a useful method for pricing financial futures contracts. By
taking into account the costs of carrying the underlying asset until the delivery date, investors can
better understand the theoretical price of the futures contract and make more informed investment
decisions. The cost of carry model is widely used in financial markets and is an essential tool for
traders, investors, and analysts alike.