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THEORIES &

CHARACTERISTICS

•Futures Trading is an important economic

activity for the development of any Economy. It is

the first form of Derivatives Trading.

•Being a specialized field, to be a successful market

operator (Speculator, Arbitrageur, Trader, Investor or

Hedger) one must have professional expertise and

sound knowledge of the functioning of the Futures

Markets.

Futures Prices

In this chapter, we discuss how futures

contracts are priced. This chapter is organized

into the following sections:

1. Reading Futures Prices

2. The Basis and Spreads

3. Models of Futures Prices

READING THE

FUTURES PRICES

Futures prices are published in

all important Magazines, News

Papers and Journals.

These prices are reported

in Standardized Format.

FUTURES NEWSPAPER QUOTES

(sample)

Open High Low Settle Change High Low

Open

Interest

GOLD

Aug 293 294 292.45 Xxxxxx Xxxxx xxxxx Xxxxx Xxxxxx

Sep 296 297 296 Xxxxxx Xxxxx xxxxx Xxxxx Xxxxxx

Oct 300 302.5 299.5 Xxxxxx Xxxxx xxxxx xxxxx Xxxxxx

Nov 304 306.55 303.55 Xxxxxx Xxxxx xxxxx xxxxx Xxxxxx

Dec 307 309.55 306 xxxxxx Xxxxx xxxxx xxxxx Xxxxxx

Terminology

•Expiry Cycle : This appears in the first column on

the left side of the table. Every contract is given an

expiry cycle by the Exchange on the Contract that is

traded. When the delivery date is reached, the

Contract is dropped from the table.

•Open : The Open Column refers to the price at which

the first contract of the day was transacted or in other

words ‘the price for the day’s first trade which

occurs during the designated time period’ is the

Open Price.

•High : The Highest price of the contract recorded

during the day.

•Low : The Lowest Price of the contract recorded

during the day.

TERMINOLOGY

•Settlement Price : Settlement price is the

price that contracts are traded at the end of

the trading day.

•Trading Session Settlement Price :New

term used to reflect round-the-clock trading.

•Open Interest : Open interest is the number

of futures contracts for which delivery is

currently obligated.

BASIS

•The Basis is an important term in Futures Trading.

The Basis is the difference between the

Current/Cash/Spot Price and the Futures Price of a

particular asset at a Specified Location.

•The Futures prices are different from places to

places. Therefore Basis refers to the difference

between the Cash Price and the nearby Futures price

of the Contract.

•When the Futures Contract is at Expiration, the

Futures Price and the Spot Price of an Asset becomes

the SAME. This behaviour of the Basis over the time is

known as CONVERGENCE.

Spreads

Where

F

0,t

= The current futures price for delivery of the product

at time t.

This might be the price of a futures contract

on wheat for delivery in 3 months.

F

0,t+k

= The current futures price for delivery of the

product at time t +k.

This might be the price of a futures contract

for wheat for delivery in 6 months.

Spread relationships are important to speculators.

t k t F F Spread , 0 , 0 ÷ = +

Spread

A spread is the difference in price between two futures contracts on

the same commodity for two different maturity dates:

Spreads

Suppose that the price of a futures contract on wheat for

delivery in 3 months is Rs. 4000 per Quintal

Suppose further that the price of a futures contract on

wheat for delivery in 6 months is Rs.4500 per Quintal.

What is the spread?

t F k t F Spread , 0 , 0 ÷ + =

500 . 4000 . 4500 . Rs Rs Rs Spread = ÷ =

Repo Rate

Repo Rate

The repo rate is the finance charges faced by

traders. The repo rate is the interest rate on

repurchase agreements.

A Repurchase Agreement

An agreement where a person sells securities

at one point in time with the understanding

that he/she will repurchase the security at a

certain price at a later time.

Example: Pawn Shop.

Models of Futures Prices

Cost-of-Carry Model

The common way to value a futures contract is by using the Cost-

of-Carry Model. The Cost-of-Carry Model says that the futures

price should depend upon two things:

– The current spot price.

– The cost of carrying or storing the underlying good from

now until the futures contract matures.

Assumptions:

– There are no transaction costs or margin requirements.

– There are no restrictions on short selling.

– Investors can borrow and lend at the same rate of interest.

CARRYING COSTS

Storage Costs

Insurance Costs

Transportation Costs

Financing Costs.

Cash-and-Carry Arbitrage

A cash-and-carry arbitrage occurs when a

trader borrows money, buys the goods today

for cash and carries the goods to the expiration

of the futures contract. Then, delivers the

commodity against a futures contract and

pays off the loan. Any profit from this strategy

would be an arbitrage profit.

0 1

1. Borrow money

2. Sell futures contract

3. Buy commodity

4. Deliver the commodity

against the futures contract

5. Recover money & payoff

loan

Reverse Cash-and-Carry Arbitrage

A reverse cash-and-carry arbitrage occurs when a

trader sells short a physical asset. The trader

purchases a futures contract, which will be used to

honor the short sale commitment. Then the trader

lends the proceeds at an established rate of interest.

In the future, the trader accepts delivery against the

futures contract and uses the commodity received to

cover the short position. Any profit from this strategy

would be an arbitrage profit.

0 1

1. Sell short the commodity

2. Lend money received

from short sale

3. Buy futures contract

4. Accept delivery from futures

contract

5. Use commodity received

to cover the short sale

Arbitrage Strategies

Table 3.5

Transactions for Arbitrage Strategies

Market

Cash-and-Carry

Reverse Cash-and-

Carry

Debt

Borrow funds

Lend short sale

proceeds

Physical

Buy asset and

store; deliver

against futures

Sell asset short;

secure

proceeds from

short sale

Futures

Sell futures

Buy futures; accept

delivery; return

physical asset to

honor short sale

commitment

Cost-of-Carry Model

) , 0 1 ( 0 , 0 t C S t F + =

Where:

S

0

= the current spot price

F

0,t

= the current futures price for delivery of

the product at time t.

C

0,t

= the percentage cost required to store (or carry) the

commodity from today until time t.

The cost of carrying or storing includes:

1. Storage costs

2. Insurance costs

3. Transportation costs

4. Financing costs

The Cost-of-Carry Model can be expressed as:

Cost-of-Carry Rule 1

The futures price must be less than or equal to the spot price of

the commodity plus the carrying charges necessary to carry the

spot commodity forward to delivery.

Cash-and-Carry Gold Arbitrage Transactions

Prices for the Analysis:

Spot price of gold

$400

Future price of gold (for delivery in one year) $450

Interest rate 10%

Transaction

Cash Flow

t = 0 Borrow $400 for one year at 10%.

Buy 1 ounce of gold in the spot market for

$400.

Sell a futures contract for $450 for deliv-

ery of one ounce in one year.

+$400

- 400

0

Total Cash Flow

$0

t = 1 Remove the gold from storage.

Deliver the ounce of gold against the futu-

res

contract.

Repay loan, including interest.

$0

+450

-440

Total Cash Flow

+$10

) 1 ( , 0 0 , 0 t t C S F + s

Cost-of-Carry Rule 1

0 1

1. Borrow $400

2. Buy 1 oz gold

3. Sell futures contract

4. Deliver gold against

futures contract

5. Repay loan

The Cost-of-Carry Rule 2

Since the futures price must be either less than or equal to the

spot price plus the cost of carrying the commodity forward by rule

And the futures price must be greater than or equal to the spot

price plus the cost of carrying the commodity forward by rule .

The only way that these two rules can reconciled so there is no

arbitrage opportunity is by the cost of carry rule .

Rule #2: the futures price must be equal to the spot price plus the

cost of carrying the commodity forward to the delivery date of the

futures contract.

) 1 ( , 0 0 , 0 t t C S F + =

If prices were not to conform to cost of carry rule #2, a cash-and carry

arbitrage profit could be earned.

Recall that we have assumed away transaction costs, margin

requirements, and restrictions against short selling.

Spreads and The Cost-of-Carry

As we have just seen, there must be a relationship

between the futures price and the spot price on the

same commodity.

Similarly, there must be a relationship between the

futures prices on the same commodity with differing

times to maturity.

The following rules address these relationships:

Cost-of-Carry Rule 3

Cost-of-Carry Rule 4

Cost-of-Carry Rule 5

The Cost-of-Carry Rule 3

The distant futures price must be less than or equal to the nearby

futures price plus the cost of carrying the commodity from the

nearby delivery date to the distant delivery date.

) 1 ( , , 0 , 0 d n n d C F F + s

where d > n

F

0,d

= the futures price at t=0 for the distant delivery

contract maturing at t=d.

F

o,n

= the futures price at t=0 for the nearby delivery contract

maturing at t=n.

C

n,d

= the percentage cost of carrying the good from t=n

to t=d.

If prices were not to conform to cost of carry rule # 3, a cash-and-carry

arbitrage profit could be earned.

Spreads and the Cost-of-Carry

Table 3.6

Gold Forward Cash-and-Carry Arbitrage

Prices for the Analysis

Futures price for gold expiring in 1 year $400

Futures price for gold expiring in 2 years $450

Interest rate (to cover from year 1 to year 2) 10%

Transaction

Cash Flow

t = 0 Buy the futures expiring in 1 year.

Sell the futures expiring in 2 years.

Contract to borrow $400 at 10% for year

1 to year 2.

+$0

0

0

Total Cash Flow

$0

t = 1 Borrow $400 for 1 year at 10% as

contracted at

t = 0.

Take delivery on the futures contract.

Begin to store gold for one year.

+$400

- 400

0

Total Cash Flow

$0

t = 2 Deliver gold to honor futures contract.

Repay loan ($400 x 1.1)

+$450

- 440

Total Cash Flow +

$10

Table 3.6 shows that the spread between two futures contracts

can not exceed the cost of carrying the good from one delivery

date forward to the next, as required by the cost-of-carry rule #3.

The Cost-of-Carry Rule 3

0 1

1. Buy futures contract w/exp

in 1 yrs.

2. Sell futures contract w/exp

in 2 years

3. Contract to borrow $400

from yr 1-2

7. Remove gold from storage

8. Deliver gold against 2 yr. futures contract

9. Pay back loan

2

4. Borrow $400

5. Take delivery on 1 yr to exp

futures contract.

6. Place the gold in storage for one

yr.

The Cost-of-Carry Rule 4

The nearby futures price plus the cost of carrying the

commodity from the nearby delivery date to the distant

delivery date cannot exceed the distant futures price.

Or alternatively, the distant futures price must be greater

than or equal to the nearby futures price plus the cost of

carrying the commodity from the nearby futures date to

the distant futures date.

If prices were not to conform to cost of carry rule # 4, a

reverse cash-and-carry arbitrage profit could be earned.

( )

d n n d

C F F

, , 0 , 0

1+ >

The Cost-of-Carry Rule 4

Table 3.7 illustrates what happens if the nearby futures

price is too high relative to the distant futures price. When

this is the case, a forward reverse cash-and-carry arbitrage

is possible.

Table 3.7

Gold Forward Reverse Cash-and-Carry Arbitrage

Prices for the Analysis:

Futures price for gold expiring in 1 year $440

Futures price for gold expiring in 2 years $450

Interest rate (to cover from year 1 to year 2) 10%

Transaction

Cash Flow

t = 0 Sell the futures expiring in one year.

Buy the futures expiring in two years.

Contract to lend $440 at 10% from year 1

to

year 2.

+$0

0

0

Total Cash Flow

$0

t = 1 Borrow 1 ounce of gold for one year.

Deliver gold against the expiring futures.

Invest proceeds from delivery for one

year.

$0

+ 440

- 440

Total Cash Flow

$0

t = 2 Accept delivery on expiring futures.

Repay 1 ounce of borrowed gold.

Collect on loan of $440 made at t = 1.

- $450

0

+ 484

Total Cash Flow +

$34

The Cost-of-Carry Rule 4

0 1

1. Sell futures contract

w/exp in 1 yrs.

2. Buy futures contract

w/exp in 2 years

3. Contract to lend

$400 from yr 1-2

7. Accept delivery

on exp 2 yr

futures contract

8. Repay 1 oz.

borrowed gold.

9. Collect $400

loan

2

4. Borrow 1 oz. gold

5. Deliver gold on 1

yr to exp futures

contract.

6. Invest proceeds

from delivery for

one yr.

Cost-of-Carry Rule 5

Since the distant futures price must be either less than or equal to

the nearby futures price plus the cost of carrying the commodity

from the nearby delivery date to the distant delivery date by rule

#3.

And the nearby futures price plus the cost of carrying the

commodity from the nearby delivery date to the distant delivery

date can not exceed the distant futures price by rule #4.

The only way that rules 3 and 4 can be reconciled so there is no

arbitrage opportunity is by cost of carry rule #5.

Cost-of-Carry Rule 5

The distant futures price must equal the nearby

futures price plus the cost of carrying the

commodity from the nearby to the distant

delivery date.

If prices were not to conform to cost of carry rule

#5, a cash-and-carry arbitrage profit or reverse

cash-and-carry arbitrage profit could be earned.

Recall that we have assumed away transaction costs,

margin requirements, and restrictions against short

selling.

) 1 ( , , 0 , 0 d n n d C F F + =

Implied Repo Rates

If we solve for C

0,t

in the above equation, and assume that

financing costs are the only costs associated with holding an

asset, the implied cost of carrying the asset from one time point

to another can be estimated. This rate is called the implied repo

rate.

The Cost-of-Carry model gives us:

t C , 0 Solving for

And

) 1 ( , 0 0 , 0 t t C S F + =

) 1 ( , 0

0

, 0

t

t

C

S

F

+ =

t

t

C

S

F

, 0

0

, 0

1= ÷

Implied Repo Rates

Example: cash price is $3.45 and the futures price is

$3.75. The implied repo rate is?

086956 . 0 1

45 . 3 $

75 . 3 $

= ÷

That is, the cost of carrying the asset from today until the expiration

of the futures contract is 8.6956%.

t

t

C

S

F

, 0

0

, 0

1= ÷

The Cost-of-Carry Model in

Imperfect Markets

In real markets, no less than four factors

complicate the Cost-of-Carry Model:

1. Direct transactions costs

2. Unequal borrowing and lending rates

3. Margin and restrictions on short selling

4. Limitations to storage

Transaction Costs

Transaction Costs

Traders generally are faced with transaction costs when

they trade. In this case, the profit on arbitrage

transactions might be reduced or disappear altogether.

Types of Transaction Costs:

– Brokerage fees to have their orders executed

– A bid ask spread

A market maker on the floor of the exchange needs

to make a profit. He/She does so by paying one

price (the bid price) for a product and selling it for a

higher price (the ask price).

Unequal Borrowing & Lending

Rates

Thus far we have assumed that investors can

borrow and lend at the same rate of interest.

Anyone going to a bank knows that this

possibility generally does not exist.

Incorporating differential borrowing and lending

rates into the Cost-of-Carry Model gives us:

Where:

C

L

= lending rate

C

B

= borrowing rate

) 1 )( 1 ( ) 1 )( 1 ( 0 , 0

0 B

t

L

C T S F C T S + + s s + ÷

Unequal Borrowing & Lending Rates

Table 3.11

Illustration of No-Arbitrage Bounds

with Differential Borrowing and Lending Rates

Prices for the Analysis:

Spot price of gold

$400

Interest rate (borrowing)

12%

Interest rate (lending)

8%

Transaction costs (T )

3%

Upper No-Arbitrage Bound with Transaction Costs and a Borrowing Rate

F0,t < S0(1 + T )(1 + CB ) = $400(1.03)(1.12) = $461.44

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate

F0,t > S0(1 BT )(1 + CL ) = $400(.97)(1.08) = $419.04

Restrictions on Short Selling

Thus far we have assumed that arbitrageurs can sell short

commodities and have unlimited use of the proceeds.

There are two limitations to this in the real world:

– It is difficult to sell some commodities short.

– Investors are generally not allowed to use all

proceeds from the short sale.

How do limitations on the use of funds from a short sale

affect the Cost-of-Carry Model?

We can examine this by editing our transaction cost and

differential borrowing Cost-of-Carry Model as follows:

Restrictions on Short Selling

The transaction cost and differential cost of borrowing

model is as follows:

We modify this by recognizing that you will not get all of

the proceeds from the short sale. You will get some

portion of the proceeds.

) 1 )( 1 ( ) 1 )( 1 ( 0 , 0 0

B

t

L

C T S F fC T S + + s s + ÷

) 1 )( 1 ( ) 1 )( 1 ( 0 , 0

0 B

t

L

C T S F C T S + + s s + ÷

Where:

ƒ = the proportion of funds received

Restrictions on Short Selling

Table 3.12 illustrates the effect of limitations on the use of short

sale proceeds.

Table 3.12

Illustration of No-Arbitrage Bounds

with Various Short Selling Restrictions

Prices for the Analysis:

Spot price of gold

$400

Interest rate (borrowing)

12%

Interest rate (lending)

8%

Transaction costs (T )

3%

Upper No-Arbitrage Bound with Transaction Costs and a Borrowing Rate

F0,t < S0(1 + T )(1 + CB ) = $400(1.03)(1.12) = $461.44

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 1.0

F0,t > S0(1 BT )(1 + fCL ) = $400(.97)[1 + (1.0)(.08)] = $419.04

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 0.75

F0,t > S0(1 B T)(1 + fCL ) = $400(.97)[1 + (.75)(.08)] = $411.28

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 0.5

F0,t > S0(1 BT )(1 + f CL ) = $400(.97)[1 + (0.5)(.08)] = $403.52

Restrictions on Short Selling

The effect of the proceed use limitation is to

widen the no-arbitrage trading bands.

Futures Price

Time

$403.52

$461.44

Limitations on Storage

The ability to undertake certain arbitrage transactions

requires storing the product. Some items are easier to

store than others.

Gold is very easy to store. You simply rent a safe deposit

box at the bank and place your gold there for safekeeping.

Wheat is moderately easy to store.

How about milk or eggs?

They can be stored, but not for long periods of time.

To the extent that a commodity can not be stored, or has

limited storage life, the Cost-of-Carry Model may not hold.

How Traders Deal with Market Imperfections

The costs associated with carrying commodities forward

vary widely among traders.

If you are a floor trader, your transaction costs will be very

low. If you are a farmer with unused grain storage on your

farm, your cost of storage will be very low.

Individuals with lowest trading costs (storage costs, and

cost of borrowing) will have the most profitable arbitrage

opportunities.

The ability to sell short varies between traders.

Convenience Yield

When there is a return for holding a

physical asset, we say there is a

convenience yield.

A convenience yield can cause futures

prices to be below full carry.

In extreme cases, the cash price can

exceed the futures price.

When the cash price exceeds the futures

price, the market is said to be in

“backwardation.”

Futures Prices and

Expectations

If futures contracts are priced appropriately, the current futures

price should tell us something about what the spot price will be

at some point in the future.

There are four theories about futures prices and future spot

prices:

– Expectations or Risk Neutral Theory

– Normal Backwardation

– Contango

– Capital Asset Pricing Model (CAPM)

Speculators play an important role in the futures market, they

ensure that futures prices approximately equal the expected

future spot price.

Expectations or Risk Neutral

Theory

The Expectations Theory says that the futures price equals

the expected future spot price.

Where

=the expected future spot price

) ( 0 , 0 S E F t =

) ( 0 S E

Normal Backwardation

The Normal Backwardation Theory says that futures markets are

primarily driven by hedgers who hold short positions. For

example, farmers who have sold futures contracts to reduce their

price risk.

The hedgers must pay speculators a premium in order to assume

the price risk that the farmer wishes to get rid of.

So speculators take long positions to assume this price risk.

They are rewarded for assuming this price risk when the futures

price increases to match the spot price at maturity.

So this theory implies that the futures price is less than the

expected future spot price.

) ( 0 , 0 S E F t <

Contango

The Contango Theory says that futures markets are

primarily driven by hedgers who hold long positions. For

example, grain millers who have purchased futures

contracts to reduce their price risk.

The hedgers must pay speculators a premium in order to

assume the price risk that the grain miller wishes to get

rid of.

So speculators take short positions to assume this price

risk. They are rewarded for assuming this price risk when

the futures price declines to match the spot price at

maturity.

So this theory implies that the futures price is greater

than the expected future spot price.

) ( 0 , 0 S E F t >

Capital Asset Pricing Model

(CAPM)

The CAPM Theory is consistent with the Normal

Backwardation Theory, the Contango Theory, and the

Expectations Theories.

This model is applied to all kinds of financial

instruments. In general Higher the Risk, Higher will be the

expected return.

The CAPM model leads to the conclusion that there are two

types of Risks – SYSTEMATIC & UNSYSTEMATIC

Unsystematic Risk can be eliminated by holding a well

diversified Portfolio. Systematic Risk cannot be diversified

away.

So as per this model, the investors should be compensated

only for Systematic Risk.

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