Pricing of Futures

Cost of Carry Model

The cost of carry model determines futures prices in such
a way that no arbitrage opportunities arise.
The price of the contract defined under this model is:
F = S + C
Futures price = Spot price + Carry costs
Pricing of Futures

 If an investor wants to acquire shares in a particular

company,  he can acquire this shares today itself at the
current price or he can take a long position in futures. 
In either case,  he will be having the asset. No doubt, the
market determined cost of acquiring the asset in either of
these strategies must be equal. So, there is some
relationship between the current price of the asset and cost
of holding it in future and futures price today.
Pricing of futures
The relationship between the current spot price and the
futures price is known as spot-futures  parity or cost of
carry relationship. The expected dividend (income)  the
asset gives during the futures period can also be
accommodated in the analysis. 
The price of futures contract depends on the following:
 1) The price of the underlying asset in the cash market
 2) The rate of return expected from investment in the
asset
3) Risk free rate of interest
Pricing of futures
Suppose, in cash market,  the underlying asset is selling at 
Rs.100. The expected return from the asset is 3% per quarter.
The risk-free rate of borrowing or lending is 8% per annum or
2% per quarter. The futures contract period is also for 3
months. What should be the price of futures?
Now Futures price = Spot price + Carry costs
F = S + S(r-y)
Where, S =  current spot price of the asset
     F =  futures price
     r =   % financing cost per futures period
     y =  percentage yield on investment per futures period
Pricing of futures
 Suppose, the investor borrows funds to purchase one
unit of asset “x” resulting in no initial cash outlay for his
strategy. At the end of three months period, Rs.3  will be
received from holding the asset “x”  and would be
required to pay interest (financing cost)  of Rs.2.
In the example given above,
F = 100 + 100(0.02 - 0.03)
  = Rs.99
So, the futures price should be Rs.99.  This is called the
theoretical price of the futures.
Pricing of futures
What  happens if the futures price is Rs.92 or Rs.107? The
position can be explained as follows:

In case, the futures contract is available at Rs.92 (less than the

theoretical price of Rs.99),  the investor should buy one future
contract for Rs.92 and should sell one unit of  asset “x” for
Rs.100  and invest the money @ 8% per annum for 3 months. 
After 3 months, he will receive the proceeds of Rs.102
(Rs.100 +Rs.2).  he will spend Rs.92 to purchase an asset (out
of futures contract)  Besides, he will not receive the yield of
Rs.3  from the Asset.  So his cost is Rs.95 (92 + 3).  His gain  
would be Rs.7 (102-95).
Pricing of futures
Similarly,  if the futures contract price is Rs.107, He should sell
futures contract at Rs.107  and should  borrow Rs.100 now to buy
one unit of asset x  in the spot market.
After  3 months,  proceeds would be Rs.110 (107+3) and payment
would be Rs.102 (100+2).  He would be able to make a profit of
Rs.8.
So,  if the futures prices other than the theoretical price Rs.99,  it
could give rise to arbitrage opportunities.  in case of price of Rs.92
or Rs.107,  investors can look for riskless arbitrage profit  of Rs.7
or Rs.8. The  demand and supply forces would react to this
arbitrage opportunity and the futures price would settle around the
equilibrium level of Rs.99
Pricing of futures
The procedure for pricing futures can be standardised in 3 different
situations as follows:
When the asset provides no income
F = S x ert
 

When the asset provides known dividend (i.e. Dividend in Rs.)

F = (S x ert) – (I x ert)
 
When the asset provides a known dividend yield (i.e. Dividend in
terms of %)
F = S x e(r-q)t
Pricing of futures
Where, F = Futures Price
S = Spot Price of the underlying asset
e = 2.7183
r = Rate of interest on borrowing or lending
t = Time or duration of futures contract
I = Expected Dividend
q = Dividend yield.
Cash and Carry Arbitrage
Cash-and-carry-arbitrage is a market neutral strategy
combining the purchase of a long position in an asset such as a
stock or commodity, and the sale (short) of a position in a
futures contract on that same underlying asset.
It seeks to exploit pricing inefficiencies for the asset in the
cash (or spot) market and futures markets, in order to make
riskless profits.
The futures contract must be theoretically expensive relative to
the underlying asset or the arbitrage will not be profitable.
Cash and carry Arbitrage strategy is implemented when
futures is Over Priced.
Cash and Carry Arbitrage (Cont.)
Following are the steps in Cash and Carry Arbitrage:
Step 1: Borrow amount equal to Spot price of an asset
at risk-free rate.
Step 2: Purchase the asset in the spot market at the
current spot price
Step 3: Sell the futures based in the asset.
Step 4: On maturity of the contract, deliver the share
at futures price
Step 5: Repay the loan with interest.
Reverse Cash and Carry Arbitrage
Reverse cash-and-carry arbitrage is a market neutral
strategy combining a short position in an asset and a long
futures position in that same asset.
Its goal is to exploit pricing inefficiencies between that
asset's cash, or spot, price and the corresponding future's
price to generate riskless profits.
Reverse Cash and carry Arbitrage strategy is
implemented when futures are Under Priced.
Reverse Cash and Carry Arbitrage (Cont.)
Following are the steps in Reverse Cash and Carry Arbitrage:
Step 1: Borrow share of the company under Stock Lending and
Borrowing Scheme.
Step 2: Sell the borrowed share at the current spot price in the
stock market.
Step 3: Lend money realized for the stock market at a risk free rate
of interest.
Step 4: Buy Futures contract on the share of the company.
Step 5: On maturity recover the loan with interest.
Step 6: Purchase the share on maturity of futures contract and
return the share to the broker.