Theories of Future contract

prices
 Introduction
• Future prices are dependent on the following factors
• 1. market price of the underlying asset
• 2. money market rate
• 3. expected dividend income arising during the life time of
the future
• 4. supply and demand of the asset
Theories of Future contract prices

• There are four important models of future prices

• 1. cost of carry model
– In perfect market
– In imperfect market
• 2. Expectation model
• 3. Normal backwardation model
• 4. Capital asset pricing model
 cost of carry model

• Future prices depends on two factors

• 1. current spot (cash) price of underlying asset
• 2. cost of carrying the underlying asset

• Cost of carrying is the sum total of various components of

carrying cost associated with underlying asset.

• Gross Cost of carrying includes

• 1. storage cost
• 2. insurance cost
• 3. transportation cost
• 4. cost of financing.

• convenience yield: it is the benefits that arise from the

ownership of an asset during the life of the future contract
• Gross Cost of carrying = storage cost+ insurance cost+
transportation cost + cost of financing.

• Net carrying cost= gross carrying cost – convenience

yield
 assumptions of cost of carry model
• 1. no transaction costs

• 2. there is no restriction on short selling

• 3. investors can borrow and lend

• 4. there is no credit risk hence no margin is required.

 cost of carry model

• cost of carry model can be expressed as

» F(0,t)= S0 (1 + C(0,t) )

• Where
• F(0,t)= the current future price for delivery of the
underlying asset
• S0 = current spot price
• C(0,t) = cost of carrying expressed as a percentage of the
spot price
• Note:

• If the contracted future price is greater than the

calculated future price, chances of arbitrage arise known
as cash and carry arbitrage.

• If the contracted future price is less than the calculated

future price, chances of arbitrage arise known as reverse
cash and carry arbitrage.