future-pricing-formula

Understanding Futures Pricing Formula

Understanding Futures Pricing Formula

Futures pricing formula is essential to understand, and that’s why this formula must have clear attention while discussing.
In futures trading, there are different sets of traders; some traders are called instinctive traders that make their decisions based on feelings.
Successful trading requires skills, knowledge and experience to turn your trading into a profitable one.
However, it is important to understand the future pricing formula when stepping into future trading.

A future price is measured by the moves in sync and the cost of the underlying asset. If the cost of underlying increases, the cost of futures will rise and if it decreases, the cost of future will fall.
Remember, the future price is not equal to the value of the underlying asset because, in the market, they can be traded at several different prices. For example:
The spot price of a particular asset can be different than the future price, and the price is called the Spot-future party.
So what is the possible reason behind the prices that are different at different price frames? Well, it is time to expire, dividends and especially interest rates.
The future price is a mathematical representation of how future price change if any of the variables in the market changes.
Futures Price = Spot price *(1+ rf – d)
Where,
rf - risk-free rate
d – dividend
A risk-free return rate means a return rate on a particular investment with absolutely zero risks—for example – a treasury bill.
An individual can adjust a treasury bill proportionately for two to three months until the future expiry. So with that, the formula is:
Futures Price = Spot price * [1+ rf*(x/365) – d]
X – number of days to expiry
Let’s discuss it with an example. To help with calculation, we are assuming the following values.
The spot price of ABC Corporation is Rs 2,380.5
Risk-free rate = 8.3528 percent
Days to expiry = 7 days
Futures Price = 2380.5 x [1+8.3528 ( 7/365)] – 0
Here we have written zero at the end is because the company is not paying any dividend on it, but if the company pays any dividend, it will be included in the formula.
This futures price formula will give you what we called as the ‘fair value.’ The major difference between market prices and fair value is caused by a margin, taxes, transaction charges, and such.
Using this future pricing formula, we can quickly calculate a fair value for any expiration days.
Mid-month calculation
Number of days to expiry is 34 days
2380.5 x [1+8.3528 ( 34/365)] – 0
Far-month calculation
Number of days to expiry is 80 days
2380.5 x [1+8.3528 ( 80/365)] – 0

The price of a futures contract is just the spot price of an underlying asset that is adjusted for time, interest, and paid out dividends. The difference between the futures price and spot price forms the basis of spread. At the beginning of the series, the spread is maximum, but soon it converges into the settlement date. The future prices and spot price of an underlying asset are equal at the time of the expiration date.

The price of a futures contract is just the spot price of an underlying asset that is adjusted for time, interest, and paid out dividends. The difference between the futures price and spot price forms the basis of spread. At the beginning of the series, the spread is maximum, but soon it converges into the settlement date. The future prices and spot price of an underlying asset are equal at the time of the expiration date.

  • Clearing House
  • In an active market, futures are traded through an exchange which is called a clearinghouse. In India, National Stock Exchange Limited (NSE) participates in futures trading through the future index.

  • Buying Vs. Selling Future Contracts
  • Futures are legal and standardized agreements. In the future, the buyer generally has a long position while the seller has a short position.

  • Margin Requirement
  • Margin means the total amount that is deposited in the clearinghouse by the parties. When the time comes, it acts as a guarantee that all parties will honor this contract.
    At the starting of the trade, both parties have to deposit a margin. Due to the market process, if the starting margin falls drastically down than the maintenance amount, the part will receive a margin call.

  • Marking to Market
  • Marking to market is a process in which future prices are settled daily. The rise and fall of future prices are because of active trading. After each trading, clearing houses have adopted to pay the price difference by crediting and debiting the margin amount from the differential amount deposited by the parties.

Stockholders are generally traders who get involved in future trading while the market is active. They bet on market trends to secure big profit from the deal rather than looking to receive the physical delivery of the commodity.
These traders book their biases on future quotes, which is a technical tool that helps them to predict future price movements.
The chart is a clear example of a future quote containing all the essential information about the futures contract and periodical price movement.
At the very top, this char mentions the name of the underlying commodity and expiration date. Apart from information, a trader can check the index of price movement and the current price at the corner.
However, at the bottom of the graph, settlement and open prices are clearly mentioned.

  • What does future price mean?
  • A future price is measured by the moves in sync and the cost of the underlying asset. If the cost of underlying increases, the cost of futures will rise and if it decreases, the cost of future will fall.

  • What position does buyers and sellers have in futures?
  • Futures are legal and standardized agreements. In the future, the buyer generally has a long position while the seller has a short position.

  • What does stockholders perform in future trading?
  • Stockholders are generally traders who get involved in future trading while the market is active. They bet on market trends to secure big profit from the deal rather than looking to receive the physical delivery of the commodity.

Final Thoughts

Futures trading requires a lot of practice and understanding. Market variables are also present that influence future prices in the market. However, learning the future pricing formula is a solid way to start trading. It will help to easily understand all the future quotes and plan the position better.