Pricing Futures

When a futures contract is created, with a buyer and seller, the price of it is the amount that both sides think they should pay, in other words neutral. It has to be, otherwise one of the parties would be unwilling to enter into the contract. But in the light of subsequent events and market sentiment, the value changes each day, and that is where you can make a profit or loss.

In the introductory module, I introduced a simple method of pricing a future, which is called ‘cash and carry’. As long as the underlying is not perishable, the person who contracts to sell the underlying at a future date could simply borrow money, paying interest, and buy the underlying today, keeping it in store until contract expiration. That effectively puts a lid on how high the price can be. The price would be the sum of the current cost, interest charges, and any storage required. If the price was higher, everyone would start making risk free money by doing just this.

Just consider what this means. Say the market price of gold is $1100 per ounce. Interest rates are low, but storage and insurance would cost a little. So the price of a futures contract for gold six months out couldn’t be more than whatever that works out to be, say $1200 per ounce. If it was any higher, people would borrow money, do cash and carry, and have a guaranteed reward. But many people are convinced that gold is going to increase dramatically in price, given the amount of inflation being caused by currency printing. With figures of $2000 being mentioned, surely it will make $1500 in six months? (this is a rhetorical question that some people would concur with, and not a suggestion!).

You can see the conflict and the tension that can arise in the futures markets. Any time the underlying commodity increases in value more quickly than the prevailing interest rate, there is an automatic discrepancy which can be exploited. Perhaps it’s this that makes futures trading so exciting.

As the delivery date approaches, a futures contract gets closer to the market price of the underlying. On the expiration date, the contract should be the same as the underlying.

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