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 the pricing is neutral. It has to be by definition, otherwise one of the parties would be unwilling to enter into the contract and there would be no transaction. 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.

As in all markets, the price is simply the result of what the participants think it should be. As futures markets are more prone to variations, in that you’re not buying and selling a product but buying and selling a promise which can be affected by many factors which are unseen at present, you have to be prepared for volatility which may not on the face of it make sense, but which is driven by market emotions.

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. Depending who is taking out the contract the resulting price can differ, as some market participants may be able to borrow at a more favourable interest rate than others, and some may have their own storage available at low-cost. But taken as a whole, this idea 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. Add in the complication of futures trading on perishable goods, such as agricultural commodities, and you can see why some people find 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. Once again, the market dominates and eliminates any obvious arbitrage opportunities. The only sure thing is that there is no such thing as a sure thing.

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