This archive report was first published on 23 July 2019.
Published on July 23, 2019, a new study on futures pricing has shed light on the complex structure of futures contracts.
Futures contracts are derivative products whose price relies largely on the price of the underlying stocks or indices. However, the pricing is not usually direct, with a difference between the prices of the underlying asset in the cash segment and in the derivatives segment.
There are two primary pricing models used in futures markets: the cost of carry model and the expectancy model of future pricing. The choice of pricing model determines whether the market value is equal to the fair value of a futures contract.
The Cost of Carry Model ¶
This model assumes that the futures markets are efficiently perfect, eliminating any opportunity for arbitrage. As a result, investors are indifferent to the spot and market price while trading in futures, as the final earnings are eventually the same.
The future price is equal to the spot price plus the net cost incurred in carrying the futures contract till its maturity date, known as the carry cost minus the carry return.
The Expectancy Model of Futures Pricing ¶
This model states that the future price of the futures contract is what the spot price of the futures contract is expected to be in the future. It assumes that there is no relationship between the futures price and the spot price, with the only factor being the expected spot price of the asset.
The difference between the future price and the spot price is called the basis. A negative basis indicates that the futures market is expected to rise in the future, while a positive basis suggests a bear run on the futures market.
