Skip to main content




Difference Between Spot & Futures Pricing


Futures are derivative products whose value depends largely on the price of the underlying stocks or indices. However, the pricing is not that direct. There remains a difference between the prices of the underlying asset in the cash segment and in the derivatives segment. This difference can be understood through two simple pricing models for futures contracts. These will allow you to estimate how the price of a stock futures or index futures contract might behave. These are:


  • The Cost of Carry Model
  • The Expectancy Model
However, remember that these models merely give you platform on which to base your understanding of futures prices. That said, being aware of these theories gives you a feel of what you can expect from the futures price of a stock or an index.

WHAT IS THE COST OF CARRY MODEL





The Cost of Carry Model assumes that markets tend to be perfectly efficient. This means there are no differences in the cash and futures price. This, thereby, eliminates any opportunity for arbitrage – the phenomenon where traders take advantage of price differences in two or more markets.
When there is no opportunity for arbitrage, investors are indifferent to the spot and futures market prices while they trade in the underlying asset. This is because their final earnings are eventually the same.
The model also assumes, for simplicity sake, that the contract is held till maturity, so that a fair price can be arrived at.
In short, the price of a futures contract (FP) will be equal to the spot price (SP) plus the net cost incurred in carrying the asset till the maturity date of the futures contract.
FP = SP + (Carry Cost – Carry Return)
Here Carry Cost refers to the cost of holding the asset till the futures contract matures. This could include storage cost, interest paid to acquire and hold the asset, financing costs etc. Carry Return refers to any income derived from the asset while holding it like dividends, bonuses etc. While calculating the futures price of an index, the Carry Return refers to the average returns given by the index during the holding period in the cash market. A net of these two is called the net cost of carry.
The bottom line of this pricing model is that keeping a position open in the cash market can have benefits or costs. The price of a futures contract basically reflects these costs or benefits to charge or reward you accordingly.


WHAT IS THE EXPECTANCY MODEL OF FUTURES PRICING

The Expectancy Model of futures pricing states that the futures price of an asset is basically what the spot price of the asset is expected to be in the future.
This means, if the overall market sentiment leans towards a higher price for an asset in the future, the futures price of the asset will be positive.
In the exact same way, a rise in bearish sentiments in the market would lead to a fall in the futures price of the asset.
Unlike the Cost of Carry model, this model believes that there is no relationship between the present spot price of the asset and its futures price. What matters is only what the future spot price of the asset is expected to be.
This is also why many stock market participants look to the trends in futures prices to anticipate the price fluctuation in the cash segment.

WHAT IS BASIS?

At a practical level, you will observe that there is usually a difference between the futures price and the spot price. This difference is called the basis.
If the futures price of an asset is trading higher than its spot price, then the basis for the asset is negative. This means, the markets are expected to rise in the future.
On the other hand, if the spot price of the asset is higher than its futures price, the basis for the asset is positive. This is indicative of a bear run on the market in the future.

Comments

Post a Comment

Popular posts from this blog

OPTION TRADING

A Special Agreement There are two types of options – The Call option and the Put option. You can be a buyer or seller of these options. Based on what you choose to do, the P&L profile changes. Of course we will get into the P&L profile at a much later stage. For now, let us understand what “The Call Option” means. In fact the best way to understand the call option is to first deal with a tangible real world example, once we understand this example we will extrapolate the same to stock markets. So let’s get started. Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued at Rs.500,000/-. Ajay has been informed that in the next 6 months, a new highway project is likely to be sanctioned near the land that Venu owns. If the highway indeed comes up, the valuation of the land is bound to increase and therefore Ajay would benefit from the investment he would mak...
Post a Comment
Read more
CALL OPTIONS BASICS Breaking the Ice The options market makes up for a significant part of the derivative market, particularly in India. I would not be exaggerating if I were to say that nearly 80% of the derivatives traded are options and the rest is attributable to the futures market. Internationally, the option market has been around for a while now, here is a quick background on the same – Custom options were available as Over the Counter (OTC) since the 1920’s. These options were mainly on commodities Options on equities began trading on the Chicago Board Options Exchange (CBOE) in 1972 Options on currencies and bonds began in late 1970s. These were again OTC trades Exchange-traded options on currencies began on Philadelphia Stock Exchange in 1982 Interest rate options began trading on the CME in 1985 Clearly the international markets have evolved a great deal since the OTC days. However in India from the time of inception, the options market was facilita...
Post a Comment
Read more

2 Must Read Books For Stock Market Investors.

2 Must Read Books For Stock Market Investors. It’r really important to know the basics about the stocks before entering the market as lack of knowledge in this field almost always leads to a huge financial loss. Further, loss of capital also leads to a decline in the morale of the investor. Therefore, today I am going to give you the names of 10 must read books for the stock market investors. So, be with me for the next few minutes while i give you a brief introduction and review about the 10 must read books for stock market investors. Here it goes: 2 Must Read Books For Stock Market Investors: This book is ranked 1 in my list of 10 must read books for stock market investors.  Peter Lynch,  the Author of the book, is one of the most successful fund manager with  an average annual return of 30%  on his portfolio for a period of 13 years. A great record for a mutual fund manager. This classic book explains all the important basics that a beginn...
Post a Comment
Read more