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

Axis Bank to sell 9% to Bain Capital, others to raise Rs 11,625 crore

The board of Axis Bank on Friday approved stake sale to private equity player Bain Capital and other investors in its bid to raise capital by issue of equity linked securities on a preferential basis. The board of Axis Bank on Friday approved a 9 percent stake sale to Bain Capital and other investors including LIC in its bid to raise capital worth Rs 11,626 crore by issue of equity of equity linked securities on a preferential basis. The issue price of equity Shares at Rs 525 per share while the issue price of convertible warrants is Rs 565 per share. Entities affiliated with Bain Capital propose to invest Rs. 6,854 crore while LIC or Life Insurance Corporation will be issued around 3.02 crore equity shares on a preferential basis to help the bank raise over Rs 1,583 crore, the bank said. Approved by the Board today, Axis Bank proposes to raise Rs 9,063 crore through issuance of equity and the remaining Rs 2,563 crore through issue of warrants. The capital raise ...
Post a Comment
Read more
THE NIFTY FUTURE  Basics of the Index Futures Within the Indian derivatives world, the Nifty Futures has a very special place. The ‘Nifty Futures’ is the most widely traded futures instrument, thus making it the most liquid contract in the Indian derivative markets. In fact you may be surprised to know that Nifty Futures is easily one of the top 10 index futures contracts traded in the world. Once you get comfortable with futures trading I would imagine, like many of us you too would be actively trading the Nifty Futures. For this reason, it would make sense to understand Nifty futures thoroughly. As we know the futures instrument is a derivative contract that derives its value from an underlying asset. In the context of Nifty futures, the underlying is the Index itself. Hence the Nifty Futures derives its value from the Nifty Index. This means if the value of Nifty Index goes up, then the value of Nifty futures also goes up. Likewise if the value of Nifty Index decl...
Post a Comment
Read more
The Chart Types we need a charting technique that displays this information in the most comprehensible way. If not for a good charting technique, charts can get quite complex. Each trading day has four data points’ i.e the OHLC. If we are looking at a 10 day chart, we need to visualize 40 data points (1 day x 4 data points per day). So you can imagine how complex it would be to visualize 6 months or a year’s data. As you may have guessed, the regular charts that we are generally used to – like the column chart, pie chart, area chart etc does not work for technical analysis. The only exception to this is the line chart. The regular charts don’t work mainly because they display one data point at a given point in time. However Technical Analysis requires four data points to be displayed at the same time. Below are some of the chart types: 1. Line chart 2. Bar Chart 3. Japanese Candlestick The focus of this module will be on the Japanese Candlesticks however before we get...
Post a Comment
Read more