All you wanted to know about futures pricing

Akhil Nallamuthu | | Updated on: Nov 27, 2021
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Originally conceived as a hedging product, derivative contracts i.e., futures and options have become mainstream trading/speculative products today. The possibility of trading higher number of shares (as derivatives are traded in standardised contracts) with margin money has resulted in more participants coming to derivatives trading.

However, many will rarely try to understand the pricing mechanism, but it can give you an edge especially when you plan to implement quantitative strategies rather than trading with intuition. We have already discussed about options pricing(, here we see how futures are priced.

The basic formula of a futures contract looks like this,


Here, F is futures price, S is spot (underlying) price, Rf is risk-free rate and d is dividends if any.

The rate of treasury bills can be considered for risk-free rate in accordance with the time to expiry. Here Rf is annualised rate, but derivative contracts expire every month. So, adjusting for the same, the formula can be modified as below,


Here, n is the number of days to expiry.

The price that we arrive at by applying above formula is the fair price of a futures contract. However, the market price i.e., the price at which the contract is traded at a given time can vary from fair price. This is because of the everchanging supply-demand dynamics because of the varying expectation on the performance of the underlying asset. Most of the time, futures price will be higher than spot price and we call futures is at premium. There are times when futures can be at discount to spot price which hints at bearish expectations.

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Published on November 27, 2021

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