| There are two basic concepts in finance: time-value of money and uncertainty about expectations. |
There are two fundamental concepts in finance: the time value of money and uncertainty about expectations. |
| The two concepts are the core of financial valuations, including futures contracts. |
Both concepts are at the core of financial valuations, including futures contracts. |
| cost-of-carry model is the most widely accepted and used for pricing futures contract |
The transportation cost model is the most widely accepted and used for pricing futures contracts. |
| Cost-of-carry Model |
The transportation cost mode |
| Cost-of-carry model is an arbitrage-free pricing model. |
The transportation cost model is an arbitrage-free pricing model. |
| Its central theme is that futures contract is so priced as to preclude arbitrage profit. |
Its central theme is that the futures contract is priced in such a way as to prevent arbitrage profit |
| In other words, investors will be indifferent to spot and futures market to execute their buying and selling of underlying asset because the prices they obtain are effectively the same. |
In other words, investors will be indifferent between the spot market and the futures market when executing their purchases and sales of underlying assets because the prices they obtain are effectively the same. |
| Expectations do influence the price, but they influence the spot price and, through it, the futures price. |
Expectations influence the price, but they influence the spot price and, through it, the futures price.
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| They do not directly influence the futures price. |
Expectations do not have a direct impact on the price of futures contracts. |
| According to the cost-of-carry model, the futures price is given by Futures price(Fp) = Spot Price(Sp) + Carry Cost(Cc) - Carry Return(Cr) (1) |
According to the cost of carry model, the futures price is determined by the equation: Futures Price (Fp) = Spot Price (Sp) + Cost of Carry (Cc) - Convenience Yield (Cy). (1) |
| Carry cost (CC) is the interest cost of holding the underlying asset (purchased in spot market) until the maturity of futures contract. |
The carry cost (CC) is the interest cost of holding the underlying asset (purchased in the spot market) until the expiration of the futures contract |
| Carry return (CR) is the income (e.g., dividend) derived from underlying asset during holding period. |
The carry return (CR) is the income (e.g., dividend) derived from the underlying asset during the holding period. |
| Thus, the futures price (F) should be equal to spot price (S) plus carry cost minus carry return. |
Therefore, the futures price (F) should be equal to the spot price (S) plus the carrying cost minus the carrying return. |
| If it is otherwise, there will be arbitrage opportunities as follows |
Otherwise, there will be arbitrage opportunities as follows |
| When F > (S + CC - CR): Sell the (overpriced) futures contract, buy the underlying asset in spot market and carry it until the maturity of futures contract. |
When F > (S + CC - CR): Sell the futures contract (overvalued), buy the underlying asset in the spot market, and hold it until the expiration of the futures contract. |
| This is called "cash-and-carry" arbitrage. |
This is called "cash and carry" arbitrage. |
| When F < (S + CC - CR): Buy the (under priced) futures contract, short-sell the underlying asset in spot market and invest the proceeds of short-sale until the maturity of futures contract. |
When F < (S + CC - CR): Buy the futures contract (undervalued), short sell the underlying asset in the spot market, and invest the proceeds from the short sale until the expiration of the futures contract |
| This is called "reverse cash-and-carry" arbitrage. |
This is called "reverse cash and carry" arbitrage. |
