How to Calculate Fair Value of Future Contract
As we can see in the image above, the current rate is 8.3528%. To keep this in perspective, let`s work on an example of pricing. Assuming Infosy`s spot is trading at 2,280.5, with an additional 7 days to expire, how should Infosys` futures contract be valued for the current month? Now that you have started trading, you have to wait for the current month`s futures contracts to expire. After expiration, we know the futures contracts of the current month and the spot converges at a single price. Of course, it practically makes sense to settle the transaction just before it expires. In this example, you could watch TV and think, » « AWESOME, » futures indicate a higher opening to the market, but at a second glance and with a little math, the screen actually shows a bearish vibe. How? Notice. Fair value is just a calculation where the future « should be ». Above, traders value a discount to the fair value of 2 points (FV – S&P Future), which implies a lower opening for the cash index of 2. Futures contracts are not always traded richer than the spot. There could be cases – mainly due to short-term imbalances between supply and demand – where futures contracts would trade cheaper than their corresponding location.
In this situation, futures are said to trade at a discount to the spot. In the world of commodities, the same situation is called « demotion ». This value is often displayed on financial information networks and posted online before the stock markets open for trading. Fair value can provide insight into overall market sentiment. The forward price may differ from fair value due to short-term influences of supply and demand for the futures contract. Fair value always refers to the first month futures contract as opposed to another outgoing month contract. Number of expiry days = 34 (since the contract expires on March 26, 2015) Here is an important concept, « Fair Value In Futures Contract ». It`s a bit like the forward interest parity that we talked about in the forward rate.
What should be the price of futures contracts? Well, let`s look at a physical delivery futures contract where the grain is stored and there is a percentage of storage costs per unit of time. Let`s say per year. So, « s » is the percentage of the value of the goods that it would cost you to store them for a year. This is something that is quoted to you by one camp. A warehouse will tell you, I will keep it for you for a year for this or that amount in dollars. You divide that today by the value and that`s the storage costs as a percentage. `r` is the interest rate for the same time interval. So now we`re talking about a futures contract, let`s say a year in advance. Or it could be every two years ahead of us, times to come, but we have to adapt. If it`s a month in advance, we mark an interest rate of one month and the storage cost of one month. The equation of fair value, says the famous equation, the price of the future is equal to the price of the spot times 1 plus r plus s.
Which means that usually because r and s are generally positive, futures contracts are usually in contango. They are usually upward-facing, because the longer the contract is dated in the future, the more r. Remember that this is r per month if it is a month in the future. That`s r per year if it`s a year in the future, which would be 12 times bigger. So you can see that this usually lowers the futures contract. Except at harvest time, perhaps. At harvest time, it could be said that this is no longer the case. You can express it differently. One way is to say that this no longer applies because no one stores anymore. But of course, someone saves and they have to keep it somewhere.
But maybe it`s become rare. Another thought is that some people say we can end up behind when storage costs turn negative. Well, that`s one way of thinking. How can storage costs be negative? Well, it`s possible. Here`s how it can happen. Go to a breakfast cereal manufacturer. This guy thinks it`s very important that we ship so many boxes of cereal for breakfast every month. And there`s uncertainty about deliveries and deliveries, so the guy there wants to keep a supply of grain, let`s say wheat, in the factory warehouse. Because if you don`t – suppose you`re the wheat farmer and you suddenly run out of wheat, then one morning your employees all show up to make wheat, and there`s no wheat.
So you have to pay them for the work of the day and they didn`t do anything, so you lose money. So you want to have wheat in stock at all times. Suppose wheat becomes really scarce. It`s the end of the season and the harvest isn`t there yet, so you can`t buy it from farmers. You could actually point to negative storage costs for someone who wants to store wheat properly. They said, look, I don`t want to risk the closure of my factory. So I`ll just charge you -2% if you let me store the wheat. So that`s what happens in backwardness. Or another way of saying that if the goods are not stored, it is possible that the future – if you want to count this as normal storage costs, the price of the future may be less than the fair value.
That`s how it happens sometimes. If you recall, in some of the previous chapters, we sometimes discussed the « forward price formula » as the main reason for the difference between the spot price and the forward price. Well, I think the time has come to lift the veil and introduce the « future pricing formula ». One question that comes to mind is how to find such a trader? Can we automate a strategy on Pi that automatically searches for scripts that have C&C arbitrage or normal spread? If we were to calculate the right price for each individual script, the trading opportunity would be lost. .