Forex Investment and Currency Trading

Futures prices are continuously determined during exchange trading hours. You can find selected prices, such as the opening price, the highest price (day high), the lowest price (day low) and the closing price in financial newspapers.

Price determination
The price of a futures contract depends on:

• The price of the underlying asset (spot price),
• The cost of carry, and
• Other influencing factors (e.g. market liquidity)

It is essential for you as an investor to understand how futures contracts are valued. Only through a precise understanding of the most important factors which determine supply and demand will you be able to efficiently utilize these instruments.

Influence of the spot price

Upon maturity of a futures contract, either the underlying asset is physically delivered against payment, or a net cash settlement is made. The futures price, therefore, depends largely on the price of the underlying asset or instrument. This means that the futures price generally increases if the spot price rises and falls if the spot price falls.

The futures price and the spot price are identical on the date of maturity. Before maturity, on the other hand, the two prices will normally differ but basically move in the same direction. Differences between futures prices and the spot prices may be attributed to cost of carry as well as other influencing factors.

Cost of carry

A key reason for differences between the price of the futures contract and the underlying asset is the cost related to outright ownership of the underlying asset, called “cost of carry”.

Apart from margin deposit, the buyer of a futures contract is not required to provide any funds until the final settlement date. If, on the other hand, he had purchased the underlying asset and holds it for the relevant period, he would have to pay and finance the full amount of the position up front.

As a result, he would either incur financing costs by borrowing funds or opportunity costs by losing the income which would have otherwise been earned through alternative investment of his funds. However, if his position involves shares, he might also earn offsetting income from the underlying asset in the form of dividends and rights issues, and likewise if his position involves bonds, he may receive offsetting interest payments.

The net financing costs (the cost of financing the underlying asset less any income received from it) of an equivalent spot position is referred to as the cost of carry. This cost has to be taken into account in determining the fair market price of a futures position.

The theoretical futures price can thus be defined as follows:

Theoretical futures price = spot price + cost of carry = spot price + cost of financing the position – income received

A change in the cost of carry, for example resulting from a change in market interest rates or in the income form the asset, will result in a change in the futures price, all other things being equal. A rise (fall) in market interest rates will result in a higher (lower) futures price.

Other influences

Cost of carry generally does not fully explain differences between the spot prices and the futures prices. In addition to cost of carry, other influencing factors (F) which in many cases cannot be directly measured play an important role. Some examples of these are market liquidity and subjective expectations. Assessments of market participants may lead to movements in the futures market which anticipate the spot market, or conversely the futures market may have a delayed reaction to a change in the spot market. Differences in financing costs among market participants also lead to differing individual calculations of cost of carry and thus of fair futures prices.

Actual futures price = spot price + cost of carry + other influencing factors (F)

Excursus: The meaning of “basis”

“Basis” means the difference between the futures price and the spot price of the underlying asset. It may be positive or negative. On the maturity date, the spot price and the futures price are identical; the basis is zero.

Carry basis

The difference between the theoretical price of a futures contract and the spot price of the underlying asset is the theoretical basis, called the “carry basis”. It is equal to the cost of carry.

Theoretical futures price – spot price = cost of carry = “carry basis”

Value basis

The difference between the actual price of a future contract and the spot price of the underlying asset is the actual basis, called the “value basis”. It corresponds to the cost of carry plus other influencing factors (F).

Actual futures price – spot price = cost of carry + F = “value basis”

Quotation of futures

Futures on indices and other instruments quoted in points

Futures contracts based on equity indices and other index-based instruments are quoted in index points. The value of a futures contract is obtained by multiplying the index level by the value of an index point.

Futures on long-term interest-rate instruments (bonds)
Futures contracts on long-term interest rates generally follow the quotation method of the underlying bond. The price of a bond is normally quoted either by means of the decimal method (e.g., a market value of $82.60 per $100 nominal value of the bond) or – common in international markets – in full percentage points and 1/32nds thereof. A quotation of 82-19 for a U.S. treasury bond approximately equals a decimal quotation of 82.60 (82 + 19/32 = 82.59375). The value of the futures contract is then the nominal amount of the underlying instrument (i.e. USD 100,000 for a U.S. treasury bond), multiplied by the quoted futures price.

An exception to the above, futures contracts may alternatively be quoted according to the index method, whereby the prices of the underlying bonds are converted into an index.