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Futures Pricing

Futures Pricing​

Futures pricing is influenced by several factors, including the spot price of the underlying asset, interest rates, dividends, and the time remaining until contract expiry. For AlgoTest traders, understanding how futures contracts are priced can help in building accurate strategies using the Strategy Builder and testing them in the Simulator.

The Futures Pricing Formula​

The basic formula used to calculate the price of a futures contract is:

Futures Price = Spot Price * [1 + (Rf * (x / 365))] – d

Where:

  • Rf is the risk-free interest rate (often the RBI’s Treasury Bill rate).
  • x is the number of days to expiry.
  • d represents any dividends expected during the contract period.

This formula ensures that futures contracts are priced based on the current spot price, adjusted for the cost of carrying the position over time. The risk-free rate compensates the trader for holding the futures contract rather than the asset itself, while dividends lower the futures price since they are paid to the holder of the underlying asset.

Practical Example​

Suppose Infosys stock is trading at ₹2,300, and there are 30 days remaining until the futures contract expires. The risk-free rate is 6%, and no dividend is expected during this period. The futures price can be calculated as:

Futures Price = ₹2,300 * [1 + (6% * 30/365)]

Solving this gives the futures price as approximately ₹2,304.5, which would be considered the fair value of the futures contract. In practice, however, the actual price may vary due to market dynamics such as demand and supply, transaction costs, or tax considerations.

Basis and Spread​

The difference between the spot price and the futures price is known as the basis or spread. A positive basis (futures price higher than spot) indicates the futures are trading at a premium, while a negative basis (futures price lower than spot) means they are at a discount. This is important for traders who look to profit from arbitrage opportunities by exploiting price discrepancies between the spot and futures markets.

Real-World Application​

AlgoTest users can utilize the Strategy Builder to create strategies that take advantage of futures pricing principles. For instance, if a stock’s futures are trading at a significant premium due to market imbalances, a trader might short the futures while going long on the underlying asset (a strategy known as cash-and-carry arbitrage).

Conclusion​

Futures pricing is a vital concept in trading, as it helps align the future price of an asset with its current value, adjusting for interest rates and time to expiry. Understanding this can provide AlgoTest traders with insights into building better strategies and identifying arbitrage opportunities.