Pricing of Futures and Forwards
Abdulla Javeri
30 years: Financial markets trader
In the second video, Abdulla describes how the spot, and forward or futures prices are connected by the arbitrage-free principle. The relationship is based on the costs of carry. In efficient markets, arbitrage activity will generally ensure that the prices in the respective markets are maintained at levels consistent with that principle.
In the second video, Abdulla describes how the spot, and forward or futures prices are connected by the arbitrage-free principle. The relationship is based on the costs of carry. In efficient markets, arbitrage activity will generally ensure that the prices in the respective markets are maintained at levels consistent with that principle.
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Pricing of Futures and Forwards
6 mins 23 secs
Buying and selling of assets can be undertaken in any of three markets, spot, forward and futures markets. There is usually a difference in the prices prevailing in spot and forward/futures markets. The difference can be explained by the principle of no arbitrage or arbitrage free pricing principle. The arbitrage free principle is based on the costs of carry- usually referred to as the carry.
Key learning objectives:
Understand the connection between the spot price and a forward or futures price
Describe the cost of carry, and its components
Understand how to calculate the forward price or futures fair value
Define the terms Contango and Backwardation
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What connects the spot price and a forward or futures price?
The principle of no arbitrage. Arbitrage refers to the ability to make a risk-free profit by buying and selling the same asset simultaneously. So for example, buy for one hundred and sell for one hundred and one at the same time. Arbitrage activity takes place if spot and forward/futures prices deviate sufficiently from the arbitrage free price.
What is the cost of carry, and what are its components?
What underlies that zero or no arbitrage principle is what’s called the cost of carry, or carry for short. It comprises of:
- Finance cost
- Income
- Storage
- Insurance
- Other incidental costs
How do we calculate the forward price or futures fair value?
Forward price = Spot price + Cost of carry
What do the terms Contango and Backwardation mean?
- When there is a net cost of carry, forward/futures prices are higher than spot – Contango
- When there is a benefit (income outweighs other costs), forward/futures prices are lower than spot – Backwardation
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This content is also available as part of a premium, accredited video course. Sign up for a 14-day trial to watch for free.
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