Futures contracts assignment help

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What is futures pricing and how does it work?

Futures are financial instruments that allow two parties to exchange an asset at a specified price on a future date. Futures don’t specify who will buy or sell the underlying instrument, just that one party will pay another party the difference between today’s agreed-upon price and the actual current market price of the asset in question, at some point in the future.

Futures pricing is a complex process. Futures prices depend upon the current price of the underlying instrument, and they also depend on how long investors think it will be before delivery is necessary. Futures pricing depends upon three factors: the relationship between risk free interest rates and future returns, volatility of future returns, and time to delivery.

Inherent Futures Pricing Factors

The factors affecting future prices include:

Interest Rates

The first factor that influences a Futures contract is interest rates. Futures prices are discounted by the amount of interest that could be earned on the money tied up in Futures contracts.

Volatility

Another factor that impacts Futures prices is volatility. If Futures prices are high, it means there’s a greater chance of changing spot market price by next expiry day than if Futures prices were low. This change in spot price will make Futures values fluctuate between expiry day and the actual date of Futures contract delivery.

Futures prices and volatility are inversely correlated, meaning Futures price and volatility move opposite of each other. High Futures prices indicate low Futures volatility and vice versa. Volatility is measured by the standard deviation of an underlying instrument over a period of time (usually one month) plus Futures price.

 

Time to Delivery

The time to Futures delivery also affects Futures prices. Futures prices are discounted by the present value of an expected return, but this expected future return changes according to when the Futures contract will expire.

Risk-Free Interest Rates

Futures contracts are derivative instruments, which means their value is derived from the price of an underlying instrument. Futures prices will change when interest rates change because Futures prices are inversely correlated with interest rates. Futures prices tend towards zero when risk free interest rates approach zero or when future interest rates approach Futures prices.

Applications of futures contracts

Futures contracts are in essence agreements to buy or sell assets in the future at a price that is predetermined today. Futures have played an important role in the funding of commodity producers and manufacturers, financial institutions’ risk management activities, hedging strategies for companies and individuals looking to mitigate their risks against adverse fluctuations in prices of commodities like crude oil, metals, currencies and more.

Futures contracts are standardized to facilitate trading on a futures exchange – the contract specifications outline the quality and quantity of the underlying asset, place and exact time of the transaction, risk management practices employed by exchanges in case of default/failure to deliver etc. Futures prices vary from one exchange to another depending upon.

Hedging

Futures pricing is used when the value of an asset is too uncertain to determine its value in the future. Futures help manage risk by allowing investors to eliminate or mitigate their exposure to certain events that they think might affect the underlying instrument’s price, such as interest rates and market volatility. Futures can also provide opportunities for achieving profits by opening up ways to create positions that would be difficult or expensive, if not impossible, to otherwise achieve.

Arbitrage profits

Futures prices could vary considerably depending on the type of underlying asset (such as gold, corn, etc.) and whether it is traded in an active market (exchange-traded futures) or less-active market (over-the-counter derivatives). Futures are often used by producers to lock in the sale price of their goods, ensuring that they will receive a certain amount of money for the sale; or by speculators who wish to make profits.

Cashflow management

Futures also help organizations manage their cash flow and reduce debt, because they allow organizations to fix prices for future deliveries of goods and services before they are produced. Futures prices are determined by numerous factors, including interest rates, time to maturity, price of the underlying instrument, volatility, expectations of future events (e.g., stock market performance), storage or carrying costs (including inflation).

Risk associated with counter-party failure if OTC derivatives are used, dividends paid on the underlying instrument, and more. Futures prices are typically more volatile than cash market prices, which makes them useful for speculators who wish to profit from price differences between spot and futures market prices.

Futures price is also known as Futures theoretical value, which is derived from the Futures volatility of an underlying instrument. Futures contracts are used to hedge against risk, so Futures prices are always lower than spot prices.

How to calculate a Futures price

Price of Futures contract = Asset price * Spot Price Multiplier

Where: Asset price is the current market value of an underlying asset e.g. if gold is trading at $1500 and you want to buy Futures on gold then Futures contract price will be $1500 * Futures Price Multiplier. Futures Price Multiplier is the number of units of underlying asset required to purchase one Futures contract.

Price of Futures contract = 1500 * 100 (Futures price multiplier)

Price of Futures Contract = $150,000

In case Futures price multiplier is not provided then Futures Price = Asset price/Spot Price.

In the above example if gold Futures contracts are trading at $150 and spot price of gold is $1500 then Futures price multiplier = 1.

Futures contract price = 1500 * 100 = 150,000

Price of Futures contract = 150,000

The advantages and disadvantages of using futures contracts as an investment vehicle

The merits and demerits include;

Advantages

Futures contracts guarantee a certain price thereby eliminating the risks involved in fluctuating prices of commodities Futures contracts perform as an efficient cost management tool for risk management purposes such as price fluctuations. Futures exchanges (over the counter) provide anonymity to their users and limit legal liabilities.

Futures can be used as a means to mitigate risks involved in investing and can also be used to speculate on commodity prices. Futures contracts provide a convenient way of transferring the underlying asset from one party to another through Futures exchanges. Futures markets allow for easy access to commodities such as crude oil, metals, currencies etc.

Futures are an efficient mechanism for risk management purposes Futures are regulated Futures markets are highly competitive Futures contracts have greater liquidity Futures contracts have lower transaction costs Futures exchanges allow for anonymous transactions Futures contracts provide a convenient way of transferring the underlying asset from one party to another through Futures exchanges

 

Disadvantages

• Futures can be subject to high brokerage
• Futures contracts are prone to price manipulation
• Futures contracts are complex Futures exchanges are open for only six months in a year
• Futures prices are subject to continuous fluctuation Futures contracts may attract short-term holding period tax implications.

Types of future contracts

There exists various types which include but not limited to:

commodity futures

These are contracts on non-investment goods.They include futures contract for agricultural commodities such as corn Futures contracts for financial instruments such Futures contracts for metals such as gold, silver etc Futures contracts for energy such as crude oil Futures contracts to buy or sell foreign currencies Futures contracts used to purchase assets other than physical assets such as interest rates and stock indices.

Stock index futures are Futures contracts to buy or sell financial instruments Futures are standardized Futures exchanges Futures prices are determined by demand and supply factors Futures prices are inversely related to spot prices.

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