forward trader.

It can be concluded that if the interest is positively correlated

with the futures price then a long trader will prefer a futures position than a
forward position. If the futures price and the interest rates both decline, then
the futures trader must make the payment at lower rates of interest.

Future price and the expected future spot prices: Future prices
keep on changing continuously. Thus future price can be an estimate of the
expected future spot price.

The volatility of futures prices: The futures prices are vulnerable to

volatility i.e. there exists a direct relationship between futures trading and
the volatility and the patterns in the volatility of futures prices. According to
some studies, futures trading increased volatility of cash market. Also, lesser
the time to expiration, higher the volatility. Sometimes volatility phenomenon
is quite seasonal and at some points in time in particular days. Some other
studies reveal a positive correlation between futures trading volume and the
volatility of the futures prices. Easy and early accessibility of information
make futures price more volatile.

2.3.2 Theories of futures pricing

There are several theories which have made efforts to explain the
relationship between spot and futures prices. A few important of them are as
follows:

2.3.2.1 The cost-of-carry approach

Some economists like Keynes and Hicks, have argued that futures
prices essentially reflect the carrying cost of the underlying assets. In other
words, the inter-relationship between spot and futures prices reflect the
carrying costs, i.e., the amount to be paid to store the asset from the present
time to the futures maturity time (date). For example, foodgrains on hand in
June can be carried forward to, or stored until, December. Cost of carry which

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includes storage cost plus the interest paid to finance the asset less the
income earned on assets. For more understanding of the concept, let’s take
the following cases:

Case 1: For generalization, let us assume a forward contract on an

investment asset with price S0 that provides no income. The following
equation gives the price of a forward:

F0 = S0erT … (2.1)

Where F0 is forward price.

S0- Price of an investment asset with no income.

T- Time to maturity

e- Constant

r- Risk free rate of return.

If F0 > S0erT, then the arbitrageurs will buy the asset and short forward
contracts on the assets. If F0 < S0erT they can short the asset and buy forward
contracts.

Case II: In case of an asset with income I, the forward price can be
calculated as:

F0 = (S0 – I) erT … (2.2)

Case III: In case of asset with yield q the forward price is given by:

F0 = S0e(r-q)T … (2.3)

In the similar fashion, the future price of a stock index paying dividend
can be calculated as follows:

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 Since dividend provides a known yield

F0 = S0e(r-q)T

Illustration 2.1: Suppose a four month forward to buy a zero coupon

bond will mature one year hence. The current price of bond is Rs. 930.
Assuming risk free rate of return (Compounded) is 6% per annum, the
forward price can be calculated as

F0 = 930 e0.06 ×4/12 = Rs. 948.79

Where S0 = Rs. 930, r = 0.06, T = 4/12 = 1/3.

Illustration 2.2: Supposing a three-month Nifty index future contract

provides a dividend yield of 1% p.a., current value of stock is Rs. 400 and risk
free interest is 6% p.a.

The future price of the index is:

F0 = 400 e(0.06-0.01)×0.25

= Rs. 405.03

If storage cost is also adjusted then the formula for calculating futures
prices becomes:

F0 = (S0 + U) erT.

Where U is the present value of all storage cost incurred during life
span of a contract.

Illustration 2.3: Assuming that one year futures contract on gold costs
Rs. 2 per 10 gm to store it with payment being made at the end of the year.

Spot price stands at Rs. 450 with risk-free interest rate of 7% p.a.

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 Here, U = 2e-0.07×1 = 1.865

Where S0 = 450, T = 1, r = 0.07

Hence the price of future will be

F0 = (450 + 1.865) e0.07×1 = Rs. 484.63.

In case where storage cost are proportional to the price by the

commodity, they are known as negative yield and the future price becomes:

F0 = S0e(r+u)T

Where u denotes the storage cost p.a. as a proportion of the spot price.

The cost-of-carry model in perfect market: The following formula

describes a general cost-of-carry price relationship between the cash (spot)
price and futures price of any asset:

Futures price = Cash (spot) price + Carrying cost

Assumptions: The following are the assumptions of this approach:

• There are no information or transaction costs associated with
the buying and selling the asset.
• No restriction limit for borrowing and lending.
• Borrowing and lending rates are homogeneous.
• No credit risk associated and margin requirement.
• Goods can be stored indefinitely without loss to the quality of the
goods.
• There are no taxes.

In simple terms, the futures prices are influenced to some extent on

expectations prevailing at the current time. Under this hypothesis, if markets
are operating perfectly then

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 Current futures price = Expected futures spot price

2.3.2.2 The expectation approach

The advocates of this approach J.M. Keynes, J.R. Hicks and N. Kalidor
argued the futures price as the market expectation of the price at the futures
date. Many traders and investors, especially those using futures market to
hedge, will be interested to study how today’s futures prices are related to
market expectations about futures prices. For example, there is general
expectation that the price of the gold next Oct 1, 2006 will be Rs. 7000 per 10
grams. The futures price today for Jan 1, 2007 must somewhat reflect this
expectation. If today’s futures price is Rs. 6800 of gold, going long futures will
yield an expected profit of

Expected futures profit = Expected futures price–Initial futures price

Rs. 200 = Rs. 7000 – Rs. 6800

Differences of the futures prices from the expected price will be

corrected by speculation. Profit seeking speculators will trade as long as the
futures price is sufficient far away from the expected futures spot price. This
approach may be expressed as follows:

F0,t = E0 (St)

Where F0,t is Futures price at time t = 0 and E0(St) is the expectation at

t = 0 of the spot price to prevail at time t.

The above equation states that the futures price approximately equals
the spot price currently expected to prevail at the delivery date, and if, this
relationship did not hold, there would be attractive speculative opportunity.
Future prices are influenced by expectations prevailing currently.

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 This is also known as hypothesis of unbiased futures pricing because it
advocates that the futures price is an unbiased estimate of the futures spot
price, and on an average, the futures price will forecast the futures spot price
correctly.

2.3.2.3 The theory of normal backwardation

In general, backwardation is the market in which the futures price is

less than the cash (spot price). In other words, the basis is positive, i.e.,
difference between cash price and future price is positive. This situation can
occur only if futures prices are determined by considerations other than, or in
addition, to cost-of-carry factors. Further, if the futures prices are higher than
the cash prices, this condition is usually referred to as a contongo-market
market; and the basis is negative. Normal backwardation is used to refer
to a market where futures prices are below expected futures spot prices.

Second way of describing the cantango and backwardation market is

that the former (cantango) is one in which futures prices are reasonably
described most of time by cost-of-carry pricing relationship, whereas later
(backwardation) is one in which futures prices do not fit a full cost-of-carry
pricing relationship. Futures prices are lower than those predicted by the
cost-of-carry pricing formula.

It has been observed in many futures markets that the trading volume
of short hedging (sales) exceeds the volume of long hedging (purchases),
resulting in net short position. In such situation, Keynes has argued that, in
order to induce long speculators to take up the net-short-hedging volume, the
hedgers had to pay a risk premium to the speculators. As a result, the futures
price would generally be less than the expected futures spot price, by the
amount of risk premium which can be stated in equation as:

F=E–r

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 Where, F is futures price for a futures date, E is expected price at that
date and r is risk premium.

The theory of normal backwardation states that futures prices should

rise overtime because hedgers tend to be net-short and pay speculators to
assume risk by holding long positions.

Fig. 2.1: Patterns of futures prices

Figure 2.1 illustrates the price patterns of futures which is expected

under different situations. If the traders correctly assess the futures spot
price so that the expected futures spot price turns out to be the actual spot
price at the maturity. If the futures price equals the expected futures spot
price then it will lie on the dotted line. However such situations, sometimes,
do not occur, and alternative conceptions exist like normal backwardation
and cantango. If speculators are net long then futures prices must rise over
the life of the contract if speculators to be compensated for bearing risk.
Futures prices then follow the path as labelled normal backwarding in Fig 2.1
It is to be noted that this line will terminate at the expected futures spot
price.

2.3.2.4 Future pricing and CAPM

The risk and return relationship can be very well explained by CAPM
which suggests that systematic risk is important in return calculations. The

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Capital Asset Pricing Model (CAPM) can also be used in determining the
prices of the futures.

Sometimes, the futures prices differ from expected future spot prices
even after adjusting for systematic risk because of unevenly distributed
demand by hedgers for futures positions. For example, if hedgers are
dominating in the market through short sales then long hedgers will receive
an expected profit in addition to any systematic risk premium. This theory is
called hedging pressure explanation. Let us explain the systematic risk
explanation by an example.

Suppose the current price of HLL share is Rs. 500 and Treasury Bill
rate is 10 per cent per year, assuming that HLL pays no dividend. On the
basis of stock index, the arbitrageurs will guarantee that the futures price of
HLL share after one year is:

= Ft,T = St (1 + rt,T)

= Rs. 500 (1 + 0.10) = Rs. 550

where St is current spot price at time t, Ft,T is current futures price at

time T and rt,T is rate of return at time T.

If the unbiasedness hypothesis holds, the expected futures spot price

should be Rs. 550. It means that HLL share will have a 10 per cent return
just like the T. Bill despite the fact that the HLL is a riskier stock. So higher
risk must be compensated. Assuming HLL share gives expected return of 15
per cent then the expected futures spot price will be

Et (ST) = St (1 + rt*,T )

= Rs. 500 (1 + 0.15) = Rs. 575

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 where Et (ST) is expected futures spot price at time T and rt*,T is

expected rate of return on stock.

Thus, in this illustration, the futures price is less than the expected
futures spot price in equilibrium.

Futures price < Expected futures spot price

Or Ft,T < Et (ST)

Rs. 550 < Rs. 575

This implies that, on average, a long futures position will provide a

profit equal to Rs. 25 (575-550). In other words, Rs. 25 expected profit on the
futures position will compensate the holder for the risk of synthetic stock
(synthetic stock = T-bill + Long futures), that is above the risk of T-Bill.

Briefly it can be stated that the difference between the futures price
and the expected futures spot price is the same as the difference between the
expected profit on riskless securities and that on pure asset with the
systematic price risk as the futures contract. Thus, future expected price will
be:

E t (S T ) − Ft,T
=
Pt*

= rt*,T – rt.T

where Pt is price of a pure asset with the same price risk as the
underlying asset of the futures contract, rt,T is expected rate return on that
asset and rt*,T –rt,T is premium of pure asset with same risk as futures over

the riskless rate.

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 Pt can be easily calculated as present value of the expected futures
price of the underlying asset:

E t (S T )
Pt =
1 + rt*,T

Where St is price of a pure asset.

If the underlying asset of a futures contract is a pure asset then Pt* will

be equal to Pt and vice-versa. The discount rate rt*,T can be determined with

the CAPM too.

CAPM defines the relationship between risk and return as:

rt* = rf + β i (rm* − rf )

ρ im σ i
βi =
σm

Where ri* is expected (required) rate of return on a pure asset i, rm* is

expected rate of return on the market portfolio, rf is riskless return
(essentially equal to rtT), ρim is correlation between return on individual and
market return, σi is standard deviation of rate of return on the asset and σm
is standard deviation of rate of return on market portfolio.

The expected return on each pure asset is earned from the difference
between the current spot price and expected futures spot price. The CAPM
shows this difference as to be:

E t (S t ) − Pt* = ri* Pt* + β i (rm* − rf )Pt*

Thus, as stated earlier, the difference between the future price and the
expected futures spot price must be equal to this differential. Where βi is the
systematic risk.

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 E t (S t ) − Ft,T = β i (rm* − rf )Pt*

The earlier equation has an important view that futures prices can be
unbiased predictor of futures spot price only if the asset has zero systematic
risk, i.e., βi = 0. In such situation, the investor can diversify away the risk of
the futures position. In general, futures prices will reflect an equilibrium bias.
If βi > 0 (is positive) then, Ft,T < Et – (ST), and if Bi < 0, a long futures position
has negative systematic risk, such a position will yield an expected loss, so
Ft,T > Et–(ST). This situation purely reflects the CAPM. In brief, according to
CAPM, the expected return on a long futures position depends on the beta of
the futures contract if βi > 0, the futures price should rise overtime; if βi = 0,
the futures price should not change, and if βi < 0, the futures price should fall
over time and vice-versa in the case of short futures.

2.4 Forward markets and trading mechanism

The growth of futures markets followed the growth of forward market.

In early years, there was no so much transporting facilities available, and
hence, a lot of time was consumed to reach at their destination. Sometimes, it
took so much time that the prices drastically changed, and even the producers
of the goods had to sell at loss. Producers, therefore, thought to avoid this
price risk and they started selling their goods forward even at the prices
lower than their expectations. For example, a farmer could sell the produce
forward to another party. And by the time the actual goods reached the
market, he could have protected himself against the future unfavourable
price movements. This is known as short selling. On the other hand, the long
position holder agrees to buy the grain at a pre-specified price and at a
particular date. For this trading, a middleman is needed who knows the
expectations of buyers and sellers and he charges a fees for this purpose
known as commission.

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