CHAPTER 3

Futures Prices

In this chapter, we discuss how futures contracts are

priced. This chapter is organized into the following
sections:

1. Reading Futures Prices

2. The Basis and Spreads

3. Models of Futures Prices

4. Futures Prices and Expectations

5. Future Prices and Risk Aversion

6. Characteristics of Futures Prices

Chapter 3 1
 Reading Futures Prices

TERMINOLOGY
To understand how to read the Wall Street Journal futures
price quotations, we need to first understand some
terminology.
Spot Price
Spot price is the price of a good for immediate delivery.
Nearby Contract
Nearby contracts are the next contract to mature.
Distant Contract
Distant contracts are contracts that mature sometime after
the nearby contracts.

Chapter 3 2
 Reading Futures Prices

TERMINOLOGY

Settlement Price

Settlement price is the price that contracts are traded at the

end of the trading day.

Trading Session Settlement Price

New term used to reflect round-the-clock trading.

Open Interest

Open interest is the number of futures contracts for which

delivery is currently obligated.

Chapter 3 3
 Reading Futures Prices

Insert figure 3.1 Here

Chapter 3 4
 How Trading Affects Open Interest

The last column in Figure 3.1 shows the open interest or

total number of contracts outstanding for each maturity
month. Assume that today, Dec 1997, widget contract has
just been listed for trading, but that the contract has not
traded yet. Table 3.1 shows how trading affects open
interest at different times (t).

Table 3.1
How Trading Affects Open Interest
Time Action Open Interest
t=0 Trading opens for the popular widget contract. 0
t=1 Trader A buys and Trader B sells 1 widget contract. 1
t=2 Trader C buys and Trader D sells 3 widget contracts. 4
t=3 Trader A sells and Trader D buys 1 widget contract. 3
(Trader A has offset 1 contract and is out of the mar-
ket. Trader D has offset 1 contract and is now short
2 contracts.)
t=4 Trader C sells and Trader E buys 1 widget contract. 3
Ending Trader Long Position Short Position
Posi- B 1
tions C 2
D 2
E 1
All Traders 3 3

Chapter 3 5
Open Interest &Trading Volume Patterns

Insert Figure 3.2 Here Insert Figure 3.3 Here

Chapter 3 6
 The Basis

The Basis

The basis is the difference between the current cash

price of a commodity and the futures price for the
same commodity.

Basis  S 0  F 0 , t

S0 = current spot price

F0,t = current futures price for delivery of the product at
time t.
The basis can be positive or negative at any given time.
Normal Market
Price for more distant futures are higher than for nearby
futures.
Inverted Market
Distant futures prices are lower than the price for contracts
nearer to expiration.

Chapter 3 7
 The Basis

Table 3.2
Gold Prices and the Basis
(July 11)
Contract Prices The Basis
CASH 353.70
JUL (this year) 354.10 -.40
AUG 355.60 -1.90
OCT 359.80 -6.10
DEC 364.20 -10.50
FEB (next year) 368.70 -15.00
APR 373.00 -19.30
JUN 377.50 -23.80
AUG 381.90 -28.20
OCT 386.70 -33.00
DEC 391.50 -37.80

Example: if the current price of gold in the cash market

is $353.70 (July 11) and a futures contract
with delivery in December is $364.20.
How much is the basis?

Basis  S 0  F 0, t
Basis  $353.7  364.20  $10.50
Basis  $10.50
Chapter 3 8
 The Basis

Convergence
As the time to delivery passes, the futures price will change
to approach the spot price.
When the futures contract matures, the futures price and
the spot price must be the same. That is, the basis must
be equal to zero, except for minor discrepancies due to
transportation and other transactions costs.
The relatively low variability of the basis is very important
for hedging.

Insert Figure 3.4 here Insert Figure 3.5 here

Chapter 3 9
 Spreads

Spread
A spread is the difference in price between two futures
contracts on the same commodity for two different
maturity dates:

Spread  F 0, t  k  F 0, t

Where
F0,t = The current futures price for delivery of the
product at time t.
This might be the price of a futures contract on
wheat for delivery in 3 months.

F0,t+k = The current futures price for delivery of the

product at time t +k.
This might be the price of a futures contract for
wheat for delivery in 6 months.

Spread relationships are important to speculators.

Chapter 3 10
 Spreads

Suppose that the price of a futures contract on wheat for

delivery in 3 months is $3.25 per bushel.

Suppose further that the price of a futures contract on

wheat for delivery in 6 months is $3.30/bushel.

What is the spread?

Spread  F 0, t  k  F 0, t
Spread  $3.30  $3.25  $0.05

Insert Figure 3.7 Here

Chapter 3 11
 Repo Rate

Repo Rate

The repo rate is the finance charges faced by traders. The

repo rate is the interest rate on repurchase agreements.

A Repurchase Agreement

An agreement where a person sells securities at one point

in time with the understanding that he/she will repurchase
the security at a certain price at a later time.

Example: Pawn Shop.

Chapter 3 12
 Arbitrage

An Arbitrageur attempts to exploit any discrepancies in

price between the futures and cash markets.

An academic arbitrage is a risk-free transaction consisting

of purchasing an asset at one price and simultaneously
selling it that same asset at a higher price, generating a
profit on the difference.

Example: riskless arbitrage scenario for IBM stock trading

on the NYSE and Pacific Stock Exchange.

Assumptions:
1. Perfect futures market

2. No taxes

3. No transactions costs

4. Commodity can be sold short

Price Exchange

Arbitrageur Buys IBM ($105) Pacific Stock E.

Arbitrageur Sells IBM $110 NYSE
Riskless Profit $ 5

Chapter 3 13
 Models of Futures Prices

Cost-of-Carry Model

The common way to value a futures contract is by using

the Cost-of-Carry Model. The Cost-of-Carry Model says
that the futures price should depend upon two things:
– The current spot price.

– The cost of carrying or storing the underlying good from

now until the futures contract matures.

Assumptions:
– There are no transaction costs or margin requirements.

– There are no restrictions on short selling.

– Investors can borrow and lend at the same rate of interest.

In the next section, we will explore two arbitrage strategies that are
associated with the Cost-and-Carry Model:

– Cash-and-carry arbitrage

– Reserve cash-and-carry arbitrage

Chapter 3 14
 Cash-and-Carry Arbitrage

A cash-and-carry arbitrage occurs when a trader borrows

money, buys the goods today for cash and carries the
goods to the expiration of the futures contract. Then,
delivers the commodity against a futures contract and pays
off the loan. Any profit from this strategy would be an
arbitrage profit.

0 1

1. Borrow money 4. Deliver the commodity

2. Sell futures contract against the futures contract
3. Buy commodity 5. Recover money & payoff
loan

Chapter 3 15
 Reverse Cash-and-Carry Arbitrage

A reverse cash-and-carry arbitrage occurs when a trader

sells short a physical asset. The trader purchases a
futures contract, which will be used to honor the short sale
commitment. Then the trader lends the proceeds at an
established rate of interest. In the future, the trader
accepts delivery against the futures contract and uses the
commodity received to cover the short position. Any profit
from this strategy would be an arbitrage profit.

0 1

1. Sell short the commodity 4. Accept delivery from futures

2. Lend money received contract
from short sale 5. Use commodity received
3. Buy futures contract to cover the short sale

Table 3.5 summarizes the cash-and-carry and the

reverse cash-and-carry strategies.

Chapter 3 16
 Arbitrage Strategies

Table 3.5
Transactions for Arbitrage Strategies
Market Cash-and-Carry Reverse Cash-and-Carry
Debt Borrow funds Lend short sale proceeds
Physical Buy asset and store; deliver Sell asset short; secure
against futures proceeds from short sale
Futures Sell futures Buy futures; accept delivery;
return physical asset to honor
short sale commitment

Chapter 3 17
 Cost-of-Carry Model

The Cost-of-Carry Model can be expressed as:

F 0, t  S 0(1  C 0, t )
Where:
S0 = the current spot price
F0,t = the current futures price for delivery of
the product at time t.
C0,t = the percentage cost required to store (or
carry) the commodity from today until
time t.
The cost of carrying or storing includes:
1. Storage costs

2. Insurance costs

3. Transportation costs

4. Financing costs

In the following section, we will examine the cost-of-carry

rules.

Chapter 3 18
 Cost-of-Carry Rule 1

The futures price must be less than or equal to the spot

price of the commodity plus the carrying charges
necessary to carry the spot commodity forward to delivery.

F 0, t  S 0(1  C 0, t )

Table 3.3
Cash-and-Carry Gold Arbitrage Transactions
Prices for the Analysis:

Spot price of gold $400

Future price of gold (for delivery in one year) $450
Interest rate 10%
Transaction Cash Flow
t=0 Borrow $400 for one year at 10%. +$400
Buy 1 ounce of gold in the spot market for $400. - 400
Sell a futures contract for $450 for delivery of 0
one ounce in one year.
Total Cash Flow $0
t=1 Remove the gold from storage. $0
Deliver the ounce of gold against the futures +450
contract.
Repay loan, including interest. -440
Total Cash Flow
+$10

Chapter 3 19
 Cost-of-Carry Rule 1

0 1

1. Borrow $400 4. Deliver gold

2. Buy 1 oz gold against
3. Sell futures contract futures contract
5. Repay loan

Chapter 3 20
 The Cost-of-Carry Rule 2

The futures price must be equal to or greater than the spot

price of the commodity plus the carrying charges necessary to
carry the spot commodity forward to delivery.

F 0, t  S 0(1  C 0, t )

Table 3.4
Reverse Cash-and-Carry Gold Arbitrage Transactions
Prices for the Analysis

Spot price of gold $420

Future price of gold (for delivery in one year) $450
Interest rate 10%
Transaction Cash Flow
t=0 Sell 1 ounce of gold short. +$420
Lend the $420 for one year at 10%. - 420
Buy 1 ounce of gold futures for delivery in 1 0
year.
Total Cash Flow $0
t=1 Collect proceeds from the loan ($420 x 1.1). +$462
Accept delivery on the futures contract. -450
Use gold from futures delivery to repay short 0
sale.
Total Cash Flow +$12

Chapter 3 21
 The Cost-of-Carry Rule 2

0 1

1. Sell short 1 oz. gold 4. Collect proceeds

2. Lend $420 at 10% from loan
interest 5. Accept delivery on
3. Buy a futures contract futures contract
6. Use gold from futures
contract to repay the
short sale

Chapter 3 22
 The Cost-of-Carry Rule 3

Since the futures price must be either less than or equal to

the spot price plus the cost of carrying the commodity
forward by rule #1.
And the futures price must be greater than or equal to the
spot price plus the cost of carrying the commodity forward
by rule #2.
The only way that these two rules can reconciled so there
is no arbitrage opportunity is by the cost of carry rule #3.
Rule #3: the futures price must be equal to the spot price
plus the cost of carrying the commodity forward to the
delivery date of the futures contract.

F 0, t  S 0(1  C 0, t )

If prices were not to conform to cost of carry rule #3, a

cash-and carry arbitrage profit could be earned.

Recall that we have assumed away transaction costs,

margin requirements, and restrictions against short selling.

Chapter 3 23
 Spreads and The Cost-of-Carry

As we have just seen, there must be a relationship

between the futures price and the spot price on the same
commodity.

Similarly, there must be a relationship between the futures

prices on the same commodity with differing times to
maturity.

The following rules address these relationships:

Cost-of-Carry Rule 4

Cost-of-Carry Rule 5

Cost-of-Carry Rule 6

Chapter 3 24
 The Cost-of-Carry Rule 4

The distant futures price must be less than or equal to the

nearby futures price plus the cost of carrying the
commodity from the nearby delivery date to the distant
delivery date.

F 0, d  F 0, n(1  Cn , d )
where d > n

F0,d = the futures price at t=0 for the distant delivery

contract maturing at t=d.

Fo,n= the futures price at t=0 for the nearby delivery contract
maturing at t=n.

Cn,d= the percentage cost of carrying the good from t=n

to t=d.

If prices were not to conform to cost of carry rule # 4, a

cash-and-carry arbitrage profit could be earned.

Chapter 3 25
 Spreads and the Cost-of-Carry

Table 3.6 shows that the spread between two futures

contracts can not exceed the cost of carrying the good
from one delivery date forward to the next, as required by
the cost-of-carry rule #4.

Table 3.6
Gold Forward Cash-and-Carry Arbitrage
Prices for the Analysis

Futures price for gold expiring in 1 year $400

Futures price for gold expiring in 2 years $450
Interest rate (to cover from year 1 to year 2) 10%
Transaction Cash Flow
t=0 Buy the futures expiring in 1 year. +$0
Sell the futures expiring in 2 years. 0
Contract to borrow $400 at 10% for year 1 to 0
year 2.
Total Cash Flow $0

t=1 Borrow $400 for 1 year at 10% as contracted at +$400

t = 0.
Take delivery on the futures contract. - 400
Begin to store gold for one year. 0
Total Cash Flow $0

t=2 Deliver gold to honor futures contract. +$450

Repay loan ($400 x 1.1) - 440

Total Cash Flow + $10

Chapter 3 26
 The Cost-of-Carry Rule 4

0 1 2

1. Buy futures 7. Remove gold

contract w/exp 4. Borrow $400 from storage
5. Take delivery on 1 8. Deliver gold
in 1 yrs. against 2 yr.
2. Sell futures yr to exp futures futures contract
contract w/exp 9. Pay back loan
contract.
in 2 years 6. Place the gold in
3. Contract to storage for one yr.
borrow $400
from yr 1-2

Chapter 3 27
 The Cost-of-Carry Rule 5

The nearby futures price plus the cost of carrying the

commodity from the nearby delivery date to the distant
delivery date cannot exceed the distant futures price.
Or alternatively, the distant futures price must be greater
than or equal to the nearby futures price plus the cost of
carrying the commodity from the nearby futures date to the
distant futures date.

F0,d  F0,n 1  C n ,d 

If prices were not to conform to cost of carry rule # 5, a

reverse cash-and-carry arbitrage profit could be earned.

Chapter 3 28
 The Cost-of-Carry Rule 5

Table 3.7 illustrates what happens if the nearby futures

price is too high relative to the distant futures price. When
this is the case, a forward reverse cash-and-carry arbitrage
is possible.

Table 3.7
Gold Forward Reverse Cash-and-Carry Arbitrage
Prices for the Analysis:

Futures price for gold expiring in 1 year $440

Futures price for gold expiring in 2 years $450
Interest rate (to cover from year 1 to year 2) 10%

Transaction Cash Flow

t=0 Sell the futures expiring in one year. +$0

Buy the futures expiring in two years. 0
Contract to lend $440 at 10% from year 1 to 0
year 2.
Total Cash Flow $0

t=1 Borrow 1 ounce of gold for one year. $0

Deliver gold against the expiring futures. + 440
Invest proceeds from delivery for one year. - 440

Total Cash Flow $0

t=2 Accept delivery on expiring futures. - $450

Repay 1 ounce of borrowed gold. 0
Collect on loan of $440 made at t = 1. + 484

Total Cash Flow + $34

Chapter 3 29
 The Cost-of-Carry Rule 5

0 1 2

1. Sell futures 7. Accept delivery

contract w/exp 4. Borrow 1 oz. gold on exp 2 yr
5. Deliver gold on 1 futures contract
in 1 yrs. yr to exp futures 8. Repay 1 oz.
2. Buy futures borrowed gold.
contract w/exp contract. 9. Collect $400
6. Invest proceeds loan
in 2 years from delivery for
3. Contract to one yr.
lend $400
from yr 1-2

Chapter 3 30
 Cost-of-Carry Rule 6

Since the distant futures price must be either less than or

equal to the nearby futures price plus the cost of carrying
the commodity from the nearby delivery date to the distant
delivery date by rule #4.
And the nearby futures price plus the cost of carrying the
commodity from the nearby delivery date to the distant
delivery date can not exceed the distant futures price by
rule #5.
The only way that rules 4 and 5 can be reconciled so there
is no arbitrage opportunity is by cost of carry rule #6.

Chapter 3 31
 Cost-of-Carry Rule 6

The distant futures price must equal the nearby futures

price plus the cost of carrying the commodity from the
nearby to the distant delivery date.

F 0, d  F 0, n(1  Cn , d )

If prices were not to conform to cost of carry rule #6, a

cash-and-carry arbitrage profit or reverse cash-and-carry
arbitrage profit could be earned.

Recall that we have assumed away transaction costs,

margin requirements, and restrictions against short selling.

Chapter 3 32
 Implied Repo Rates

If we solve for C0,t in the above equation, and assume that

financing costs are the only costs associated with holding
an asset, the implied cost of carrying the asset from one
time point to another can be estimated. This rate is called
the implied repo rate.

The Cost-of-Carry model gives us:

F 0, t  S 0(1  C 0, t )

Solving for C 0, t

F 0, t
 (1  C 0, t )
S0

And

F 0, t
 1  C 0, t
S0

Chapter 3 33
 Implied Repo Rates

Example: cash price is $3.45 and the futures price is

$3.75. The implied repo rate is?

F 0, t
 1  C 0, t
S0

$3.75
 1  0.086956
$3.45

That is, the cost of carrying the asset from today until the
expiration of the futures contract is 8.6956%.

Chapter 3 34
 The Cost-of-Carry Model in Imperfect
Markets

In real markets, no less than four factors complicate the

Cost-of-Carry Model:

1. Direct transactions costs

2. Unequal borrowing and lending rates

3. Margin and restrictions on short selling

4. Limitations to storage

Chapter 3 35
 Transaction Costs

Transaction Costs
Traders generally are faced with transaction costs when they
trade. In this case, the profit on arbitrage transactions might be
reduced or disappear altogether.

Types of Transaction Costs:

– Brokerage fees to have their orders executed

– A bid ask spread

A market maker on the floor of the exchange needs to make a

profit. He/She does so by paying one price (the bid price) for a
product and selling it for a higher price (the ask price).

Chapter 3 36
 Cost-of-Carry Rule 1
with Transaction Costs

Recall that the futures price must be less than or equal to

the spot price of the commodity plus the carrying charges
necessary to carry the spot commodity forward to delivery.

F 0, t  S 0(1  C 0, t )

We can modify this rule to account for transaction

costs:

F 0, t  S 0(1  T )(1  C 0, t )

Where T is the percentage transaction cost.

Chapter 3 37
 Cost-of-Carry Rule 1
with Transaction Costs

To show how transaction costs can frustrate an arbitrage

consider Table 3.8.

Table 3.8
Attempted Cash-and-Carry Gold Arbitrage Transactions
Prices for the Analysis:

Spot price of gold $400

Future price of gold (for delivery in one year) $450
Interest rate 10%
Transaction cost (T ) 3%
Transaction Cash Flow
t=0 Borrow $412 for one year at 10%. +$412
Buy 1 ounce of gold in the spot market for - 412
$400 and pay 3% transaction costs, to total 0
$412.
Sell a futures contract for $450 for delivery of
one ounce in one year. Total Cash Flow $0
t=1 Remove the gold from storage. $0
Deliver the ounce of gold to close futures +450.00
contract.
Repay loan, including interest. -453.20
Total Cash Flow -$3.20

Chapter 3 38
 Cost-of-Carry Rule 2
with Transaction Costs

Recall from Cost-of-Carry Rule 2 that the futures price

must be equal to or greater than the spot price of the
commodity plus the carrying charges necessary to carry
the spot commodity forward to delivery.

F 0, t  S 0(1  C 0, t )

We can modify this rule to allow for transaction costs as

follows:

F 0, t  S 0(1  T )(1  C 0, t )

Chapter 3 39
 Cost-of-Carry Rule 2
with Transaction Costs

To show how transaction costs can frustrate an attempt to

reserve cash-and-carry arbitrage. Consider Table 3.9.

Table 3.9
Attempted Reverse Cash-and-Carry Gold Arbitrage
Prices for the Analysis:

Spot price of gold $420

Future price of gold (for delivery in one year) $450
Interest rate 10%
Transaction costs (T ) 3%
Transaction Cash Flow
t=0 Sell 1 ounce of gold short, paying 3%
transaction costs. Receive $420(.97) = +$407.40
$407.40. - 407.40
Lend the $407.40 for one year at 10%. 0
Buy 1 ounce of gold futures for delivery in 1
year. Total Cash Flow $0

t=1 Collect loan proceeds ($407.40 x 1.1). +$448.14

Accept gold delivery on the futures contract. -450.00
Use gold from futures delivery to repay short 0
sale.
Total Cash Flow
-$1.86

Chapter 3 40
 No-Arbitrage Bounds

Incorporating transaction costs and combining cost-of-carry

rules 1 and 2, we have the following.

S 0(1  T )(1  C 0, t )  F 0, t  S 0(1  T )(1  C 0, t )

This equation defines the “No Arbitrage Bounds”. That is,

as long as the futures price trades within this range, no
cash-and-carry or reverse cash-and-carry arbitrage
transactions will be profitable.

Table 3.10 illustrates this equation.

Chapter 3 41
 No-Arbitrage Bounds

Table 3.10
Illustration of No-Arbitrage Bounds
Prices for the Analysis:

Spot price of gold $400

Interest rate 10%
Transaction costs (T ) 3%

No-Arbitrage Futures Price in Perfect Markets

F0,t = S0(1 + C ) = $400(1.1) = $440

Upper No-Arbitrage Bound with Transaction Costs

F0,t < S0(1 + T )(1 + C ) = $400(1.03)(1.1) = $453.20

Lower No-Arbitrage Bound with Transaction Costs

F0,t > S0(1 B T )(1 + C ) = $400(.97)(1.1) = $426.80

In this case, as long as the futures price is between

$426.80 and $453.20, arbitrage transactions will not be
profitable.

Chapter 3 42
 No-Arbitrage Bounds

$453.20

Futures
Price

$426.80

Time

Chapter 3 43
 Differential Transaction Costs

Situations occur where all traders do not have equal

transaction costs.

For example, a floor trader, trading on his own behalf

would have a lower transaction cost than others. So while
he/she might be able to earn an arbitrage profit, others
could not.

Such a transaction is called a quasi-arbitrage.

Chapter 3 44
 Unequal Borrowing & Lending Rates

Thus far we have assumed that investors can borrow and

lend at the same rate of interest. Anyone going to a bank
knows that this possibility generally does not exist.

Incorporating differential borrowing and lending rates into

the Cost-of-Carry Model gives us:

S 0 (1  T )(1  C L )  F 0, t  S 0(1  T )(1  C B )

Where:
CL = lending rate
CB = borrowing rate

Chapter 3 45
 Unequal Borrowing & Lending Rates

Table 3.11
Illustration of No-Arbitrage Bounds
with Differential Borrowing and Lending Rates
Prices for the Analysis:

Spot price of gold

$400
Interest rate (borrowing)

12%
Interest rate (lending)

8%
Transaction costs (T )

3%

Upper No-Arbitrage Bound with Transaction Costs and a Borrowing Rate

F0,t < S0(1 + T )(1 + CB ) = $400(1.03)(1.12) = $461.44

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate

F0,t > S0(1 B T )(1 + CL ) = $400(.97)(1.08) = $419.04

Chapter 3 46
 Restrictions on Short Selling

Thus far we have assumed that arbitrageurs can sell short

commodities and have unlimited use of the proceeds.
There are two limitations to this in the real world:

– It is difficult to sell some commodities short.

– Investors are generally not allowed to use all

proceeds from the short sale.

How do limitations on the use of funds from a short sale

affect the Cost-of-Carry Model?
We can examine this by editing our transaction cost and
differential borrowing Cost-of-Carry Model as follows:

Chapter 3 47
 Restrictions on Short Selling

The transaction cost and differential cost of borrowing

model is as follows:

S 0 (1  T )(1  C L )  F 0, t  S 0(1  T )(1  CB )

We modify this by recognizing that you will not get all of

the proceeds from the short sale. You will get some
portion of the proceeds.

S 0(1  T )(1  fC L )  F 0, t  S 0(1  T )(1  C B )

Where:
ƒ = the proportion of funds received

Chapter 3 48
 Restrictions on Short Selling

Table 3.12 illustrates the effect of limitations on the use of

short sale proceeds.

Table 3.12
Illustration of No-Arbitrage Bounds
with Various Short Selling Restrictions
Prices for the Analysis:

Spot price of gold

$400
Interest rate (borrowing)

12%
Interest rate (lending)

8%
Transaction costs (T )

3%

Upper No-Arbitrage Bound with Transaction Costs and a Borrowing Rate

F0,t < S0(1 + T )(1 + CB ) = $400(1.03)(1.12) = $461.44

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 1.0

F0,t > S0(1 B T )(1 + fCL ) = $400(.97)[1 + (1.0)(.08)] = $419.04

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 0.75

F0,t > S0(1 B T)(1 + fCL ) = $400(.97)[1 + (.75)(.08)] = $411.28

Lower No-Arbitrage Bound with Transaction Costs and a Lending Rate, f = 0.5

F0,t > S0(1 B T )(1 + f CL ) = $400(.97)[1 + (0.5)(.08)] = $403.52

Chapter 3 49
 Restrictions on Short Selling

The effect of the proceed use limitation is to widen the no-

arbitrage trading bands.

$461.4
4
Futures
Price

$403.52

Time

Chapter 3 50
 Limitations on Storage

The ability to undertake certain arbitrage transactions

requires storing the product. Some items are easier to
store than others.

Gold is very easy to store. You simply rent a safe deposit

box at the bank and place your gold there for safekeeping.

Wheat is moderately easy to store.

How about milk or eggs?

They can be stored, but not for long periods of time.

To the extent that a commodity can not be stored, or has

limited storage life, the Cost-of-Carry Model may not hold.

Chapter 3 51
 How Traders Deal with Market
Imperfections

The costs associated with carrying commodities forward

vary widely among traders.

If you are a floor trader, your transaction costs will be very

low. If you are a farmer with unused grain storage on your
farm, your cost of storage will be very low.

Individuals with lowest trading costs (storage costs, and

cost of borrowing) will have the most profitable arbitrage
opportunities.

The ability to sell short varies between traders.

Chapter 3 52
 The Concept of Full Carry Market

To the extent that markets adhere to the following equations

markets are said to be at “full carry”:

F 0, t  S 0(1  C 0, t )

F 0, d  F 0, n(1  Cn , d )

If the futures price is higher than that specified by above

equations, the market is said to be above full carry.

If the futures price is below that specified by the above

equations, the market is said to be below full carry.

To determine if a market is at full carry, consider the

following example:

Suppose that:

September Gold $410.20

December Gold $417.90
Bankers Acceptance Rate 7.8%

Chapter 3 53
 The Concept of Full Carry Market
Step 1: compute the annualized percentage difference
between two futures contracts.
M
AD  ( FF )
0, d

0. N
12  1

Where
AD = Annualized percentage difference
M = Number of months between the maturity of the
futures contracts.
3
AD  ( $410.20
)
$417.90 12
1

AD  1.0772  1

AD  0.0772

Step 2: compare the annualized difference to the interest

rate in the market.

The gold market is almost always at full carry. Other

markets can diverge substantially from full carry.

Chapter 3 54
 The Concept of Full Carry Market

Insert Figure 3.1 here

Futures Price Quotations

Chapter 3 55
 Market Features That Promote Full
Carry

Ease of Short Selling

To the extent that it is easy to short sell a commodity, the
market will become closer to full carry.
Difficulties in short selling will move a market away from full
carry.
Selling short of physical goods like wheat is more difficult,
while selling short of financial assets like Eurodollars is
much easier. For this reason, markets for financial assets
tend to be closer to full carry than markets for physical
assets.
Large Supply
If the supply of an asset is large relative to its consumption,
the market will tend to be closer to full carry. If the supply
of an asset is low relative to its consumption, the market
will tend to be further away from full carry.

Chapter 3 56
Market Features that Promote Full Carry

Non-Seasonal Production
To the extent that production of a crop is seasonal,
temporary imbalances between supply and demand can
occur. In this case, prices can vary widely.
– Example: in North America, wheat harvest occurs
between May and September.

Non-Seasonal Consumption
To the extent that consumption of commodity is seasonal,
temporary imbalances between supply and demand can
occur.
– Example: propane gas during winter
Turkeys during thanksgiving

High Storability
A market moves closer to full carry if its underline
commodity can be stored easily.
The Cost-of-Carry Model is not likely to apply to
commodities that have poor storage characteristics.
– Example: eggs

Chapter 3 57
 Convenience Yield

When there is a return for holding a physical asset, we say

there is a convenience yield. A convenience yield can
cause futures prices to be below full carry. In extreme
cases, the cash price can exceed the futures price. When
the cash price exceeds the futures price, the market is said
to be in “backwardation.”

Chapter 3 58
 Futures Prices and Expectations

If futures contracts are priced appropriately, the current

futures price should tell us something about what the spot
price will be at some point in the future.

There are four theories about futures prices and future spot
prices:
– Expectations or Risk Neutral Theory

– Normal Backwardation

– Contango

– Capital Asset Pricing Model (CAPM)

Speculators play an important role in the futures market,

they ensure that futures prices approximately equal the
expected future spot price.

Chapter 3 59
 Expectations or Risk Neutral Theory

The Expectations Theory says that the futures price equals

the expected future spot price.

F 0, t  E ( S 0)

Where

E ( S 0) = the expected future spot price

Chapter 3 60
 Normal Backwardation

The Normal Backwardation Theory says that futures

markets are primarily driven by hedgers who hold short
positions. For example, farmers who have sold futures
contracts to reduce their price risk.
The hedgers must pay speculators a premium in order to
assume the price risk that the farmer wishes to get rid of.
So speculators take long positions to assume this price
risk. They are rewarded for assuming this price risk when
the futures price increases to match the spot price at
maturity.
So this theory implies that the futures price is less than the
expected future spot price.

F 0, t  E ( S 0)

Chapter 3 61
 Normal Backwardation

Figure 3.9 depicts a situation that might prevail in the

futures market for a commodity.

Insert figure 3.9 here

Chapter 3 62
 Contango

The Contango Theory says that futures markets are

primarily driven by hedgers who hold long positions. For
example, grain millers who have purchased futures
contracts to reduce their price risk.

The hedgers must pay speculators a premium in order to

assume the price risk that the grain miller wishes to get rid
of.

So speculators take short positions to assume this price

risk. They are rewarded for assuming this price risk when
the futures price declines to match the spot price at
maturity.

So this theory implies that the futures price is greater than

the expected future spot price.

F 0, t  E ( S 0)

Chapter 3 63
 Contango

Figure 3.10 illustrates the price patterns for futures under

different scenarios.

Insert Figure 3.10 here

Chapter 3 64
 Capital Asset Pricing Model (CAPM)

The CAPM Theory is consistent with the Normal Backwardation

Theory, the Contango Theory, and the Expectations Theories.

However, the CAPM Theory suggests that speculators will be

rewarded only for the systematic portion of the risk that they are
assuming.

Chapter 3 65
 Statistical Characteristics of Futures
Prices

Futures prices exhibit statistically significant first-order

autocorrelation. However, not strong enough to allow
profitable trading strategies.

Autocorrelation
– A time series is correlated when one observation in the
series is statistically related to another.

– first-order autocorrelation occurs when one observation is

related to the immediately preceding observations.

The Volatility of Futures Prices

– Evidence suggests that futures trading does not increase
the volatility of the cash market.

Time to Expiration and Futures Price Volatility

– Price changes are large when more information is known
about the future spot price.

Chapter 3 66