Know-How are Futures Prices Determined

The world of financial investment is diverse. It offers opportunities to a variety of stakeholders such as investor, hedger, trader, or an analyst. While some securities are as simple as buying or selling of stock, there are certain investments such as ‘futures’ also known as ‘futures contract‘ that are more complex and require a lot of research and a significant amount of speculation.

Let’s take a look at what futures means, the important terms associated with it, and how to calculate futures price of stock.

What is a futures contract?

Simply put, a futures contract is a legal contract between the buyer and seller where they decide to transact an asset such as a commodity, security, or financial instrument, at a later time for a special price. This time, price, and quantity of the asset are predetermined by the parties. This means that the seller must sell the asset at the contractually agreed-upon price, and the seller must buy the asset at the same price, regardless of the market price of the asset on the date of contract expiration.

A futures contract is standardised so that it can be traded on a futures exchange. In India, the Bombay Stock Exchange, Indian Energy Exchange, National Spot Exchange, National Stock Exchange of India, are some of the futures exchanges. The futures contracts are regulated, and free of counterparty risk as the exchange clearinghouses guarantee that the contractual parties will honour the obligations of the agreement.

Example of a futures contract:

Typically, two types of market participants engage in futures contracts- speculators and hedgers. A speculator is a portfolio manager or trader who makes a bet based on their speculation of the price movement of a particular product. A hedger is a producer or buyer who wants to protect themselves against any market volatility.

Let’s illustrate a typical futures contract for better understanding. Company ABC manufactures cheese. As part of its operations, milk is one of the essential raw materials they need. On the other side is a livestock producer who needs to ensure that they can sell their milk. They enter into a futures contract through a broker, as the buyer and seller know that they will need to buy milk/sell milk. Both want to protect themselves from the market volatility associated with the price of milk. Both know the price they will pay/receive when the contract expires. This way, the buyer and seller can rest assured of the money involved, and prepare accordingly.

On the contract expiration date, if the price of milk is more than the stated price in the futures contract, the investor holding a contract with the livestock producer gains. In contrast, the investor with the cheese manufacturer gets to profit when the price of milk is lower than the price stated in the futures contract.

In this way, the livestock producer and cheese manufacturer both protect their work by transferring the risks and rewards to the investor or speculator.

Trading futures contract:

One of the most important questions for anyone looking to trade in futures is, “how are futures prices determined?” If we were to consider a company, let’s say Company ABC, how could we determine the futures price of its stock?

Before we get to the formula to calculate the price of the futures, we need to understand certain terms.

Spot-price is the current market value of the asset that will be paid by the buyer to get immediate delivery. A futures price is the price agreed upon by the buyer and seller for the future delivery of the commodity. The difference between the two prices is called the ‘basis’ or ‘spread’. This spread is due to interest rates, dividend yields, or time until expiry.

The futures contract’s price is arrived at based on the spot price of the underlying asset, adjusted for dividend accumulated till the contract expiry date, and time.

There is a mathematical formula used to price futures. It takes into consideration the spot-price, the risk-free rate of return, and dividends.

The formula to calculate futures price is-

Futures Price = Spot price *(1+ rf – d).

Here, ‘rf’ means risk- free rate of return, and ‘d’ means dividend that the company gives.

In India, the Reserve Bank of India gives the risk-free rate.

Pros and cons of futures trading:

Just like any other stock market related investment, there are certain pros and cons associated with futures trading.

A company that relies on raw materials such as oil or milk can protect themselves from the pricing volatility of these resources. For example, an aviation company may speculate that the cost of crude oil will significantly increase in 6 months. So, they may enter a futures contract with a trader to ensure that they still get their oil at a predetermined, acceptable price point. This way, they mitigate the risk of paying a heftier price for fuel. The other advantage is that the investor doesn’t have to pay the full value of the contract up front. They can pay an agreeable margin or fraction of the contract value to the broker.

Futures trading has its risks; investors can lose much more than the initial margin amount. Taking the aviation company example from earlier, the aviation company may lose out on the opportunity to buy cheaper fuel in case the oil prices are lower at the time of the contract expiration.

Hence, the astute investor will need to be alert, perceptive, and think critically before they hedge their bets on futures trading.

If you wish to navigate the complex but promising world of futures contracts with more ease, seek out a good brokerage who will help you open an account, and guide you to invest as wisely as possible.