Pricing: Futures- vs Spot Market Instruments

If you buy a spot market instrument you have to bare the total cost of carry (financing costs) immediately at the point you buy it. On the other side, if you buy a future you can bare the financing costs at a later point. Therefore it seems reasonable that a future will cost more. (Money you have now is always more worth money you have in the future -assuming its the same amount – cause you could invest it)

A futures price consists of several factors. Volatility, duration, interest rate, underlying value/ exercise value of future.

A future’s current worth is intrinsic value. That means the value if you exercise the option right now.

If you add the time value you basically add the possible changes (increase/decrease) for the future of the derivatives. (They get more with time)

Price of the future:

F = S * (1+r) ^ (T-t)

(T-t)…. Duration

F….. Future

S….. Spot price

c….. cost of carry

Example: Future price is too high.

Future Price: 100 Euro

Financing Costs: 0,5 %

Spot market price (underlying): 80 Euro

Therefore you would short the underlying.

1. You get credit (amount 80 Euro)
2. You buy the underlying for 80 Euro
3. You sell a future (short) on the underlying

After one year:

1. Your credit amounts to 80,4
2. You deliver the underlying to the future holder. Therefore you get 100 Euro.
3. You made 19,6 Euro profit.

Here is an other example: The Future price is too low.

Future price: 80 Euro

Financing costs: 0,5 % (interest rate)

Spot market price (of underlying) 80 Euro

1. Therefore you would (short) sell your underlying and invest the return, which is 80 Euro.

2. Furthermore you buy a call future

After one year

1. You exercise your call future and buy the underlying for 80 Euro

2. You get your invested return (80 Euros) back + the interest rate of 0,5% = 80,4 Euro

3. You made 0,4 Euro profit