Understanding Pricing for Futures

Investing in futures contracts is considered to be a relatively low risk form of investment. Nonetheless, it is a given that the future delivery price will not be the same as the amount that was initially agreed upon. In some cases, the delivery price may be higher, while it may be lower in other cases.

When the price of the underlying commodity of the futures contract is higher on the future delivery date than the spot price, it is referred to as contango. This term is also used to describe the situation in which the far future delivery price has become higher than the nearer future delivery price.

When the reverse situation happens, it is referred to as backwardation. In this situation, the price of the commodity for future delivery is actually lower than the spot price. Or, the far future delivery price is lower than the price for the nearer future delivery.

If there is a plentiful supply of the deliverable asset or if the asset can be freely created, the price of the futures contract is set through arbitrage arguments. In this case, the forward price actually represents the value that is expected for the future. This figure is determined through the risk free rate. It is important to note that any difference that this creates from the theoretical price will help provide investors with a profit opportunity that is free of risk.

In this face, determining the value of a future/forward for a non-dividend paying asset is determined by compounding its current value when it reaches its maturity date by the rate of the return. This method is referred to as continuous compounding. The relationship used to make this determination, however, may be modified by certain variables. These variables include dividends, storage costs, convenience yields, and dividend yields.

If everything works smoothly within the market, the relationship between the spot prices and the futures will only depend upon these variables. In reality, however, there are a number of imperfections in the market that can have an impact on this relationship. These include differential borrowing and lending rates, transaction costs, and restrictions on short selling. Each of these imperfections can effectively prevent complete arbitrage from taking place. Therefore, the price of the futures will actually vary within the arbitrage boundaries, though staying around the theoretical price.

If the deliverable commodity is not plentiful or if it does not yet exist, such as is the case with crops that have yet to be harvested, the price of the futures cannot be fixed through arbitrage. In this case, the only variable that can set the price is the law of supply and demand for the asset.

If the market is truly liquid, the effects of supply and demand should balance the price. This would represent an unbiased expectation for the price of asset in the future. As such, a speculator should expect to break even from the investment. If the market is not liquid, on the other hand, the relationship between the actual price and the future price can be severely compromised.