How Are Futures Priced?

The world is full of uncertainty and so are the markets. Anybody who buys or sells a share in the markets is taking a risk. The buyer takes a risk that the stock price will not fall further while the seller takes a risk that the price will not rise further. And when it comes to predicting prices in the future, it is even more risky.

And when the risk is high, the returns should be higher. As discussed in previous examples, you are not entering into a contract with Mr. X but with the stock exchange. If you are required to pay 20% margin to the exchange, so does Mr. X have to. And if Mr. X is willing to take a risk and is investing 20% money, he expects a reasonable return on it. Considering 15% as the reasonable rate of return on stocks, he should be at least expecting a return of 1.25% every month. So, if Reliance is trading at 2000 today and he is expecting a return of 1.25%, he will be willing to sell Reliance at a price above 2025 (Rs.25 being the return he is expecting). This is also known as the cost of carry. Mr. X is charging you a cost of carry because he is locking up a part of his money and is either paying interest on it (if the funds are borrowed) or losing some interest on it if he had invested it elsewhere.

The other important factor while pricing futures is the time value. Uncertainty is directly proportional to the time to expiry. Anything can happen in a month - the inflation (declared weekly) may increase, the economy may show signs of slowing down, the company's main director may resign, the government may impose some restrictions on the company, a neighbouring country may declare war or the government may fall. But as you come closer to the expiry, the same is not likely to happen and the uncertainty considerably decreases. So, the time value is the maximum at the beginning of a contract and least when it is close to expiry. This uncertainty also demands a certain amount of premium. So, most likely, Mr. X would charge you Rs.2000 (the spot price of Reliance today) plus Rs.25/- (the cost of carry) and something more (the time value premium). Which explains why he was willing to sell Reliance at 2040 in the beginning of the month when the spot price was only 2000.