Futures Contracts: A buyer gets into the Futures market in order to ensure that a particular asset will be available at the expected time of his need. Similarly, a seller participates in the Futures market to be in a position to dispose of an asset at a time convenient to him.
A manufacturer who needs a raw material for production two months from now may decide to ensure availability of the raw material with a definite price through a two-months Futures contract. What will be the price specified in this contract?
The manufacturer has two choices: 1) He can buy the raw material right now and preserve it for two months before using it or 2) He can get into the Futures contract in which case he will pay the price after two months. If he buys it right now, he has to pay the spot price, incur interest on this price for two months and also bear storage charges.
These two choices will involve the same cost because otherwise the costlier choice is no choice at all. (If the cost is different in these two choices, there will be 'arbitrage' possibility.)
So spot price + interest + storage charges = Futures price.
Sometimes, the asset under consideration may produce some income in the interval between now and the Futures period. A typical example is an equity share which may generate dividend in the intervening period. This income is to be deducted from cost to arrive at the Futures price. To calculate the Futures price more accurately, compounding at relevant interest rate has to be done for costs incurred and incomes received at different times.
Futures price will normally be higher than the present spot price. The difference between the spot price and the Futures price is called the 'Basis'. In a normal market , also called as 'contango' market, Basis is negative. If Futures price is less than present spot price, Basis is positive and such a market is called as 'backwardation' market.
A manufacturer who needs a raw material for production two months from now may decide to ensure availability of the raw material with a definite price through a two-months Futures contract. What will be the price specified in this contract?
The manufacturer has two choices: 1) He can buy the raw material right now and preserve it for two months before using it or 2) He can get into the Futures contract in which case he will pay the price after two months. If he buys it right now, he has to pay the spot price, incur interest on this price for two months and also bear storage charges.
These two choices will involve the same cost because otherwise the costlier choice is no choice at all. (If the cost is different in these two choices, there will be 'arbitrage' possibility.)
So spot price + interest + storage charges = Futures price.
Sometimes, the asset under consideration may produce some income in the interval between now and the Futures period. A typical example is an equity share which may generate dividend in the intervening period. This income is to be deducted from cost to arrive at the Futures price. To calculate the Futures price more accurately, compounding at relevant interest rate has to be done for costs incurred and incomes received at different times.
Futures price will normally be higher than the present spot price. The difference between the spot price and the Futures price is called the 'Basis'. In a normal market , also called as 'contango' market, Basis is negative. If Futures price is less than present spot price, Basis is positive and such a market is called as 'backwardation' market.
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