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Futures Prices
In this chapter, we discuss how futures contracts are
priced. This chapter is organized into the following
sections:
1. Reading Futures Prices
2. The Basis and Spreads
3. Models of Futures Prices
4. Futures Prices and Expectations
5. Future Prices and Risk Aversion
6. Characteristics of Futures Prices
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The Basis
The Basis
The basis is the difference between the current cash
price of a commodity and the futures price for the
same commodity.
Basis S 0 F 0 , t
S0 =
F0,t =
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The Basis
Basis S 0 F 0, t
Basis $353.7 364.20 $10.50
Basis $10.50
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The Basis
Convergence
As the time to delivery passes, the futures price will change
to approach the spot price.
When the futures contract matures, the futures price and
the spot price must be the same. That is, the basis must
be equal to zero, except for minor discrepancies due to
transportation and other transactions costs.
The relatively low variability of the basis is very important
for hedging.
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Spreads
Spread
A spread is the difference in price between two futures
contracts on the same commodity for two different
maturity dates:
Spread F 0, t k F 0, t
Where
F0,t =
F0,t+k =
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Spreads
Suppose that the price of a futures contract on wheat for
delivery in 3 months is $3.25 per bushel.
Suppose further that the price of a futures contract on
wheat for delivery in 6 months is $3.30/bushel.
What is the spread?
Spread F 0, t k F 0, t
Spread $3.30 $3.25 $0.05
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Repo Rate
Repo Rate
The repo rate is the finance charges faced by traders. The
repo rate is the interest rate on repurchase agreements.
A Repurchase Agreement
An agreement where a person sells securities at one point
in time with the understanding that he/she will repurchase
the security at a certain price at a later time.
Example: Pawn Shop.
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Arbitrage
An Arbitrageur attempts to exploit any discrepancies in
price between the futures and cash markets.
An academic arbitrage is a risk-free transaction consisting
of purchasing an asset at one price and simultaneously
selling it that same asset at a higher price, generating a
profit on the difference.
Example: riskless arbitrage scenario for IBM stock trading
on the NYSE and Pacific Stock Exchange.
Assumptions:
1. Perfect futures market
2. No taxes
3. No transactions costs
4. Commodity can be sold short
Price
Exchange
($105)
$110
$ 5
Pacific Stock E.
NYSE
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Assumptions:
There are no transaction costs or margin requirements.
There are no restrictions on short selling.
Investors can borrow and lend at the same rate of interest.
In the next section, we will explore two arbitrage strategies that are
associated with the Cost-and-Carry Model:
Cash-and-carry arbitrage
Reserve cash-and-carry arbitrage
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Cash-and-Carry Arbitrage
A cash-and-carry arbitrage occurs when a trader borrows
money, buys the goods today for cash and carries the
goods to the expiration of the futures contract. Then,
delivers the commodity against a futures contract and pays
off the loan. Any profit from this strategy would be an
arbitrage profit.
1. Borrow money
2. Sell futures contract
3. Buy commodity
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Arbitrage Strategies
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Cost-of-Carry Model
The Cost-of-Carry Model can be expressed as:
Where:
S0
F0,t
C0,t
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Cost-of-Carry Rule 1
The futures price must be less than or equal to the spot
price of the commodity plus the carrying charges
necessary to carry the spot commodity forward to delivery.
F 0, t S 0(1 C 0, t )
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Cost-of-Carry Rule 1
1. Borrow $400
2. Buy 1 oz gold
3. Sell futures contract
4. Deliver gold
against
futures contract
5. Repay loan
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F 0, t S 0(1 C 0, t )
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4. Collect proceeds
from loan
5. Accept delivery on
futures contract
6. Use gold from futures
contract to repay the
short sale
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F 0, t S 0(1 C 0, t )
If prices were not to conform to cost of carry rule #3, a
cash-and carry arbitrage profit could be earned.
Recall that we have assumed away transaction costs,
margin requirements, and restrictions against short selling.
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where d > n
F0,d = the futures price at t=0 for the distant delivery
contract maturing at t=d.
Fo,n= the futures price at t=0 for the nearby delivery contract
maturing at t=n.
Cn,d= the percentage cost of carrying the good from t=n
to t=d.
If prices were not to conform to cost of carry rule # 4, a
cash-and-carry arbitrage profit could be earned.
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1. Buy futures
contract w/exp
in 1 yrs.
2. Sell futures
contract w/exp
in 2 years
3. Contract to
borrow $400
from yr 1-2
4. Borrow $400
5. Take delivery on 1
yr to exp futures
contract.
6. Place the gold in
storage for one yr.
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7. Remove gold
from storage
8. Deliver gold
against 2 yr.
futures contract
9. Pay back loan
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F0,d F0,n 1 C n ,d
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1. Sell futures
contract w/exp
in 1 yrs.
2. Buy futures
contract w/exp
in 2 years
3. Contract to
lend $400
from yr 1-2
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7. Accept delivery
on exp 2 yr
futures contract
8. Repay 1 oz.
borrowed gold.
9. Collect $400
loan
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Cost-of-Carry Rule 6
Since the distant futures price must be either less than or
equal to the nearby futures price plus the cost of carrying
the commodity from the nearby delivery date to the distant
delivery date by rule #4.
And the nearby futures price plus the cost of carrying the
commodity from the nearby delivery date to the distant
delivery date can not exceed the distant futures price by
rule #5.
The only way that rules 4 and 5 can be reconciled so there
is no arbitrage opportunity is by cost of carry rule #6.
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Cost-of-Carry Rule 6
F 0, d F 0, n (1 Cn , d )
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F 0, t S 0(1 C 0, t )
Solving for
C 0, t
F 0, t
(1 C 0, t )
S0
And
F 0, t
1 C 0, t
S0
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F 0, t
1 C 0, t
S0
$3.75
1 0.086956
$3.45
That is, the cost of carrying the asset from today until the
expiration of the futures contract is 8.6956%.
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Transaction Costs
Transaction Costs
Traders generally are faced with transaction costs when they
trade. In this case, the profit on arbitrage transactions might be
reduced or disappear altogether.
Types of Transaction Costs:
Brokerage fees to have their orders executed
A bid ask spread
A market maker on the floor of the exchange needs to make a
profit. He/She does so by paying one price (the bid price) for a
product and selling it for a higher price (the ask price).
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Cost-of-Carry Rule 1
with Transaction Costs
Recall that the futures price must be less than or equal to
the spot price of the commodity plus the carrying charges
necessary to carry the spot commodity forward to delivery.
F 0, t S 0(1 C 0, t )
F 0, t S 0(1 T )(1 C 0, t )
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Cost-of-Carry Rule 1
with Transaction Costs
To show how transaction costs can frustrate an arbitrage
consider Table 3.8.
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Cost-of-Carry Rule 2
with Transaction Costs
Recall from Cost-of-Carry Rule 2 that the futures price
must be equal to or greater than the spot price of the
commodity plus the carrying charges necessary to carry
the spot commodity forward to delivery.
F 0, t S 0(1 C 0, t )
F 0, t S 0(1 T )(1 C 0, t )
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Cost-of-Carry Rule 2
with Transaction Costs
To show how transaction costs can frustrate an attempt to
reserve cash-and-carry arbitrage. Consider Table 3.9.
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No-Arbitrage Bounds
Incorporating transaction costs and combining cost-of-carry
rules 1 and 2, we have the following.
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No-Arbitrage Bounds
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No-Arbitrage Bounds
$453.20
Futures
Price
$426.80
Time
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$461.4
4
Futures
Price
$403.52
Time
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Limitations on Storage
The ability to undertake certain arbitrage transactions
requires storing the product. Some items are easier to
store than others.
Gold is very easy to store. You simply rent a safe deposit
box at the bank and place your gold there for safekeeping.
Wheat is moderately easy to store.
How about milk or eggs?
They can be stored, but not for long periods of time.
To the extent that a commodity can not be stored, or has
limited storage life, the Cost-of-Carry Model may not hold.
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F 0, t S 0(1 C 0, t )
F 0, d F 0, n(1 Cn , d )
If the futures price is higher than that specified by above
equations, the market is said to be above full carry.
If the futures price is below that specified by the above
equations, the market is said to be below full carry.
To determine if a market is at full carry, consider the
following example:
Suppose that:
September Gold
December Gold
Bankers Acceptance Rate
$410.20
$417.90
7.8%
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( FF )
0, d
0. N
M
12 1
Where
AD = Annualized percentage difference
M = Number of months between the maturity of the
futures contracts.
AD 1.0772 1
AD 0.0772
Step 2: compare the annualized difference to the interest
rate in the market.
The gold market is almost always at full carry. Other
markets can diverge substantially from full carry.
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Non-Seasonal Consumption
To the extent that consumption of commodity is seasonal,
temporary imbalances between supply and demand can
occur.
High Storability
A market moves closer to full carry if its underline
commodity can be stored easily.
The Cost-of-Carry Model is not likely to apply to
commodities that have poor storage characteristics.
Example: eggs
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Convenience Yield
When there is a return for holding a physical asset, we say
there is a convenience yield. A convenience yield can
cause futures prices to be below full carry. In extreme
cases, the cash price can exceed the futures price. When
the cash price exceeds the futures price, the market is said
to be in backwardation.
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F 0, t E ( S 0)
Where
E ( S 0)
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Normal Backwardation
F 0, t E ( S 0)
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Normal Backwardation
Figure 3.9 depicts a situation that might prevail in the
futures market for a commodity.
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Contango
The Contango Theory says that futures markets are
primarily driven by hedgers who hold long positions. For
example, grain millers who have purchased futures
contracts to reduce their price risk.
The hedgers must pay speculators a premium in order to
assume the price risk that the grain miller wishes to get rid
of.
So speculators take short positions to assume this price
risk. They are rewarded for assuming this price risk when
the futures price declines to match the spot price at
maturity.
So this theory implies that the futures price is greater than
the expected future spot price.
F 0, t E ( S 0)
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Contango
Figure 3.10 illustrates the price patterns for futures under
different scenarios.
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