Futures products are derivative products whose price or value rely largely on the price of the underlying stocks or indices, but the pricing is not usually direct. There is usually a difference between the prices of the underlying asset in the cash segment and in the derivatives segment. The theoretical price of a futures contract is a mathematical estimation of the price that a particular future contract should have. The theoretical price is also known as the fair value of a futures contract. Is the market value always equal to fair value? The answer to this question will be determined on the basis of which pricing model was used. There are two types of pricing model used; the cost of carry model and the expectancy model of future pricing.
a) The Cost of Carry Model.
This model assumes that the futures markets will tend to be efficiently perfect thus there are no differences in the cash and future price. This results to any elimination of any opportunity for arbitrage. This makes investors indifferent to the spot and market price while trading in futures, this is due to the fact that the final earnings are eventually the same.
In summary, the future price is equal to the spot price plus the net cost incurred in carrying the futures contract till its maturity date (Carry cost-Carry return).
b) The Expectancy Model of Futures Pricing.
This model states that the future price of the futures contract is what the spot price of the futures contract is expected to be in the future. It assumes that there is no relationship between the futures price and the spot price. The only thing that matters is what the spot price of the asset is expected to be. A reason why the stock market participants look to the trends in futures anticipating the price fluctuation in the cash segment.
The difference between the future price and the spot price is called the basis. If the future price is higher than the spot price then the basis of the future contract is negative an indication that the futures market is expected to rise in the future. On the other hand if the spot price is higher than the futures price then the basis of the futures contract is positive an indication that of a bear run on the futures market in the future.
