How futures are valuedWhen you trade a futures contract, you agree either to buy or to sell the asset underlying the futures contract on a specified date in the future. The price at which the contract is traded is not pre-set, but is determined by market forces.
It is possible to calculate a theoretical fair value for a futures contract.
The fair value of a futures contract should approximately equal the current value of the underlying shares or index, plus an amount referred to as the 'cost of carry'.
The cost of carry reflects the cost of holding the underlying shares over the life of the futures contract, less the amount the shareholder would receive in dividends on those shares during that time. Because the buyer of the futures contract pays only a small percentage of the contract value at the time of the transaction, they do not directly incur this funding cost.
For example, assume that:
- The S&P/ASX 200 Index is trading at 5000 points
- There are 120 days until maturity of the June futures contract
- Interest rates are currently at 7% p.a.
- The average dividend yield on stocks in the S&P/ASX200 Index is 4% p.a.
The theoretical fair value of the June ASX Mini 200 Future can be calculated as:
Fair value = current level of S&P/ASX200 + cost of carry
= 5000 + (5000 X (7% - 4%) X 120/365)
= 5049.5 points
As maturity approaches, the prices of the futures contract and the underlying asset tend to converge. The trader's profit or loss depends on how far the price of the futures contract at maturity is above or below the price at which the contract was initially traded.
The full value of the futures contract is not paid or received when the contract is established – instead both buyer and seller pay a small initial margin. The traded price is the basis on which profit or loss is calculated at maturity or on closing out the position if this takes place before maturity.