Tuesday, February 26, 2013

Excellent Trading School - 14 - Futures Pricing and Payoffs

Futures Payoffs
Futures contracts have linear or symmetrical payoffs. It implies that the losses as well as
profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.

Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.

When the index moves up from trade position, the long futures position starts making profits, and when the index moves down, position starts making losses.

Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.

When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.
  
Pricing Futures
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below:
F = Se(rt)
where:
r = Cost of financing (using continuously compounded interest rate)
T = Time till expiration in years
e = 2.71828
S= Spot price

For Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows:
F = Se(rt)
1150x e(2.71828)[0.11%+1/12] =1160
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