Financial Derivatives
Unit II: Forward & Future Contract Features of forward contract, pricing of
forward contract, settlement, cash & carry arbitrage, Reverse cash & carry
arbitrage, future v/s forward, mark to market, open interest, volume, tick size,
pricing of future, investment v/s consumption assets, interest yield and
convergence.
1. FEATURES OF FORWARD CONTRACT
A forward contract is one of the simplest and oldest forms of derivative instruments
used in financial markets. It is a private agreement between two parties to buy or sell
an underlying asset at a predetermined price on a specified future date. Forward
contracts are widely used for hedging risk, especially in commodities, currencies,
and interest rate markets. Understanding the features of forward contracts is essential
to grasp how they function as customized risk management tools.
One of the most important features of a forward contract is that it is an over-the-
counter (OTC) agreement, meaning it is not traded on a formal exchange. Instead, it
is a private contract negotiated directly between two parties. Because of this, forward
contracts are highly flexible and can be tailored to meet the specific needs of the
contracting parties. They allow customization in terms of contract size, maturity
date, and underlying asset, making them suitable for unique hedging requirements.
Another key feature is the absence of standardization.
Unlike futures contracts, which are standardized, forward contracts are completely
customizable. This flexibility allows parties to design contracts according to their
specific risk exposure. For example, an exporter and importer may enter into a
forward contract for a specific amount of foreign currency at a future date, tailored
to their exact business needs.
Forward contracts are also characterized by private negotiation and bilateral
agreement. The terms of the contract, including price, quantity, and delivery date,
are mutually agreed upon by both parties. Since there is no centralized exchange,
there is no price transparency, and contract details are not publicly disclosed. This
can sometimes lead to issues related to trust and information asymmetry.
A significant feature of forward contracts is the presence of counterparty risk. Since
these contracts are not backed by a clearing house or exchange, there is always a risk
that one party may default on their obligation. For instance, if one party fails to
deliver the asset or make payment on the due date, the other party may incur losses.
2. PRICING OF FORWARD CONTRACT
The pricing of a forward contract refers to the process of determining the fair value
or agreed price at which an asset will be bought or sold in the future under a forward
agreement. Forward pricing is based on the principle of no-arbitrage, which ensures
that there are no risk-free profit opportunities in efficient markets. The forward price
is not arbitrary; instead, it is derived from the current spot price of the underlying
asset, adjusted for cost of carry factors such as interest, storage, and income.
Understanding forward pricing is essential in financial derivatives as it helps in
hedging, speculation, and arbitrage strategies.
The fundamental principle behind the pricing of forward contracts is the cost of carry
model. This model states that the forward price is equal to the spot price of the asset
plus the cost of carrying the asset until the maturity of the contract. The cost of carry
includes factors such as the risk-free interest rate, storage costs, insurance, and any
income generated by the asset (such as dividends). If the asset generates income, it
reduces the forward price, while carrying costs increase it.
In a simple case where the underlying asset does not provide any income, the forward
price is calculated using the formula:
F = S × (1 + r)^t
Where:
F = Forward price
S = Spot price
r = Risk-free interest rate
t = Time to maturity
This formula reflects the idea that the forward price must compensate for the
opportunity cost of investing money today instead of buying the asset and holding
it.
If the asset provides income (like dividends in stocks), the forward price is adjusted
by subtracting the present value of expected income. The formula becomes:
F = (S - PV of income) × (1 + r)^t
This ensures that the forward price remains consistent with market conditions and
prevents arbitrage opportunities.
The concept of arbitrage plays a crucial role in forward pricing. If the forward price
deviates from its theoretical value, traders can exploit this difference to earn risk-
free profits. For example, if the forward price is higher than the fair value, an
arbitrageur can buy the asset in the spot market, hold it, and sell it in the forward
market. Conversely, if the forward price is lower, they can short the asset and invest
the proceeds at the risk-free rate. These arbitrage activities help bring the forward
price back to its equilibrium level.
Another important factor in forward pricing is the interest rate environment. Higher
interest rates increase the forward price because the opportunity cost of holding the
asset increases. Similarly, lower interest rates reduce the forward price. This
relationship highlights the sensitivity of forward pricing to macroeconomic
conditions.
In commodities, additional factors such as storage costs, transportation costs, and
convenience yield also influence forward pricing. The convenience yield represents
the benefit of physically holding the asset, which reduces the forward price. For
example, in the case of oil or agricultural commodities, holding the physical asset
may provide strategic advantages, thus affecting pricing.
In financial markets, forward contracts are commonly used for currencies. The
forward exchange rate is determined based on the interest rate differential between
two currencies. This is known as the interest rate parity (IRP) principle, which
ensures that the forward exchange rate reflects differences in interest rates between
countries.
Relevant Examples and Critical Insights
For example, if a stock is currently priced at ₹100 and the risk-free interest rate is
10% per annum, the forward price for one year would be approximately ₹110
(ignoring dividends). This means that the buyer agrees to purchase the stock at ₹110
after one year.
If the stock pays a dividend, say ₹5 during the year, the forward price will be lower,
as the investor holding the stock receives income, reducing the cost of carrying.
From a critical perspective, forward pricing assumes efficient markets and constant
interest rates, which may not always hold true in real-world scenarios. Factors like
market imperfections, liquidity constraints, and transaction costs can cause
deviations from theoretical pricing. However, arbitrage mechanisms generally
ensure that such deviations are short-lived, maintaining overall market efficiency.
3. SETTLEMENT
Settlement in a forward contract refers to the process by which the contractual
obligations between the buyer and seller are fulfilled at the maturity of the contract.
It involves the exchange of the underlying asset or its cash equivalent at the agreed
forward price. Settlement is a crucial stage in derivative contracts because it ensures
that the agreement is completed as per the terms decided at the time of contract
initiation. In forward contracts, settlement typically occurs only once, at maturity,
distinguishing it from other derivatives like futures that involve daily settlement.
The settlement of a forward contract is generally carried out in two main ways:
physical settlement and cash settlement. In physical settlement, the actual underlying
asset is delivered by the seller to the buyer on the maturity date, and the buyer pays
the agreed forward price. This type of settlement is common in commodity markets,
where physical delivery of goods such as wheat, oil, or gold takes place. Physical
settlement ensures that the contract is honored with the actual transfer of ownership
of the asset.
On the other hand, cash settlement involves the payment of the difference between
the forward price and the spot price of the asset at maturity, without any actual
exchange of the underlying asset. For example, if a trader enters into a forward
contract to buy an asset at ₹100, but the spot price at maturity is ₹120, the seller pays
the buyer ₹20 in cash. This method simplifies the settlement process and avoids
logistical issues related to the physical delivery of assets. Cash settlement is
commonly used in financial derivatives where physical delivery may be impractical.
Another important aspect of settlement in forward contracts is that it is a one-time
settlement process. Unlike futures contracts, which are marked-to-market daily,
forward contracts are settled only at maturity. This means that all gains or losses are
realized at the end of the contract period. As a result, the parties must be prepared to
handle the entire risk exposure until the settlement date, which increases the
importance of creditworthiness and trust between the parties.
The settlement process also highlights the issue of counterparty risk, which is one of
the major limitations of forward contracts. Since settlement depends on the
fulfillment of obligations by both parties, there is always a risk that one party may
default. If one party fails to deliver the asset or make the payment at maturity, the
other party may incur losses. This risk is especially significant in OTC markets,
where there is no central clearinghouse to guarantee performance.
4. CASH AND CARRY CARRY ARBITRAGE
Cash-and-carry arbitrage is a fundamental concept in financial derivatives that helps
explain the relationship between the spot price and the forward/futures price of an
asset. It is a risk-free arbitrage strategy used when the forward price of an asset is
higher than its fair value as determined by the cost of carry model. The strategy
involves buying the asset in the spot market, holding it (carrying it) until maturity,
and simultaneously selling it in the forward or futures market. The primary objective
is to lock in a risk-free profit by exploiting price discrepancies between the spot and
forward markets.
The cash-and-carry arbitrage strategy is based on the principle of no-arbitrage, which
states that in efficient markets, there should be no opportunity to earn risk-free
profits. However, when the forward price of an asset is higher than the theoretical
price, an arbitrage opportunity arises. In such a situation, an investor can execute the
strategy by purchasing the underlying asset in the spot market at a lower price and
simultaneously entering into a forward contract to sell the asset at a higher price in
the future.
After buying the asset, the investor needs to carry the asset until the maturity of the
forward contract. This carrying involves financing the purchase, which is usually
done by borrowing money at the risk-free interest rate. During this period, the
investor may also incur additional costs such as storage, insurance, and maintenance,
depending on the nature of the asset. These costs are referred to as the cost of carry,
which plays a crucial role in determining whether arbitrage is profitable.
At the maturity of the forward contract, the investor delivers the asset and receives
the agreed forward price. At the same time, the investor repays the borrowed amount
along with interest. If the forward price was sufficiently higher than the cost of
buying and carrying the asset, the investor earns a risk-free profit. This profit arises
because the forward price exceeded the fair value as determined by the cost of carry
model.
Mathematically, the fair forward price is given by the formula:
F = S × (1 + r)^t + Carrying Costs − Income from Asset
If the actual forward price in the market is greater than this theoretical price, then
cash-and-carry arbitrage becomes possible. The excess of the market forward price
over the theoretical price represents the arbitrage profit.
This strategy is widely used in financial markets, particularly in equity index futures,
commodities, and currency markets. For example, in equity markets, if the futures
price of a stock index is significantly higher than the spot index value adjusted for
interest and dividends, traders can execute cash-and-carry arbitrage by buying the
underlying stocks and selling futures contracts.
An important aspect of this strategy is that it is considered risk-free in theory, but in
practice, certain risks may still exist. These include transaction costs, liquidity
constraints, taxes, and execution risk. Additionally, borrowing at the risk-free rate
may not always be possible for all investors, which can limit the effectiveness of the
strategy.
5. REVERSE CASH & CARRY ARBITRAGE
Reverse cash-and-carry arbitrage is a fundamental strategy in financial derivatives
used when the forward or futures price of an asset is lower than its fair value as
determined by the cost of carry model. It is the opposite of cash-and-carry arbitrage.
In this strategy, an investor sells (shorts) the asset in the spot market and
simultaneously buys a forward or futures contract. The aim is to exploit price
discrepancies and earn a risk-free profit in efficient markets.
The reverse cash-and-carry arbitrage strategy is based on the principle of no-
arbitrage, which ensures that market prices remain in equilibrium. When the forward
price of an asset is lower than its theoretical fair price, it creates an opportunity for
arbitrageurs to lock in a risk-free profit by executing a series of transactions in both
the spot and forward markets.
The strategy begins with selling the asset in the spot market at the current higher
price. Since the arbitrageur may not already own the asset, they typically engage in
a process called short selling, where they borrow the asset, sell it in the market, and
commit to repurchasing it later. The proceeds from the sale are then invested at the
risk-free rate of return. This investment earns interest over the holding period, which
is a key component of the strategy.
At the same time, the arbitrageur buys a forward or futures contract to acquire the
same asset at the lower forward price on a future date. This ensures that the investor
can return the borrowed asset at maturity without exposing themselves to price risk.
By locking in both the sale price in the spot market and the purchase price in the
forward market, the investor eliminates uncertainty and secures a fixed profit.
At the maturity of the contract, the investor uses the forward contract to purchase
the asset at the agreed lower price and returns it to the lender from whom the asset
was borrowed. The difference between the amount received from the initial sale
(plus interest earned) and the amount paid for the forward contract represents the
arbitrage profit.
The mathematical representation of fair forward pricing is based on the cost
of carry model:
F = S × (1 + r)^t + Carrying Costs − Income
If the actual forward price is less than this theoretical price, reverse cash-and-carry
arbitrage becomes possible. The arbitrageur benefits from the price difference by
selling high in the spot market and buying low in the forward market.
This strategy is commonly used in equity markets, commodity markets, and currency
markets, especially when futures prices are undervalued compared to spot prices.
For example, if a stock index futures contract is trading below its fair value, traders
can short the underlying stocks in the spot market and go long in futures to exploit
the mispricing.
However, in practice, reverse cash-and-carry arbitrage involves certain constraints.
Short selling restrictions, borrowing costs, and margin requirements can make it
difficult to execute. Additionally, transaction costs, taxes, and market liquidity can
reduce or eliminate the potential arbitrage profit. These practical limitations mean
that although the strategy is theoretically risk-free, it may not always be feasible for
all investors.
6. FUTURE VS FORWARD
Futures and forward contracts are both derivative instruments that allow parties to
agree today on a price for a transaction that will take place in the future. They are
primarily used for hedging risk, speculation, and arbitrage. While they share a
similar economic purpose, they differ significantly in their structure, trading
mechanism, risk profile, and regulatory environment. Understanding the distinction
between futures and forward contracts is essential for analyzing derivatives markets
and choosing the appropriate instrument for risk management.
One of the most important differences between futures and forward contracts lies in
their trading platform. Futures contracts are traded on organized exchanges such as
the National Stock Exchange of India and Bombay Stock Exchange. These
exchanges provide a centralized and regulated marketplace where contracts are
standardized and transparent. In contrast, forward contracts are traded over-the-
counter (OTC), meaning they are privately negotiated between two parties without
any centralized exchange.
Another key difference is standardization. Futures contracts are highly standardized
in terms of contract size, maturity date, and quality of the underlying asset. This
standardization enhances liquidity and makes it easier for traders to enter and exit
positions. Forward contracts, on the other hand, are customized contracts, allowing
parties to tailor the terms according to their specific needs, including quantity,
delivery date, and asset type.
A major distinction between the two lies in the clearing and settlement mechanism.
Futures contracts are cleared through a clearinghouse, which acts as a central
counterparty (CCP) and guarantees the performance of the contract. This eliminates
counterparty risk. Additionally, futures contracts are subject to daily mark-to-market
(MTM) settlement, where gains and losses are settled every day. In contrast, forward
contracts do not have a clearinghouse and are settled only at maturity, exposing both
parties to higher counterparty risk.
Margin requirements also differ significantly. Futures contracts require traders to
maintain initial margin and maintenance margin, ensuring that sufficient funds are
available to cover potential losses. If the margin falls below the required level, a
margin call is issued. In forward contracts, there is typically no margin requirement,
as they are private agreements. However, this increases the risk of default.
Another important difference is liquidity and market transparency. Futures markets
are highly liquid due to the presence of many participants and standardized contracts.
Prices are publicly available, allowing efficient price discovery. Forward markets,
being OTC, are less liquid and lack transparency, as contract details are not publicly
disclosed.
In terms of regulation, futures markets are strictly regulated by authorities like the
Securities and Exchange Board of India (SEBI), which ensures transparency,
fairness, and investor protection. Forward contracts, especially in OTC markets, are
less regulated, although certain segments such as foreign exchange forwards may be
subject to regulatory oversight.
Finally, futures contracts are more suitable for speculation and short-term trading
due to their liquidity and ease of entry and exit. Forward contracts, on the other hand,
are primarily used for hedging specific risks, such as currency risk for importers and
exporters, due to their flexibility and customization.
7. MARK TO MARKET
Mark-to-Market (MTM) is a fundamental concept in derivatives markets, especially
in futures contracts, where profits and losses are calculated and settled on a daily
basis based on the current market price. It is a process of valuing an open position at
the prevailing market price and adjusting the trader’s account accordingly. MTM
ensures transparency, reduces default risk, and maintains financial discipline among
market participants. It is a key mechanism that differentiates futures contracts from
forward contracts.
Mark-to-Market is the process of revaluing a trader’s position at the end of each
trading day using the closing market price. In futures markets, positions are not
settled only at maturity; instead, gains and losses are calculated daily. This means
that if the market moves in favor of a trader, their account is credited with the profit,
while if the market moves against them, the loss is debited from their account. This
daily adjustment ensures that the trader’s account always reflects the true market
value of their position.
The MTM process is closely linked with the concept of margin requirements. When
a trader enters a futures contract, they are required to deposit an initial margin with
the clearinghouse. As the market price fluctuates, the value of the position changes.
If the position results in a loss, the margin account balance decreases. If it falls below
the maintenance margin level, the trader receives a margin call and must deposit
additional funds to restore the required level. This system ensures that traders
maintain sufficient capital to cover potential losses, thereby reducing the risk of
default.
A key advantage of MTM is that it significantly reduces counterparty risk. Since
gains and losses are settled daily, the exposure between parties does not accumulate
over time. This is particularly important in futures markets, where large price
fluctuations can occur. By settling profits and losses on a daily basis, MTM ensures
that both parties remain financially secure and capable of honoring their obligations.
The MTM process also enhances market transparency and efficiency. It provides
real-time valuation of positions, allowing traders to make informed decisions based
on current market conditions. This continuous updating of account values ensures
that the financial system remains stable and responsive to market changes.
In the Indian context, the MTM mechanism is implemented by exchanges like the
National Stock Exchange of India and Bombay Stock Exchange. These exchanges,
under the regulation of SEBI, ensure that all futures contracts are marked to market
daily and that settlements are carried out efficiently through clearing corporations.
8. OPEN INTEREST
Open Interest (OI) is a key concept in derivatives markets, particularly in futures and
options trading. It refers to the total number of outstanding contracts that have not
yet been settled, closed, or expired. Unlike trading volume, which measures the
number of contracts traded in a day, open interest reflects the total number of active
positions in the market at a given point in time. It is widely used by traders and
analysts to gauge market strength, liquidity, and trend direction.
Open interest represents the total number of derivative contracts that are still open
and have not been offset by an opposite transaction. When a new buyer and seller
enter into a contract, open interest increases because a new position is created. For
example, if one trader buys a futures contract and another trader sells it, the open
interest increases by one contract. However, if an existing buyer sells his contract to
close his position, the open interest decreases because the contract is no longer
active.
The movement of open interest provides important insights into market behavior.
When open interest increases along with rising prices, it indicates that new money
is entering the market, and the upward trend is likely to continue. This scenario
suggests strong bullish sentiment. On the other hand, if prices are rising but open
interest is falling, it indicates that traders are closing their positions, and the trend
may be weakening.
Similarly, when open interest increases while prices are falling, it suggests that new
short positions are being created, indicating bearish sentiment in the market. If both
open interest and prices are falling, it shows that traders are exiting their positions,
which may signal a lack of interest in the market or weakening momentum.
Open interest is closely related to market liquidity. A higher open interest generally
indicates a more liquid market with more participants, making it easier to enter and
exit positions without causing significant price fluctuations. Low open interest, on
the other hand, indicates low liquidity and may result in wider bid-ask spreads and
higher transaction costs.
In derivatives markets in India, open interest is monitored and reported by exchanges
such as the National Stock Exchange of India and Bombay Stock Exchange. Traders
use open interest data along with price and volume to analyze market trends and
make trading decisions.
9. VOLUME
Volume is a fundamental concept in derivatives markets that refers to the total
number of contracts traded during a specific period, such as a day. It is an important
indicator of market activity, liquidity, and investor interest. Unlike open interest,
which shows the number of outstanding contracts, volume reflects the actual trading
activity taking place in the market. It is widely used by traders and analysts to assess
the strength of price movements and overall market participation.
Volume represents the number of contracts that are bought and sold during a
particular time period. Each transaction involves both a buyer and a seller, but it is
counted as a single contract traded. For example, if 1,000 futures contracts of an
index are traded in a day, the trading volume for that day is 1,000 contracts. Volume
provides a clear picture of how active the market is and how frequently trades are
occurring.
One of the most important uses of volume is in confirming price trends. When prices
increase along with high trading volume, it indicates strong market participation and
confirms the strength of the upward trend. This suggests that many traders agree
with the price movement, making the trend more reliable. On the other hand, if prices
rise but volume is low, it may indicate a weak trend that lacks strong support and
could reverse.
Similarly, in a falling market, high volume along with declining prices indicates
strong selling pressure and a strong bearish trend. However, if prices fall with low
volume, it may suggest that the downward movement is temporary and not supported
by significant market activity.
Volume also plays a crucial role in determining market liquidity. High trading
volume indicates a liquid market where traders can easily enter and exit positions
without significantly affecting prices. Low volume, on the other hand, indicates low
liquidity, which may result in higher price volatility and difficulty in executing
trades efficiently.
In derivatives markets, volume is often analyzed together with open interest to gain
deeper insights. For example, increasing volume along with rising open interest
indicates that new positions are being created, strengthening the trend. In contrast,
high volume with decreasing open interest suggests that existing positions are being
closed, which may signal a potential reversal.
In India, trading volume data is provided by exchanges such as the National Stock
Exchange of India and Bombay Stock Exchange. Traders and analysts use this data
extensively for technical analysis and decision-making.
10. TICK SIZE
Tick size is an important concept in derivatives and financial markets that refers to
the minimum price movement allowed in the trading of a financial instrument. It
defines the smallest increment by which the price of a contract can change on an
exchange. Tick size plays a crucial role in determining price fluctuations, market
liquidity, and trading efficiency. It is predefined by stock exchanges and varies
depending on the type of asset or contract being traded.
Tick size represents the smallest permissible change in the price of a derivative
contract. For example, if the tick size of a futures contract is ₹0.05, then the price
can move only in multiples of ₹0.05, such as ₹100.00, ₹100.05, ₹100.10, and so on.
Prices cannot move in smaller increments than the specified tick size. This ensures
uniformity and consistency in price quotations across the market.
Tick size directly affects price precision and trading behavior. A smaller tick size
allows for more precise pricing and tighter bid-ask spreads, which can improve
market efficiency. Traders can quote prices more accurately, leading to better price
discovery. However, very small tick sizes may result in excessive trading activity
and increased market noise, as prices fluctuate frequently in small increments.
On the other hand, a larger tick size reduces the frequency of price changes but may
lead to wider bid-ask spreads. This can reduce liquidity and make it more expensive
for traders to enter or exit positions. Therefore, exchanges carefully determine the
tick size to strike a balance between liquidity and price stability.
Tick size also influences profit and loss calculations in derivatives trading. Since
price changes occur in fixed increments, the gain or loss on a contract depends on
the number of ticks the price moves. For example, if a trader holds a futures contract
and the price increases by 10 ticks, the profit is calculated based on the value of each
tick multiplied by the number of ticks moved.
In derivatives markets, tick size is closely related to the concept of tick value, which
represents the monetary value of one tick movement. Tick value is calculated by
multiplying the tick size by the contract size. This helps traders understand the
financial impact of price changes and manage risk effectively.
In India, tick sizes are determined by exchanges such as the National Stock
Exchange of India and Bombay Stock Exchange. These exchanges specify tick sizes
for different derivative contracts, including equity futures, index futures, and
commodity derivatives. The tick size may vary based on the price level of the asset
and market conditions.
11. PRICING OF FUTURE
The pricing of futures contracts is a fundamental concept in financial derivatives that
determines the fair value at which a futures contract should trade in the market. Like
forward contracts, futures pricing is based on the no-arbitrage principle, ensuring
that there are no opportunities for risk-free profit. The futures price is derived from
the current spot price of the underlying asset and adjusted for various factors such
as interest rates, cost of carry, and expected income from the asset. Understanding
futures pricing is essential for hedging, speculation, and arbitrage strategies.
The pricing of futures contracts is primarily based on the cost of carry model, which
reflects the cost of holding or carrying the underlying asset until the maturity of the
contract. The cost of carry includes financing costs (interest rates), storage costs,
insurance, and other related expenses. At the same time, any income generated by
the asset, such as dividends in the case of stocks, reduces the cost of carry.
The theoretical futures price is generally expressed using the formula:
F=Se(r−q)tF = S e^{(r - q)t}F=Se(r−q)t
Where:
F = Futures price
S = Spot price
r = Risk-free interest rate
q = Yield or income from the asset (e.g., dividend yield)
t = Time to maturity
This formula shows that the futures price increases with higher interest rates (cost of
financing) and decreases with higher income from the asset.
12. INVESTMENT VS CONSUMPTION ASSETS
In financial derivatives, especially in the context of futures and forward pricing,
assets are broadly classified into investment assets and consumption assets. This
classification is important because the pricing of derivatives depends significantly
on the nature of the underlying asset. Investment assets are held primarily for
financial returns, whereas consumption assets are held for usage or consumption.
Understanding this distinction helps in analyzing cost of carry, arbitrage
opportunities, and pricing models in derivatives markets.
Investment assets are those assets that are held primarily for the purpose of earning
a return, either in the form of capital appreciation or income. These include financial
assets such as stocks, bonds, and even precious metals like gold and silver when held
for investment purposes. The key characteristic of investment assets is that they can
be easily bought and sold in the market, and they are generally held as part of a
portfolio. Since these assets are not required for immediate use, investors are willing
to lend or sell them in the market, making arbitrage activities more feasible.
In the case of investment assets, derivative pricing follows a relatively
straightforward cost of carry model. The futures price is determined by the spot price
adjusted for the risk-free rate of interest and any income generated by the asset, such
as dividends in the case of stocks. Since these assets are liquid and widely traded,
arbitrage opportunities can be easily exploited, ensuring that futures prices remain
close to their theoretical values.
On the other hand, consumption assets are those assets that are held primarily for
consumption or production purposes rather than for investment. These include
commodities such as oil, natural gas, agricultural products, and industrial metals.
These assets are used in day-to-day operations or production processes, and their
value is derived from their utility rather than their investment potential.
A key feature of consumption assets is the concept of convenience yield, which
represents the benefit of physically holding the asset. For example, a manufacturing
company may prefer to hold raw materials like oil or wheat to ensure uninterrupted
production. This benefit cannot be easily quantified but plays an important role in
pricing derivatives. As a result, the pricing of futures contracts on consumption
assets is more complex and includes convenience yield in addition to cost of carry.
13. INTEREST YIELD AND CONVERGENCE
Interest, yield, and convergence are key concepts in the pricing and behavior of
futures and forward contracts in derivatives markets. These concepts explain how
the cost of capital, returns from the underlying asset, and the relationship between
spot and futures prices influence trading and valuation. Understanding these
elements is essential for analyzing futures pricing, arbitrage opportunities, and the
behavior of derivative contracts as they approach maturity.
Interest plays a central role in derivatives pricing through the concept of the risk-
free rate of return. When an investor enters into a futures contract, they are
effectively postponing the purchase or sale of an asset. Instead of buying the asset
today, the investor can invest the money at the prevailing interest rate. This
opportunity cost of capital is reflected in the futures price. Higher interest rates
increase the cost of carry, leading to higher futures prices, while lower interest rates
reduce the futures price. Thus, interest rates directly influence the relationship
between spot and futures prices.
Yield refers to the income generated by the underlying asset during the life of the
contract. This can include dividends in the case of stocks, interest payments in bonds,
or other forms of income. Yield reduces the effective cost of holding the asset
because the investor receives income while holding it. Therefore, higher yield leads
to a lower futures price, as the holder of the asset benefits from these cash flows. In
financial terms, yield is often incorporated into pricing models as a dividend yield
or income yield.
The relationship between interest and yield is captured in the futures pricing
formula:
F=Se(r−q)tF = S e^{(r - q)t}F=Se(r−q)t
where r represents the interest rate and q represents the yield. This formula shows
that the futures price increases with interest rates and decreases with yield.
Another important concept is convergence, which refers to the tendency of the
futures price and the spot price to become equal as the contract approaches its
maturity date. At the time of expiration, the futures price must equal the spot price;
otherwise, arbitrage opportunities would arise. This convergence occurs because, at
maturity, there is no difference between buying the asset in the spot market and
fulfilling the futures contract.
The process of convergence is driven by arbitrage activities. If the futures price is
higher than the spot price near maturity, traders can sell futures and buy the asset in
the spot market, earning a risk-free profit. Conversely, if the futures price is lower,
traders can buy futures and sell the asset in the spot market. These actions force the
prices to move closer together, ensuring convergence.
Convergence is a crucial feature of futures markets because it ensures that the pricing
remains consistent with the underlying asset. It also provides confidence to traders
that the futures price is a reliable indicator of the expected future spot price.
However, temporary deviations between spot and futures prices may occur due to
factors such as transaction costs, liquidity issues, or market inefficiencies.
In markets like India, convergence is clearly observed in contracts traded on
exchanges such as the National Stock Exchange of India, where futures prices align
closely with spot prices as expiry approaches.