Derivatives
Understanding Future Price
In derivatives, the price quoted today is not always the price that matters. For futures contracts, what really matters is the price agreed for delivery at a future date. That agreed value is called the future price. It reflects expectations about interest rates, income from the asset, storage costs, and the absence of arbitrage.
Future price questions appear frequently in exams because they connect spot prices, time value of money, and no-arbitrage logic.
What the Future Price Represents
The future price is the price at which the underlying asset will be exchanged at the contract’s maturity.
It is agreed today, but the actual transaction happens later.
No money usually changes hands upfront, unlike options.
The future price is set so that neither the buyer nor the seller has an advantage at initiation.
Relationship Between Spot Price and Future Price
The starting point for determining the future price is the spot price, which is the current market price of the asset.
The future price adjusts the spot price for:
- the time value of money
- income generated by the asset
- costs of holding the asset
This adjustment ensures that arbitrage opportunities do not exist.
Cost of Carry Logic
The future price is based on the cost of carry model.
Cost of carry represents the net cost of holding an asset until the future date. It includes financing costs and storage costs, and subtracts any income earned from the asset.
If carrying the asset is expensive, the future price will be higher.
If the asset generates income, the future price will be lower.
This intuition is more important than memorising formulas.
Future Price for Different Assets
For assets that do not generate income, the future price is mainly driven by interest rates.
For assets that generate income, such as dividends or coupons, that income reduces the future price.
For commodities, storage costs and convenience yield also play a role.
Exams often test whether candidates recognise which factors apply to which asset.
No-Arbitrage Principle
The future price is determined by the no-arbitrage condition.
If the future price is too high, traders can buy the asset today and sell the future contract.
If the future price is too low, traders can sell the asset today and buy the future contract.
These actions push prices back to fair value.
This arbitrage logic is central to futures pricing questions.
Difference Between Futures Price and Forward Price
In theory, futures price and forward price are the same under certain conditions.
In practice, differences may arise due to daily marking to market and interest rate correlations.
For most exam questions, they are treated as equal unless stated otherwise.
Future Price Over Time
As the contract approaches maturity, the future price converges toward the spot price.
At expiration, both prices are equal.
This convergence happens regardless of whether prices rise or fall during the contract’s life.
Understanding this convergence helps answer conceptual questions quickly.
Common Exam Mistakes
Students often forget to adjust for income from the asset.
Another mistake is ignoring the time value of money.
Some candidates confuse futures price with expected future spot price. These are not the same.
Exams frequently test this distinction.
Final Thought
The future price is not a forecast. It is a no-arbitrage price that reflects current market conditions, costs, and income. It ensures fairness between buyers and sellers at contract initiation. For exam preparation, focus on the relationship between spot price, cost of carry, and arbitrage logic. Once this intuition is clear, futures pricing questions become much easier to handle.
