Futures Prices vs. Forward Prices

Holding the Underlying Asset

Futures prices are based on the same arbitrage relationship applied when pricing forward contracts – the price of the future should equal the cost of buying the underlying asset at the spot price with borrowed funds.

When this relationship is not reflected in a futures contract price, an opportunity for arbitrage exists for traders and in an efficient market, the mispricing will on exist for a very short period of time.

Benefits of holding the underlying asset, as opposed to holding the futures contract:

• Storage and carrying costs: The futures contract does not give the contract holder physical ownership; therefore the contract holder avoids storage and carrying costs. This fact increases the price of the futures contract.
• Cash flows on the underlying: Physical ownership gives entitles the asset owner to the asset’s cash flows (such as dividends, interest coupons, etc.); the contract holder does not receive these cash flows. This fact reduces the price of the futures contract.
• Convenience yield: Physical ownership of the underlying gives the asset owner the benefit of actually being able to consume the asset; alternatively, the holder of a futures contract cannot immediately consume the underlying. This fact reduces the price of the futures contract.
• Daily margin cash flows: Technically there should be futures price adjustments based on the margin cash flows and interest, but this is not expected to be on the exam.

Theoretical Futures Price = Future Value of the Spot Price + Future Value of Storage Costs – Future Value of Asset Cash Flows – Future Value of Asset’s Convenience Yield