While a futures contract is priced in the same general manner as a forward contract, there are some small differences between futures and forwards.
- Because the daily gain/loss is settled daily on outstanding futures contracts via margin account transfers credit risk is eliminated. Alternatively, forward contracts can accumulate significant credit risk, as the value of the forward contract will change with changes to the price of the underlying asset.
- The margin accounts for futures contracts are invested in short term interest securities. This difference from forward contracts adds an element to the returns from futures contracts, affecting the pricing relationship.
- The pricing of futures contracts is affected by the correlation between interest rates and futures prices.
- When there is positive correlation the futures contract buyer benefits as he/she is gaining more from the margin account interest and the contract price is rising.
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.