- A futures contract is a financial derivative instrument. It helps in hedging against risks involved in another investment.
- People who did trading in early days, to cover their risk against price fluctuations designed futures contracts. Futures are one of the most important financial derivatives today.
- Example 1: A company that imports carbon steel plans to import 1 million tonnes of carbon steel at a price of $765 per ton. If the local currency depreciates against USD the company will be at a loss. To prevent this loss the company enters into a Foreign Exchange Futures Contract, which fixes dollar price to a specific price in local currency. This way, a company whose currency is not USD and imports metals from international market guards itself against the Forex losses.
- Example 2: An investor buys 100 MSFT equity stocks at a price of $100 per stock. To prevent against the downward price movement of the stock the investor also buys a futures contract to sell MSFT at $120 per stock one month down the line. In case, if the stock price goes down, the future contract acts as a hedge and save the investor from the losses.
- Remember, the stock price, which is called spot price, and the price of the futures contract will converge on the day of expiry of the futures contract.
Finding the value of a Futures Contract:
The formula to find the value of a futures contract is given by,
Spot Price: Spot Price of the Security
Benefits: Benefits like dividends earned
Cost: Financing Costs
r: Rate of interest
t: Time to expiry of the futures contract
Python example to find the value of an equity futures contract:
# A python function that calculates the value of a futures contract
def FuturePrice(spotPrice, benefit, cost, r, t):
return (spotPrice - benefit + cost)*math.pow(1 + r, t);
spotPrice = 100;
benefit = 0; # No dividend expected
miscCharges = 1;
t = 30;
r = 0.07;
ratePerday = r/365;
contractPrice = FuturePrice(spotPrice, benefit, miscCharges, r, t);
print("Spot price of the equity futures contract:%3.2f"%spotPrice);
print("Expected benefits like dividend:%3.2f"%benefit);
print("Expected costs to be incurred:%3.2f"%miscCharges);
print("Time to expiry of the futures contract in days:%d"%t);
print("Interest Rate in percent:%2.2f"%(r*100));
print("Price of the futures contract:%3.2f"%contractPrice)
Spot price of the equity futures contract:100.00
Expected benefits like dividend:0.00
Expected costs to be incurred:1.00
Time to expiry of the futures contract in days:30
Interest Rate in percent:7.00
Price of the futures contract:768.84