Pricing and Valuation of Futures Contracts

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2024 Curriculum CFA Program Level I Derivatives

Two ways to enjoy this Refresher Reading

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Introduction

Many of the pricing and valuation principles associated with forward commitments are common to both forward and futures contracts. For example, previous lessons demonstrated that forward commitments have a price that prevents market participants from earning riskless profit through arbitrage. It was also shown that long and short forward commitments may be replicated using a combination of long or short cash positions and borrowing or lending at the risk-free rate. Finally, both forward and futures pricing and valuation incorporate the cost of carry, or the benefits and costs of owning an underlying asset over the life of a derivative contract.

We now turn our attention to futures contracts. We discuss what distinguishes them from other forward commitments and how they are used by issuers and investors. We expand upon the daily settlement of futures contract gains and losses introduced earlier and explain the differences between forwards and futures. We also address and distinguish the interest rate futures market and its role in interest rate derivative contracts.

Learning Outcomes

The member should be able to:

• compare the value and price of forward and futures contracts
• explain why forward and futures prices differ

Summary

• Futures are standardized, exchange-traded derivatives (ETDs) with zero initial value and a futures price f₀(T) established at inception. The futures price, f₀(T), equals the spot price compounded at the risk-free rate as in the case of a forward contract.
• The primary difference between forward and futures valuation is the daily settlement of futures gains and losses via a margin account. Daily settlement resets the futures contract value to zero at the current futures price f_t(T). This process continues until contract maturity and the futures price converge to the spot price, S_T.
• The cumulative realized mark-to-market (MTM) gain or loss on a futures contract is approximately the same as for a comparable forward contract.
• Daily settlement and margin requirements give rise to different cash flow patterns between futures and forwards, resulting in a pricing difference between the two contract types. The difference depends on both interest rate volatility and the correlation between interest rates and futures prices.
• The futures price for short-term interest rate futures is given by (100 – yield), where yield is expressed in percentage terms. There is a price difference between interest rate futures and forward rate agreements (FRAs) due to convexity bias.
• The emergence of derivatives central clearing has introduced futures-like margining requirements for over-the-counter (OTC) derivatives, such as forwards. This arrangement has reduced the difference in the cash flow impact of ETDs and OTC derivatives and the price difference in futures versus forwards.