Page 54 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 5: Pricing of Future Contracts
Rupesh Roshan Singh, Lovely Professional University

Unit 5: Pricing of Future Contracts Notes

CONTENTS
Objectives
Introduction
5.1 Pricing Principles

5.2 Cost of Carry Model
5.2.1 Pricing Model for Index Futures
5.2.2 Pricing Model for Commodity Futures

5.3 Beta
5.4 Optimal Hedge Ratio
5.5 Summary
5.6 Keywords
5.7 Review Questions

5.8 Further Readings

Objectives

After studying this unit, you will be able to:
 Describe the pricing principles

 Define beta
 Compute optimal hedge ratio

Introduction

Futures contracts are like forward contracts, except that price movements are marked-to-market
each day rather than receiving a single, once-and-for-all settlement on the expiry of the contract.
Obviously, the sum of the daily mark-to-market price moves over the life of the futures equals
the overall price movement of a forward with the same maturity. With the futures position,
however, the mark-to-market profits (losses) are invested (carried) at the risk-free interest rate
until the futures expire. The value of the futures position at time T, therefore, may be greater or
less than the terminal value of the forward position, depending on the path that futures price
follows over the life of the contract.
A futures contract is a standardized agreement to buy or sell a commodity at a date in the future.
It is an obligation. The contract specifies the commodity (live cattle, feeder cattle), the product
quantity (40,000 or 50,000 pounds of live animals), the product quality (specific U.S. grades and
yields), the delivery points (only for live cattle-there are no delivery points for feeder cattle),
and the delivery date (within the month that contract terminates).

5.1 Pricing Principles

We will study here about how the pricing of futures contracts are made. Before discussing
valuation of futures contracts, we must make a clear distinction in pricing method used for

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