When the deliverable asset exists in plentiful supply or may be freely created, then the price of a futures contract is determined via
arbitrage arguments. This is typical for
stock index futures,
treasury bond futures, and
futures on physical commodities when they are in supply (e.g. agricultural crops after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist—for example on crops before the harvest or on
Eurodollar Futures or
Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date)—the futures price cannot be fixed by arbitrage. In this scenario, there is only one force setting the price, which is simple
supply and demand for the asset in the future, as expressed by supply and demand for the futures contract.
Arbitrage arguments Arbitrage arguments ("
rational pricing") apply when the deliverable asset exists in plentiful supply or may be freely created. Here, the forward price represents the expected future value of the underlying
discounted at the
risk-free rate—as any deviation from the theoretical price will afford investors a risk-free profit opportunity and should be arbitraged away. We define the forward price to be the strike K such that the contract has 0 value at the present time. Assuming interest rates are constant the forward price of the futures is equal to the forward price of the forward contract with the same strike and maturity. It is also the same if the underlying asset is uncorrelated with interest rates. Otherwise, the difference between the forward price on the futures (futures price) and the forward price on the asset, is proportional to the covariance between the underlying asset price and interest rates. For example, a futures contract on a zero-coupon bond will have a futures price lower than the forward price. This is called the futures "convexity correction". Thus, assuming constant rates, for a simple, non-dividend paying asset, the value of the futures/forward price,
F(t,T), will be found by compounding the present value
S(t) at time
t to maturity
T by the rate of risk-free return
r. :F(t,T) = S(t)\times (1+r)^{(T-t)} or, with
continuous compounding :F(t,T) = S(t)e^{r(T-t)} \, This relationship may be modified for storage costs
u, dividend or income yields
q, and convenience yields
y. Storage costs are costs involved in storing a commodity to sell at the futures price. Investors selling the asset at the spot price to arbitrage a futures price earns the storage costs they would have paid to store the asset to sell at the futures price. Convenience yields are benefits of holding an asset for sale at the futures price beyond the cash received from the sale. Such benefits could include the ability to meet unexpected demand, or the ability to use the asset as an input in production. Investors pay or give up the convenience yield when selling at the spot price because they give up these benefits. Such a relationship can be summarized as: :F(t,T) = S(t)e^{(r+u-y)(T-t)} \, The convenience yield is not easily observable or measured, so
y is often calculated, when
r and
u are known, as the extraneous yield paid by investors selling at spot to arbitrage the futures price. Dividend or income yields
q are more easily observed or estimated, and can be incorporated in the same way: :F(t,T) = S(t)e^{(r+u-q)(T-t)} \, In a perfect market, the relationship between futures and spot prices depends only on the above variables; in practice, there are various market imperfections (transaction costs, differential borrowing, and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.
Pricing via expectation When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the futures is determined by today's
supply and demand for the underlying asset in the future. In an efficient market, supply and demand would be expected to balance out at a futures price that represents the present value of an
unbiased expectation of the price of the asset at the delivery date. This relationship can be represented as:: :F(t) = E_t\left\{S(T)\right\}e^{(r)(T-t)} By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as
cornering the market), the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.
Relationship between arbitrage arguments and expectation The expectation-based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the
risk-neutral probability. In other words: a futures price is a
martingale with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity.
Contango, backwardation, normal and inverted markets The situation where the price of a commodity for future delivery is higher than the expected
spot price is known as
contango. Markets are said to be normal when futures prices are above the current spot price and far-dated futures are priced above near-dated futures. The reverse, where the price of a commodity for future delivery is lower than the expected spot price is known as
backwardation. Similarly, markets are said to be inverted when futures prices are below the current spot price and far-dated futures are priced below near-dated futures. ==Futures contracts and exchanges==