The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

PRICING STOCK INDEX FUTURES

Futures contracts are priced based on the spot price and cost of carry considerations. For equity contracts these include the cost of financing a position in the underlying asset, the dividend yield on the underlying stocks, and the time to settlement of the futures contract. The theoretical futures price is derived from the spot price adjusted for the cost of carry. This can be confirmed using risk-free arbitrage arguments.

The logic of the pricing model is that the purchase of a futures contract can be looked at as a temporary substitute for a transaction in the cash market at a later date. Moreover, futures contracts are not assets to be purchased and no money changes hands when the agreement is made. Futures contracts are agreements between two parties that establish the terms of a later transaction. It is these facts that lead us to a pricing relationship between futures contracts and the underlying. The seller of a futures contract is ultimately responsible for delivering the underlying and will demand compensation for incurring the cost of holding it. Thus, the futures price will reflect the cost of financing the underlying. However, the buyer of the futures contract does not hold the underlying and therefore does not receive the dividend. The futures price must be adjusted downward to take this into consideration. The adjustment of the yield for the cost of financing is what is called the net cost of carry. The futures price is then based ...