When the market price exceeds the NAV, the ETF is said to be trading at a premium “high-end.” It is trading at a discount if the price is lower “a reduction” When an ETF’s underlying assets, for example, trade at different hours than the stock exchange, it may trade at a premium or discount (e.g. commodities)
What is the futures price discount or premium?
The basis is the difference between an index’s or commodity’s spot or cash price and the futures price of the commodity’s or index’s next expiration contract. A premium is defined as the difference between the spot (cash) price and the futures price. It is referred to as a discount if it is trading at a reduced price.
What’s the difference between premium and discount?
The opposite of a premium is a discount. A bond is sold at a premium when it is sold for more than its face value. When a bond is sold for $1,100 instead of its par value of $1,000, a premium is paid.
What exactly is the future discount?
The process of assessing the present value of a payment or a stream of payments that will be received in the future is known as discounting. A dollar is worth more today than it will be tomorrow because of the time value of money. Discounting is the most important component in determining the price of a stream of future cash flows.
What does futures premium mean?
The specific futures market is considered to be at “Premium” when the future price is trading higher than the Spot price, which is the normal order of things.
What is the futures premium?
The difference between the prices of two futures contracts, or between the prices of two futures contracts and the cash market price. Alternatively, the purchase or selling price agreed upon between the buyer and seller of a futures option. Keep in mind that the premium is paid by the buyers and received by the sellers (authors).
What is a discount?
1: a reduction in the amount or worth of something from its gross (see gross entry 1 meaning 3b) amount or value: for example. a(1): a ten percent discount on a regular or list price is offered to customers who purchase tickets at a discount. (2): a proportionate deduction from a debt account, usually for cash or timely payment.
What does it mean to trade at a premium?
“At a premium” is a term used to describe when an asset’s current or transactional worth is higher than its fundamental or intrinsic value. “Company X is trading at a premium to company Y,” for example. “A commercial building was sold at a premium to its underlying value,” or “A commercial building was sold at a premium to its underlying value.”
What causes futures to trade at a discount?
If you were to attend a traditional Futures trading school, you would almost certainly be introduced to the futures pricing formula straight at the start. However, we have chosen to discuss it now, rather than at a later time. The reason is simple: if you trade futures based on technical analysis (which I believe the vast majority of you do), you don’t actually need to know how futures are valued, though having a basic understanding would be beneficial. If you want to trade futures using quantitative strategies like Calendar Spreads or Index Arbitrage, however, you should be aware of this. In fact, we’ll have a module dedicated to ‘Trading Methods,’ in which we’ll go through some of these strategies, so the discussion in this chapter will serve as a basis for the upcoming modules.
If you recall, we covered the ‘Futures Pricing Formula’ as the primary cause of the discrepancy between the spot and futures prices in some of the earlier chapters. So, I suppose it’s time to lift the curtain and reveal the ‘Future Pricing Formula.’
We know that the value of a futures instrument is determined by the underlying. We also know that the futures instrument follows the underlying. The futures price will fall if the actual price falls, and vice versa. The underlying price and the futures price, on the other hand, are not the same. As I write this, the Nifty Spot is trading at 8,845.5, while the comparable current month contract is trading at 8,854.7, as shown in the chart below. The “basis or spread” refers to the price difference between the futures and spot prices. The spread on the Nifty in the example below is 9.2 points (8854.7 8845.5).
The ‘Spot Future Parity’ is responsible for the price discrepancy. The discrepancy between the current and futures price that emerges owing to variables such as interest rates, dividends, time to expiry, and so on is known as the spot future parity. It is essentially a mathematical equation that equates the underlying price and its related futures price in a very broad sense. The futures pricing formula is another name for this.
Note that ‘rf’ is the risk-free rate you can earn for the whole year (365 days); because the expiry is at 1, 2, and 3 months, you may want to scale it accordingly for time periods other than 365 days. As a result, a more universal formula would be
The RBI’s 91-day Treasury bill can be used as a proxy for the short-term risk-free rate. The same information may be seen on the RBI’s home page, as illustrated in the screenshot below
The current rate is 8.3528 percent, as shown in the graph above. Let us work on a price example while keeping this in mind. If the spot price of Infosys is 2,280.5 and the current month futures contract is priced at 2,280.5, what should the current month futures contract be priced at?
Please note that Infosys is not scheduled to pay a dividend in the next seven days, so I’ve assumed a dividend of zero. The future price is 2283 when the aforementioned calculation is solved. Futures are referred to as having a ‘Fair value.’ However, as you can see in the figure below, the actual futures price is 2284. The ‘Market Price’ is the actual price at which the futures contract trades.
Market costs, such as transaction fees, taxes, and margins, account for the majority of the difference between fair value and market pricing. Fair value, on the other hand, shows where the futures should be trading at a particular risk-free rate and number of days till expiration. Let’s take this a step further and calculate the futures prices for mid- and long-term contracts.
Clearly, the determined fair value and the market price are not the same. This, I believe, is due to the applicable costs. Furthermore, the market may be taking into account some financial yearend dividends. The crucial element to remember is that as the number of days till expiration increases, the gap between fair and market value expands.
In reality, this brings us to another essential piece of market jargon: the discount and premium.
The futures market is said to be at ‘premium’ if it is trading higher than the spot, which is the natural order of things mathematically speaking. While the term “premium” is used in the equity derivatives market, the commodity derivatives market prefers the term “contango” to describe the same event. Both contango and premium, on the other hand, refer to the same thing: Futures are trading higher than Spot.
For the January 2015 series, here is a plot of the Nifty spot and its equivalent futures. The Nifty futures have been trading above the spot for the whole series, as you can see.
- The disparity between spot and futures is quite wide at the start of the series (highlighted by a black arrow). The x/365 component in the futures price method is likewise large because the number of days to expiry is big.
- The futures and the spot have converged at the end of the series (highlighted by a blue arrow). This is, in reality, a common occurrence. On the day of expiry, whether the future is at a premium or a discount, the futures and spot will always converge.
- If you fail to square off a futures position by expiry, the exchange will do it automatically, and the position will be settled at the spot price, as both futures and spot converge on the day of expiry.
Futures are not always more valuable than spot. There may be times when the futures trade cheaper than the related spot, owing to short-term demand and supply imbalances. When a futures contract trades at a discount to the spot, it is said to be trading at a discount. The same issue is referred to as “backwardation” in the commodities world.