futures trading discount contracts can be an excellent way to hedge against price risk for businesses, investors, and traders. However, the futures market can also be quite complex, and it can be challenging to know what exactly you’re buying and selling, especially concerning the prices. One of the critical factors in pricing futures is the concept of discounting. In this post, we will provide a comprehensive guide to understand discounted futures.
The first step in comprehending discounted futures is to understand that futures prices are not based on current market prices. Instead, the prices of futures contracts correspond to the expected future price of the underlying asset. Because of this forecast, future prices include a discount or premium based on the cost of financing the purchase of the underlying asset until the contract’s expiration date.
The cost of a futures contract includes three essential parts: the current market price of the underlying asset, the cost of financing the purchase of the asset before the contract’s expiration date, and an expectation that the asset’s price will change before the contract’s expiration date. The cost of financing the purchase of the asset emerges from the fact that futures contracts are leveraged; that is, investors are only required to deposit a fraction of the contract’s total value, and the rest is borrowed from the broker.
The discount or premium of a futures contract can change based on changes in the market conditions. For example, if the cost of borrowing money rises, the discount rate applied to the futures contract will also increase, leading to a higher expected price of the futures contract. In contrast, if financing costs decline, the discount rate will decrease, leading to a lower expected price.
The discount rate used in futures contracts is typically determined by the supply and demand for government securities. The risk-free rate for the required collateral is the yield on a Treasury bill of the same maturity as the futures contract, minus the dividend yield for ETFs of stocks. The reason for this is that Treasury bills are considered the most low-risk securities in the market. If future prices for a particular commodity rise above the sum of the current underlying asset price and the cost of carrying the future to expiration, the futures contract holds a positive area. The opposite case yields a negative area.
Understanding discounted futures requires a basic understanding of interest rates. The discount rate is not the interest rate paid to finance the purchase of the underlying asset in a futures contract. Still, it is based on the interest rates for government securities of the same maturity as the futures contract. This risk-free rate is used in the discounted cash flow model to compute the net present value of projected cash flows. The same calculation method applies to futures contracts, where the net present value is the expected future price of the underlying asset, minus the financing costs, discounted by the risk-free rate.
Discounted futures contracts can be an excellent risk management tool when trading commodities. Understanding discounted futures is not always straightforward, but the concepts behind pricing futures contracts can be broken down into easy-to-understand pieces. Remember, future prices include a discount or premium based on the cost of financing the purchase of the underlying asset before the contract’s expiration date. Once you understand this fact, you can better analyze the risk exposures associated with owning a futures contract. That can be an important way to reduce uncertainty when trading futures.