what causes the futures premium to vary?

[MarkB]

this may be a dumb question, but what causes the variance in futures premiums? Isn't there always supposed to be an arbitrage range between cash and futures prices?

[Alchemist]

Originally Posted by MarkB

this may be a dumb question, but what causes the variance in futures premiums? Isn't there always supposed to be an arbitrage range between cash and futures prices?

Hello MarkB,

this is not a dumb question at all. Futures prices depend on several variables, among which are days to expiration, cash index price, any dividends to be paid on the cash index, interest rates, AND market supply and demand. The latter can create temporary discrepancies around fair value.

I'm creating a sticky thread to this forum contaning links and material covering basic futures stuff. I'm planning on doing that for every forum on the site, stay tuned!

Happy Trading!

[ManhattanTrader]

Futures do not have a fixed price. you are free to bid/ask any price you want. this is the practical explanation of it. Theory, on the other hand, says that futures prices are determined by several variables like those listed by Alchemist.

[MarkB]

thanks everybody for your posts. one more thing: can you clarify how dividends and interest rates get into the valuation picture?

thanks!

[Alchemist]

Hello MarkB,

when you buy a futures contract, you can finance your purchase using another instrument (i.e. T-Bills) as collateral. Since you are earning interest on your T-Bills in addition to your futures position, the amount of interest erodes to zero on contract expiration and settlement day.

as for dividends, stocks which do pay dividends, have the amount of these dividends "built" into their prices. That is why stocks drop on their ex dividend date by the amount of their dividend. Since in a futures contract you are not getting paid any dividend, that amount has to be subtracted from fair value.

I must add that one significant factor which is often overlooked in futures valuation is market sentiment. That is among the most important factors, if not THE most important factor when it comes to futures premium valuation.

Hope this makes sense to you

Happy Trading!

[MarkB]

Everything is clear now. Thank you very much for your time, alchemist and everybody else.

thanks!

[Alchemist]

you're welcome!