Expiration of futures contracts

Why do futures contracts expire?

The mechanism for the expiry of futures contracts is not accidental. The mechanism actually plays a very important role.

The fact that the duration of a given futures contract is limited (as opposed to e. g. the following) to stocks that can theoretically be listed on the stock exchange indefinitely) is associated with the relationship between the price of a futures contract (the futures price) and the price of the underlying instrument (the spot price).

There is a difference between futures and spot prices, which is called the „base”. If the spot price exceeds the futures price, the base assumes positive values, whereas if the spot price is lower than the futures price, the base assumes negative values.

In practice, despite the existence of a base, the price of the futures contract usually remains at a level similar to the price of the underlying instrument. In theory, there is no mathematical relationship between the two prices that would establish a link between these price levels.

Why, then, is the price of futures contracts practically no different from the spot price?

Firstly, there is one exception to the rule that there is no formal link between these prices. This exception is the moment when the contract expires, in which the price of the futures contract equals the price of the underlying instrument. The final clearing price of the futures contract is determined at this moment, and is calculated according to the average price of the underlying instrument on the settlement date.

Therefore, futures and spot prices are only formally linked on one day. Why is this one condition sufficient to keep them at a similar level throughout the whole contract period? This is the result of market processes and investors’ economic thinking. In order to understand the relationship between the futures contract price and the price of the underlying instrument, we will use the following example:

(For simplicity, the example ignores transaction commissions and assumes that one futures contract is per stock)

Let’s assume that the price of the futures contract for a given company’s stocks ten days prior to its expiry is USD 370, while the price of this company’s stock is USD 350. In such a situation, a rationally thinking Investor would immediately open a short position on the contract for stocks of the company, making a simultaneous purchase of stocks. In this way, when the price of the Company’s stocks drops to, for example, USD 340, the Investor would make a gain on the contract of USD 30 (US$ 370 – US$ 340) and would incur a loss of US$ 10 (US$ 340 – US$ 350) on the purchase of stocks.

He would ultimately earn 20 USD.

Similarly, in a situation where the stock price increases to USD 375, for example, the Investor would also make a profit. An investment in stocks would gain 25 USD (375 USD – 350 USD) while an investment in a stock futures contract would lose 5 USD (375 USD – 370 USD), which would result in a profit of 20 USD (25 USD – 5 USD).

In both cases, the investor would be able to obtain a risk-free return. This is why such situations are extremely rare. Investors immediately take advantage of the opportunity to earn an easy income and take short positions on the contract, at the same time making a purchase of stocks under this contract.

In this way, they „raise” the stock price and lower the price of the futures contract until the prices approach each other to such an extent that risk-free profit is no longer possible. Such a strategy is referred to as arbitration.

The difference between the spot and futures price before the settlement date (when it does not disappear to the end) is due to transaction costs (avoided in the example), the time value of money (in the case of contracts for financial instruments) or the so-called storage costs in the case of commodity contracts.

It is also possible that the price of a futures contract will be lower than the price of the underlying instrument. In this case, the Investors will also apply an arbitration strategy, this time opening long positions on futures contracts at the same time as making a short sale of the underlying instrument. As a result of their actions, futures prices and spots will approach each other.

Thus, it is clear that the existence of a mechanism for the termination of futures transactions effectively prevents the futures price from diverging from the underlying instrument price.

Investing in futures contracts:
http://effectivinvestingmoney.blogspot.com/2017/11/investing-in-futures-contracts.html

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