The prices of index futures and on individual shares generally follow the price development in the underlying asset. The difference in the price between the underlying asset and the future, also called the basis, is fundamentally determined by the current supply and demand in the future. Arbitrage between the equity market and futures market will, however, ensure that price effects from the market expectations are adjusted so that the basis essentially reflects the money market rate.
The futures price is therefore determined by the following main factors:
The market price of the underlying asset
The money market rate
Expected dividend on the underlying asset during the life of the future
Supply/demand
The price of an index future A theoretical price of an index future may be decided based on the reasoning that the index future serves as a substitute for a share portfolio that is based on the index constituents. Regardless of the choice of investment (futures or underlying shares) the investor will achieve a capital gain or a capital loss.
The holder of a futures contract will, unlike the shareholder, not receive any dividend payments from the shares in the portfolio, but equally he does not have to tie up funds in the shares as the shareholder. The holder of a futures contract may thus achieve a payoff by using the excess liquidity elsewhere - in the money market, for example. If investments elsewhere produce a better return than the expected return from dividend payments from a share portfolio, the futures purchase will be the best alternative, and as a result the futures price will naturally be higher than the value of the index (this is referred to as the implicit interest rate of futures).
Since the size of this difference in investment return is time sensitive, the difference between the futures price and the index value will narrow towards future’s expiry date and will be eliminated at expiry. Returns in the form of dividend payments are relatively limited, and historically they have underperformed the money market rate, which is why index futures are generally priced higher than the index value.
The price of futures on individual shares The pricing of futures on individual shares follows the same principles as for index futures – the future is a substitute for buying the share. The buyer of a future therefore does not tie up liquidity in the share, but does not receive dividends either.
The price of a future on an individual share will, like an index future, generally be higher than the price of the underlying share. However, the expected dividend on a single share may influence the price of the future at the time when dividend is actually paid, by which the price of the share is higher the price of the future.
