I gotta admit, that writing this series has gotten tougher by the day for various reasons — including
- An ever increasingly hectic routine as life goes on, having to juggle work and study concurrently (side note: as of the time of writing I’ve completed my Master’s program, finally!),
- Procrastination, and
- Most importantly, the fear of being wrong
The last point is perhaps the most striking of all, a phenomenon more famously known as the Dunning-Kruger effect; in the journey of learning, one becomes less confident of one’s competence as one accumulates knowledge in the subject matter.
However, by remembering the initial intention of this article series, I managed to overcome this writing paralysis. The idea of the ‘QuantSimplified’ series was never to be academically rigorous — it was meant to be the opposite. It aims to provide readers with intuitions of difficult but important topics in quantitative finance, without getting caught up with too much technical jargon or complex concepts. The goal is to make things simple and factual, without making them simpler than necessary.
As I work to make this series better, I appreciate all feedback and questions as always. Please enjoy!
An oracle?
Perhaps one of the (if not the) biggest misnomers in financial jargon is the term ‘futures price’. Every day, one can easily find references to a certain future price whenever a news article reports the daily development of a market — statements such as “stock futures dip after latest inflation…”, or “crude oil futures climbed…” were common in daily reports.
But what exactly is a “futures price”? Briefly, a futures contract is a financial instrument (derivative) that binds the parties entering the contract into a future transaction. It is almost identical to a forward contract, which has a rigorous definition as follows:
“A forward contract is an agreement between two counterparties, a buyer and seller, to transact a specific underlying asset (can be physical or financial) at a future date (expiration date) at a pre-agreed upon price (strike price). This contract is an obligation to both parties.”
A future is simply an exchange-traded version of a forward contract, that theoretically comes with lower counterparty risks due to central clearing.
Because of the exchange-traded nature of futures contracts, it is a convenient tool to report up-to-date market sentiment. To elaborate,
- Most major futures (say S&P500, EURO STOXX 50, Brent Crude, Gold) are available for trading almost ‘round-the-clock, 5 days a week; the trading activities of futures — especially during the night hours of the markets they represent — would offer insights to how global participants react to a given news
- Whilst the main indicators of equity markets are the respective equity indices, real-time update of index prices are arguably less accessible than futures prices; futures prices are oftentimes published (at a 15-minute delay) on various platforms and exchange websites, and indices are often hidden behind paywalls. Thus, a more convenient alternative would be preferred.
- Some asset classes, specifically commodities, do not have observable spot prices; futures prices become the beacon that participants use to track the prices of these commodities (in fact, unlike other asset classes, the spot price of a commodity can be said to be a derivative of the futures price).
- Lastly, the trading volumes behind these major futures are substantial; looking at the table below, the dollar (notional) value of the average daily trading activities of some key contracts are in billions of US dollars; these futures markets are so liquid that they are arguably more “forward-looking” than the index prices
Given these reasons, most news outlets report futures prices as a convenient indicator of the most up-to-date market sentiment.
Now that we have established the definition of “futures price” and its common application in news reports, it’s time to address the misnomer — do futures prices have predictability of the prices in future?
The anatomy of futures
In the earlier discussion, we have conveniently left out a detail on futures prices; that there exists not only one but many futures prices for each underlying asset at any given time!
Recall from the definition that the parties entering a futures contract are obligated to transact at a given future date. Theoretically, there can be an infinite number of contract expiries! Practically, the futures expiration dates are determined by the listing exchanges using standardized rules (e.g. the third Friday of the third month in a quarter for most equity index futures) and there is a set number of contracts that will be listed (e.g. up to 72 consecutive months for energy contracts). The objective of standardizing the expiries and limiting the number of available contracts is to prevent the dilution of liquidity. It is a balance between meeting market participants’ hedging requirements and ensuring liquidity for price transparency.
By plotting all the available futures prices, one can derive the forward curve of the S&P 500, as shown in the figure below. The contract whose expiry is closest to the present is known as the front/ prompt month contract and the one whose prices are reported in the news.
If the front-month contract is representative of the current price of the underlying asset, are the further-dated futures representative of the future price of the asset? Are the far-dated futures prices a forecast of the asset price?
Too good to be true.
As some may already expect, when it sounds too good to be true, it is likely untrue.
It is human nature to seek certainty, and it is tempting to associate futures prices with price forecasts. And it doesn’t help with the misnomer.
A futures price works very badly as a price forecast because (in my opinion) its fundamental design is not of a forecast but of a trade-off.
When entering into a futures contract, the key problem one (the hedger) is attempting to solve is to trade a future uncertainty for a certainty today. The hedger may not want to take a chance in the future (due to personal outlook or other business practicalities) and would prefer to lock in a price today. Taking the other side of the hedger would be the futures market maker, who then faces an opposite trade-off — the market maker is forgoing certainty today to take on uncertainty in the future. Because there is no free lunch in the world, the market maker would demand a risk premium — an extra for providing the service to the hedgers. As we describe the problem, it has always been about pricing the trade-off, and not about forecasting the price trend. Even if the need for hedging came from an outlook, the forecast is not priced into the futures contract. Well, it is true that if the overall market is negative, there will be more short interests thus bringing down the futures price. But the magnitude of the drop was due to the increase in the risk premium, and not the forecasted magnitude of the negative price trend. These two may not be the same thing, due to market frictions, liquidity (or the lack thereof), information asymmetry, etc.
But more importantly, a futures price offers a point, not a set of probable prices. The futures price constantly updates itself given new market information of the trade-off. Eventually, as the time of expiry goes to zero, the futures price would converge to the spot price. This convergence is natural, but this does not mean that the futures price is a good forecast. It simply moves with the spot price and constantly reacts to new information. In fact in history, a three-month futures contract at any given point in time was never successful (except for some instances by chance) in predicting the price three months later.
Future comes in many shapes and sizes
Now that we understand that the futures prices are essentially pricing of trade-offs, the next question would be if all the forward curves should look the same.
The short answer is — not quite. It is tempting to think that because one locks in a price today for a future transaction, the time value of money should come into play, making future prices higher than spot prices. This is the case for many equity index futures due to replication. A futures contract can be replicated using a combination of stocks and savings accounts.
Consider a stylized example, in which a market maker goes into a long futures contract of a stock, expiring 3 months later. As a long holder, one is obligated to purchase the underlying stock in exactly 3 months from the counterparty. To do that, the market maker can first borrow the stock, short it, get the proceeds, and save it in the bank account. 3 months later, the market maker can then use the money one saved in the bank account to purchase the stock through the contract and return the stock to whomever one borrowed from. The fair value of this futures contract is thus the current price of the stock multiplied by the accumulation one can expect from saving the amount in a risk-free bank account. The same argument also holds for a market maker going short. In this example, we can expect that the futures price is always higher than the spot price as long as the interest rate offered by the savings account is positive. This is illustrated in the first plot in the figure below, where the forward curve is upward-sloping (contango).
From the same figure, we can see that it is not always the case that the forward curve will be upward-sloping. It could also be downward sloping (backwardat-ed), or exhibiting some kind of seasonality. To put it simply, the shape of the forward curve is driven by the economics of the underlying assets.
Take Brent crude futures as a case in point: a few reasons why the crude futures exhibit a backwardation are:
- Cost of storage: for a short futures holder to meet one’s obligation in the future delivery, the short holder needs to secure to supply today and keep it for the delivery date. Unlike financial assets that can be easily bought and sold, physical barrels are harder to procure, and forward planning is required. Because storing supplies incurs costs, these costs will be priced into the futures contract and be passed to the buyer.
- Hedging pressure: In addition to the cost of storage, in some situations, there are more short hedgers than long hedgers. This is usually the case in oil contracts, as producers are more vulnerable to price uncertainty than the ultimate consumers. Consumers can easily change their consumption to react to price changes, but producers have less flexibility in managing their production. Hence, there are likely to be more shorts than longs. Due to this imbalance, market makers would demand more premium to take the other side of the trade, thus bringing the futures prices lower.
Lastly, the long-short imbalances may not be monotonic across expiries, as seen in a natural gas contract. Sometimes, the imbalance itself may exhibit seasonality. In the case of natural gas, there may be more end-customer demand during winter due to a greater need for heating than there is during summer. There is a greater need for consumers to hedge the winter contracts (as prices are expected to be higher and consumers would want to protect against undesirable spikes in prices), resulting in a local contango. Conversely, as demand in summer is generally weaker, there would be relatively more hedging demand from suppliers to lock in summer prices ahead of time.
It is important to note that sometimes “seasonality” can manifest even without imbalances. For instance, some equity index futures may exhibit discontinuities due to corporate actions, such as expected dividend events. The chart below which shows the forward curve of the EURO STOXX 50 is a good example.
Making the best use of a tool — some forewarnings
Even though futures prices are not a good forecast of prices in the future, from the above we can conclude that futures prices are extremely helpful in the following manner
- The front-month futures price is a good proxy to “nowcast” the market, particularly when the underlying spot market is not available — e.g. Eurex Asian trading hours provide good information on market reaction to overnight news when the European cash markets are not open
- The forward curve structure reveals the economics of the underlying asset it seeks to track; comparing forward curves across time provides insights into market sentiments and any changes in the overall outlook of the short-term future relative to today (this is not the same as forecasting)
That being said, as with all types of data, one needs to be cautious of the potential downsides. With regards to the forward curve, apart from paying attention to the price, one needs to question the reliability of the prints. To determine how reliable a print is, two key measures are 1) trading volume, and 2) open interest. The more trading activity there is in a contract, the more reflective the price is of market sentiment. From the chart below, one can see that the trading volume and open interest decay exponentially the further away the expiry is (also to note, the trading volume and open interest are expressed in logarithmic scale).
All in all, despite this being a foundational concept which oftentimes overlooked by many, futures prices and the forward curve structure can offer plenty of information if one manages the information cautiously. It does pay dividends to have a good appreciation of forward and futures pricing, before diving into more complicated derivatives concepts.
I hope this article achieved its goal of providing a good primer into futures pricing and addressing some misconceptions one may have. Thanks for reading!
References:
- CME E-Mini S&P 500 futures: https://www.cmegroup.com/markets/equities/sp/e-mini-sandp500.html
- CME Gold futures: https://www.cmegroup.com/markets/metals/precious/gold.html
- CME Natural gas futures: https://www.cmegroup.com/markets/energy/natural-gas/natural-gas.html
- Eurex EURO STOXX 50 futures: https://www.eurex.com/ex-en/markets/idx/stx/euro-stoxx-50-derivatives/blc/EURO-STOXX-50-Index-Futures-160088
- Intercontinental Exchange Brent Crude futures: https://www.ice.com/products/219/Brent-Crude-Futures
- Korea Exchange KOSPI 200 futures: https://global.krx.co.kr/contents/GLB/02/0201/0201040201/GLB0201040201.jsp
