When it comes to futures trading, understanding market value is crucial to making informed investment decisions. Market value refers to the price that a futures contract is currently trading at in the open market. Calculating market value can help traders determine if a particular futures contract is over or undervalued, and plan accordingly.
To calculate the market value of a futures contract, we must first understand the variables that influence it. These variables include the current spot price of the underlying asset, the time remaining until the futures contract`s expiration, and the cost of carry, which is the cost of holding the asset until the contract`s expiration date.
The formula for calculating the market value of a futures contract is as follows:
Market Value = (Current Spot Price + Cost of Carry) x (1 + Interest Rate)ⁿ
Where n represents the time remaining until the contract`s expiration and the interest rate is the cost of financing the position until the expiration date.
Let`s break this formula down further and look at each component in detail.
Current Spot Price: This is the price of the underlying asset at the time of calculation. For example, if we are trying to calculate the market value of a crude oil futures contract, we would use the current market price of crude oil as the spot price.
Cost of Carry: This is the cost associated with holding the underlying asset until the expiration date of the futures contract. The cost of carry includes storage costs, insurance, and any other expenses incurred to maintain the asset. For example, if we are calculating the market value of a corn futures contract, the cost of carry would include transportation and storage costs.
Interest Rate: This is the cost of financing the position until the expiration date. The interest rate is typically determined by the difference between the current spot price and the futures price, as well as the time remaining until expiration. For instance, if the futures price is higher than the spot price, traders must pay a premium to buy the asset in the future. Therefore, the interest rate will be positive. If the futures price is lower than the spot price, traders receive a discount for buying in the future and the interest rate will be negative.
Time to Expiration: This is the time remaining until the expiration date of the futures contract. The longer the time until expiration, the greater the cost of carry and the more the interest rate will affect the market value.
By understanding and utilizing this formula, traders can calculate the market value of a futures contract and make informed trading decisions. However, it`s important to note that market values are constantly changing, so traders must be vigilant and adjust their trading strategies as needed. With practice and attention to market trends, traders can use market value calculations to make profitable investments in the futures market.