Determination of Forward and Futures Prices

 Forward and futures are as important as spot prices. It’s being traded in the stock market in a volume which is equivalent or some times greater than the spot market. The future market thus becomes a place of huge revenue for the investors. Some of the method that are used to determine the forward and future prices are,

• Market price is a method in which the two prices are determined. Market price is the rate at which the investors are ready to buy the futures and forwards, the market price of futures and forwards are determined by identifying the demand for the future or forward in the market. It is published real time by the exchange. It is usually transparent. It varies with the variation of the buying bids placed for the contract and the selling bids placed for the contract. Confuse may occur in case of OTC or floor traded contracts.
• Arbitrage-free price is the price deducting the risk associated with the derivative, and in this price the forward and future will yield the profit without any risk. The method to determine the arbitrage-free price is difficult. It is more complex than the above method. The variables that are needed to be considered while calculating this price are more. Black Scholes formula is used to calculate this price. One of the major assumptions made in this method is that the price cash flows from a European stock option can be replaced by continuous buying and selling strategy using only the stock. This method is however replaced by a simpler method called Binomial option model. Arbitrage-free price for OTC model or floor traded contracts cannot be determined by this method. The market prices to these trades are not available and hence it makes it impossible to find the arbitrage-free price. These models are input dependent which means the final output price is determined by the input price. It is the main reason for the failure to find the arbitrage-free price for derivatives that are traded by OTC or floor trading method. The individual agent must only find the arbitrage-free price of these derivatives.

Question

• What is market price?
• What are the methods to determine the arbitrage-free price?