Fair Value of a Futures Contract

Fair Value is the theoretical price at which a futures contract should trade, given the current spot price of the underlying commodity and the costs or benefits of holding the commodity until contract expiry.

The calculation incorporates the risk‑free interest rate, storage costs, and the convenience yield (the benefit of physically holding the commodity). In the Indian context, SEBI expects market participants to use a cost‑of‑carry framework for pricing.

For the NISM exam, you will often be asked to compute fair value, compare it with the quoted futures price, and decide whether the contract is in contango or backwardation. Remember, the term “contango” means futures price > fair value, while “backwardation” means futures price < fair value.

• Spot price – current market price of the commodity.
• Fair value – theoretical futures price derived from cost of carry.

The cost‑of‑carry model treats a futures contract as a combination of buying the spot commodity today and financing that purchase until expiry.

Four key components drive the model:

Risk‑free rate (r) – the cost of borrowing money to purchase the commodity. In India, the yield on government securities is commonly used.

Storage cost (u) – expenses incurred to store, insure, and maintain the commodity over the holding period.

Convenience yield (y) – the non‑monetary benefit of physically holding the commodity, such as ensuring supply for production.

Time to maturity (T) – expressed in years (or fraction of a year). The longer the horizon, the larger the cumulative carry cost.

While the syllabus prefers the continuous‑compounding version, some textbooks also present a discrete version: F = S_0 \times \frac{(1 + r + u)^{T}}{(1 + y)^{T}}. Both give similar results for short maturities, but continuous compounding is mathematically cleaner and aligns with SEBI’s pricing conventions.

In practice, brokers may quote futures prices using market‑derived implied rates rather than the textbook rates. However, for the NISM exam you should stick to the formula provided in the official study material.

When solving questions, first check whether the problem states “continuous” or “annual compounding”. Using the wrong method can cause a 1‑2 % error, enough to lose marks on precision‑type questions.

Market price can diverge from fair value due to supply‑demand imbalances, speculative pressure, or regulatory interventions such as position limits imposed by SEBI.

Seasonal demand (e.g., agricultural harvest cycles) often raises the convenience yield temporarily, pushing futures below fair value. Conversely, unexpected geopolitical events can increase storage costs, lifting fair value above market price.

For the exam, be ready to identify which factor is most likely responsible for a given price gap and choose the correct qualitative explanation.

Broker‑dealing firms in India calculate fair value to set bid‑ask spreads for futures on MCX (Multi Commodity Exchange). SEBI mandates transparent pricing, and fair value serves as a benchmark for monitoring market manipulation.

When a client asks for a price quote, the dealer will compare the quoted futures price with the computed fair value. If the market price deviates beyond a pre‑defined tolerance (often 2‑3 %), the dealer may adjust the spread or flag the trade for compliance review.

Exam questions may present a scenario where a dealer must decide whether to accept a client order based on the fair‑value comparison. The correct answer hinges on understanding the cost‑of‑carry components and the direction of the premium.