Premium and Discount in Futures Market: The futures market is a place where two parties enter a formal agreement, which is to be executed at a fixed date and at a predetermined price. These contracts are used by the market participants as a way to hedge, speculate, and arbitrage in the financial markets.
These contracts derive their value from the value of the underlying asset and move in tandem with it. But sometimes we will come across discrepancies between the value of the underlying asset and the futures contracts.
In this article, we will discuss the concept of premium and discount in futures Market.
What Is Spot Price?
The price at which a stock, currency, or commodity is traded for immediate delivery or settlement is referred to as the spot price. Participants use this price to buy or sell the instruments at any given period of time.
The current or the spot price of the instrument is determined by the level of demand and supply during the current period.
Also Read: Difference Between Spot Market And Future Market!
What Is the Futures Price?
The futures price is the one that is mentioned in the futures contract. Usually, this price moves in sync with the spot price of the underlying security. But this price can differ from the spot price in the market due to interest rates, dividends, and time to expiry.
What Is Premium In Futures Market:
When the value of a futures contract trades at more amount than the spot price of the underlying on which the contract is based, it is referred to as the Premium. When this phenomenon occurs in the commodity derivatives market, it is referred to as ‘Contango’.
For example, The spot price of gold is trading at Rs. 61000 for 10 grams and the futures contract is trading at Rs. 61500. This means the value of the futures contract is trading at a premium of Rs.500.
The factors that cause a Premium in the futures market:
- Increase in demand for the contract: The expectations of the market participants are one of the factors that cause the futures contract to trade at a premium.
If there are expectations for the price of the underlying asset to increase in the future, more participants will try buying the futures contracts which results in excess demand over the supply. This results in the contract trading at a premium.
- Increase in the cost of storage: Another factor that can cause a premium in the futures contract is the cost of storage. That is the cost incurred to store a particular commodity.
Let us understand this with the help of an example:
Suppose you require a particular commodity that will be deliverable to you in three months. As the commodity is deliverable to you on a future date, you are required to pay the seller for the storage of the commodity which causes a premium in the futures price
What Is Discount In Futures Market:
When the value of a futures contract trades is lesser than the spot price of the underlying, it is referred to as a discount. When this phenomenon occurs in the commodity derivatives market, it is referred to as ‘Backwardation’’.
For example, The spot price of gold is trading at Rs. 61000 for 10 grams and the futures contract is trading at Rs. 60500. This means the value of the futures contract is trading at a discount of Rs.500.
The factors that cause a discount in the futures market:
- Decrease in demand for the contract: If there are expectations for the price of the underlying asset to decrease in the future, participants will choose alternative options that are safer or that have the potential to give better returns, This decreases the demand for the contract which in turn causes the futures contract to trade at a discount.
- Short-Term Demand spikes: An increase in the demand in the near term can also cause a discount in the futures contract. For instance, there’s a short-term surge in the demand for coffee beans and its demand is expected to return to normal in the future. This will result in the spot price trading at more rate than the futures price.
What Does Premium And Discount In Futures Market Tell You?
When a futures contract is trading at a high premium, it is an indication that the price of the underlying asset may increase in the future. In this situation, one can take a long position in the underlying security
When a futures contract is trading at a huge discount, it is an indication that the price of the underlying asset may decrease in the future. In this situation, one can take a short position in the underlying security.
Also Read: Which Is More Profitable Futures Or Options Contract?
In Closing
In this article, we discussed the meaning of spot & futures prices and also discussed the meaning of premium and discount in futures market.
Premiums and discounts help us get an idea about the market expectation of the price of the underlying assets. But premiums and discounts should not be the sole indicator to identify market sentiments as they can be caused by various factors.
Thus, it should use premiums and discounts with the conjunction of technical and fundamental factors which help us get a better understanding of the underlying asset.
FAQs
1. What is the difference between premium and discount in future market?
Premium futures refer to situations where the futures price is higher than the expected spot price, indicating bullish sentiment. Discount futures, on the other hand, occur when the futures price is lower than the expected spot price, reflecting a bearish sentiment in the market.
2. How premium is calculated in futures?
The premium in futures is calculated by subtracting the current spot price from the futures price.
Premium = Futures Price – Spot Price.
For example, if the futures price for a stock is 105 and the spot price is 100, the premium would be 5.
3. Why is stock future discounted?
Stock futures are discounted primarily due to the exclusion of dividends, which benefit cash market buyers but not futures buyers. However, there can be other instances where futures trade at a discount even in the absence of dividends.
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