Futures pricing

Hey Yasaswi, great question — futures pricing and cost-of-carry can be tricky topics! Let me break it down:

1. Why use the Cost-of-Carry method despite possible losses?

The Cost-of-Carry model prices futures contracts based on the cost to hold (or “carry”) the underlying asset until the futures expiry. This includes things like:

Interest cost on capital
Storage costs (if any)
Dividends or convenience yield (if applicable)

Why does the committee use it?

Fair valuation: It provides a theoretically “fair” price reflecting all known costs and benefits of owning the underlying asset versus the futures contract.
Transparency & consistency: Using a systematic cost-based approach prevents arbitrary price setting, increasing market confidence.
Prevents arbitrage: The model helps avoid arbitrage opportunities where traders could exploit mispricing between spot and futures.
Reflects real economic costs: Even if contango (futures price > spot price) causes some margin increases, it’s a natural result of carrying costs — this prevents “artificially” low futures prices.

2. Why does contango increase basis risk and margin requirements?

In contango, futures prices are higher than spot due to carrying costs.
Basis risk arises because spot and futures don’t move perfectly together.
Increased margin requirements reflect the higher risk to brokers and exchanges.

Though this might cause temporary losses, it’s part of the market risk and price discovery process.

3. Rationale despite potential losses

Losses to some traders are often offset by gains to others — for example, hedgers vs speculators.
The model is market-neutral; it reflects true costs rather than trying to “protect” participants from market dynamics.
Losses happen if you misprice risk or hedge incorrectly, not because the method is flawed.

4. Hedging Ratio to Prevent Loss?

The hedging ratio or optimal hedge ratio (e.g., derived via minimum variance hedge ratio) helps reduce basis risk.
Using historical data on spot and futures price volatility and correlation, the hedger can decide the size of the futures position to minimize risk, not necessarily to eliminate all losses.
Dynamic hedging and adjusting hedge ratio over time is necessary, especially in contango or backwardation.

In short:

Cost-of-Carry reflects real-world costs and prevents arbitrage.
Some loss or margin increase is natural in contango but market participants are expected to manage risk via hedging.
Hedging ratio helps reduce losses but doesn’t eliminate market risk entirely.