The price of a futures contract is usually not equal to the price of the security or commodity underlying the contract. Sometimes the difference represents an investment opportunity, but not always.
Part of the difference reflects the cost of financing a futures-like transaction with borrowed funds, known as the cost-of-carry model.
The model, like many other pricing theories, considers a possible arbitrage opportunity. How could an investor profit from the mismatch without taking any risk? In a perfect market, risk and return are intimately related, so the simple arbitrage opportunity should not produce a profit.
Of course, markets are not perfect. They are subject to the vagaries of supply and demand, transaction costs, government regulations, and other factors.
Generally, if the difference between a futures contract and its underlying item are greater than that dictated by the "cost of carry" model, an arbitrage opportunity exists in the imperfect market.
A futures contract is a promise to deliver a commodity or security on a future date. Some futures contracts are based on a group of securities or an index, like The Bond Buyer's 40-bond index.
What if a futures contract expiring in two months is selling for $100 while the bonds composing the index can be had for $1007 Is it an opportunity for arbitrage?
An investor could borrow $100 to buy the bonds, putting the bonds up as collateral, while simultaneously selling the futures contract for $100. For two months, the investors could collect the coupon payments on the bonds. After two months, no matter how the market moved, the investor could deliver the bonds to the holder of the futures contract, pay back the loan, and lock in a profit.
The investor must pay interest on the borrowed $100 for two months, but the long-term rate on the bonds exceeds the two-month rate in the current market. In a perfect market, where riskless profits are theoretically impossible, there should therefore be a difference in price between the contract and the underlying bonds.
If the investor received a 6% rate for two months from the bonds while paying a 4% rate on the loan, the investor would pay about 33 cents and receive about 50 cents for a 17-cent profit.
So in a perfect market, the price of the futures contract should be slightly different than the price of the bonds to eliminate this riskless profit. If the investor received only $99.83 for selling the contract, the profits evaporate.
But in an imperfect market, the interest may not perfectly offset the arbitrage profits. If, with two months remaining, the contract is selling for more than $99.83, it is "overpriced," allowing the arbitrage investor a profit. And if the contract is selling below $99.83, it is "underpriced" allowing an arbitrage investor to profit by doing the reverse.
As the contract approaches its expiration date, the discount factor shrinks. And on expiration, the contract should settle exactly at the level of the bonds in the index.
Of course, existing tax laws prohibit an investor from using municipal bonds as collateral to finance a loan, a so-called repo transaction.
But investors can calculate the rate implied by the difference in price between the municipal futures contract and the underlying index. If this calculated rate is above or below current market rates for the same time period, the imperfect market may be "mispricing" the contract or the underlying bonds.
If the rate is higher than market rates, the contract is expensive compared with bonds. And if the rate is lower than market rates, the contract is considered cheap.
