WHAT IS THE EXPECTANCY MODEL?

Last Updated: 9 Jun 2022

In the stock markets, the pricing of any asset class is based on expectations. For example, the future price is the expected spot price and the spot price is nothing by the present value of the expected spot price. One of the important models that are used in the pricing of futures is the expectancy model. Now, this expectancy model of futures pricing looks at the futures price as the expected spot price. That is factoring in the spread which includes the cost of funds in case of cash-settled futures as well as insurance and storage in case of futures on physical commodities. The expectancy model of futures pricing is one of the most important models on which the pricing of futures is based.

EXPECTANCY MODEL

We all know that the futures price and spot price will converge on the delivery date as most of the arbitrage and spread trading is based on this premise. But, why do they converge to the spot price? There are 3 important approaches we will look at here.

• Expectations hypothesis or expectancy model
• Normal backwardation
• Contango.

The expectations hypothesis is the simplest approach but it is also very theoretical and hence not used too much in practice except for understanding the theoretical underpinnings of futures pricing. The expectations hypothesis assumes that the futures price will be equal to the expected spot price on the delivery date. Since the expectations will be consensual, it would be impossible to make riskless profits on futures trading. Also, it ignores the fact that futures price must also factor in a risk premium to encourage traders to take positions.

The second approach to futures pricing is called the normal backwardation-based pricing. This happens when the price of futures contracts is below the expected delivery date spot price. Remember, the expected delivery date spot price is based on the expectancy model, so our theoretical underpinning is still one of the expectancy models only. Contango, as you know, exists when the price of futures contracts is higher than the expected spot price on the delivery date. Due to contango, the price of futures contracts with later delivery dates is higher than those with nearer delivery dates. This is why July futures will be at a premium to June and August at a premium to July.

Finally, there is the contango approach to futures prices. The contango hypothesis is that the buyers of the products are natural hedgers since they also want a guaranteed price. Now, this is again not exactly true as the buyers can be pure speculators also, as it is permitted in the Indian markets. The contango hypothesis states that since the hedgers are desperate to protect their risk, they are normally willing to pay a higher price than the expected spot price. This results in the upward sloping contango curve wherein you see higher future prices for longer-term contracts.

The actual expectancy model tries to combine the impact of expectations, normal backwardation, and contango. Practically, the expectancy model tends to lean towards the contango approach. You will normally observe that future prices increase progressively with longer maturities. Most of the commodities with futures contracts have carrying costs like physical storage, insurance, and financing plus compensation for the risk of holding the underlying asset. Even in the case of cash-settled futures markets like equity and index futures, the contango theory holds as the contract holder must be compensated for long-term risk, more than shorter-term risk. That is the gist of the expectancy model.

How futures pricing works in practice

Without getting into the nuances of the expectancy model, the pricing would depend on the cost of capital and the risk-free rate. Here is how. If the required rate of return (cost of capital) exceeds the risk-free rate, then the current futures price will be less than the expected price on the delivery date. In a way, this is a good practical explanation of the expectancy model.

WHAT ARE THE CHARGES ON FUTURES CONTRACTS?

There are two types of charges on futures contracts viz. margins charged and costs charged. The costs on futures contracts include the brokerage cost, the GST, securities transaction tax, exchange charges, SEBI turnover tax, and stamp duties. The other type of pay-out is in the form of margins, which is part of the price to take a leveraged position. These include initial margin consisting of SPAN and exposure and regular MTM or mark-to-market margins payable on futures contracts.

WHAT ARE THE DIFFERENT STRATEGIES FOR FUTURE CONTRACTS?

Some of the popular strategies for futures contracts may be summarized as under.

• Directional futures trades
• Bounce trade on futures
• Break-out trades
• Arbitrage trades between spot and futures
• Spreads between futures of different maturities
• Futures pair trades between different asset class futures

Frequently Asked Questions

How important is expectancy model?

One of the objections to the expectancy model has been that the model is too theoretical to be of practical value. However, that is not correct. The model provides the theoretical underpinnings for futures pricing. The expectancy model brings about a relationship between the spot price and the futures price and sets a relationship which can be used to identify the under-pricing and overpricing opportunities. That is perhaps the biggest contribution of the expectancy model.