The Nature of a Future Contract

CFA Level I Derivatives
#1

(1) Is a future contract American or European by nature?

(2) Can a future converge to the spot price even before expiry?

(3) Can a future contract be sold before expiry?

#2

Although they don’t use the terms American and European (those are used for options), conceptually, they’re European: you cannot exercise them early.

Only if the risk-free rate is zero, which is extremely unlikely.

Yes, though it’s probably extremely rare.

If you want to get out of a futures contract early, you typically enter into an offsetting contract with the clearinghouse, settle the price difference in cash, and both contracts are cancelled.

#3

Thanks

#4

Assume a scenario where the risk-free rate is zero. Wouldn’t an additional premium, which is a part of the discount rate for the underlying (assuming it to not be a government security), cause the future price and the spot price to not converge?

#5

Nope.

Recall your Level I (and Level II, for that matter) derivatives: FT = S0(1 + rf)T. There’s no risk premium here.

I should clarify that I was ignoring storage costs and convenience yield when I wrote the “only if” part. In fact, if convenience yield exceeds storage costs, the costs could be equal even if the risk-free rate isn’t zero.

#6

Thanks. I get it now.

Correct me if I’m wrong, but I guess in real-life, the premium does have an effect, doesn’t it?

#7

I would think not. The purpose of the formula for forward pricing is to prevent arbitrage, not to try to predict future prices. Therefore, it’s based on the risk-free interest rate, not a rate that includes a risk premium.

#8

Okay. That’s clarified! Thanks once again.

#9

You’re quite welcome.