We have seen how we have to consider the cost of finance to arrive at the futures index value. However, the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equity futures, the holding cost is the cost of financing minus the dividend returns.
Example:
Suppose a stock portfolio has a value of Rs 100 and has an annual dividend yield of 3% which is earned throughout the year and finance rate=10% the fair value of the stock index portfolio after one year will be F= Rs 100 + Rs 100 * (0.10 – 0.03)
Futures price = Rs 107
If the actual futures price of one-year contract is Rs 109. An arbitrageur can buy the stock at Rs 100, borrowing the fund at the rate of 10% and simultaneously sell futures at Rs 109. At the end of the year, the arbitrageur would collect Rs 3 for dividends, deliver the stock portfolio at Rs 109 and repay the loan of Rs 100 and interest of Rs 10.
The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2.
Thus, we can arrive at the fair value in the case of dividend yield.
