The index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market.
How many times have you felt of making risk-less profits by arbitraging between the underlying and futures markets. If so, you need to know the cost-of-carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures.
The cost of carry model
The cost-of-carry model where the price of the contract is defined as:
F=S+C
where:
F Futures price
S Spot price
C Holding costs or carry costs
If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage.
If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.
Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of arbitrage.
Cost= 1000+30 = 1030
Arbitrage profit 40
However, one has to remember that the components of holding cost vary with contracts on different assets.
