Is normal backwardation normal? Valuing financial futures with a local index-rate covariance

Philippe Raimbourg and Paul Zimmermann
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Philippe Raimbourg: UP1 - Université Paris 1 Panthéon-Sorbonne, PRISM Sorbonne - Pôle de recherche interdisciplinaire en sciences du management - UP1 - Université Paris 1 Panthéon-Sorbonne
Paul Zimmermann: IÉSEG School Of Management [Puteaux], LEM - Lille économie management - UMR 9221 - UA - Université d'Artois - UCL - Université catholique de Lille - Université de Lille - CNRS - Centre National de la Recherche Scientifique

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Abstract: Revisiting the two-factor valuation of futures contracts, we propose a new pricing model for financial futures and their derivatives. The linkage between the money market funding rate and the underlying asset price is stochastic and state-dependent, in compliance with investors' arbitrage strategies. The model explicitly captures the impact of interest rate expectations in the marking-to-market feature of futures, as predicted by Cox, Ingersoll, and Ross (1981) theory. The backwardation vs. contango regime of financial futures depends on a new parameter, the contango factor, which paves the way for future empirical studies. Akin to the implied volatility of option contracts, the contango factor provides market participants with a universal gauge of futures contracts' level of contango, consistent across futures markets and maturities. Our numerical simulations show significant deviations from the traditional cost-of-carry model of futures prices, with price deviations above 1% even for short-term futures contracts.

Date: 2022-04
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Published in European Journal of Operational Research, 2022, 298 (1), pp.351-367. ⟨10.1016/j.ejor.2021.06.051⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-04011013

DOI: 10.1016/j.ejor.2021.06.051

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