Bitcoin’s emergence has led to various forms of digital currencies and new trading methods, despite being unregulated by most governments, which restricts financial institutions from facilitating transactions.
This analysis uncovers the intricacies of pricing Bitcoin futures contracts. Keep reading if you’re curious about how these contracts are priced, as market participants now have several trading options.
It is crucial to understand the basics of these contracts before examining the pricing mechanisms of Bitcoin futures.
Bitcoin futures contracts rely on the market’s prevailing rate, which is the price at which Bitcoin is ready for purchase or sale for immediate delivery. Bitcoin futures are influenced by spot price movements. These contracts are traded on specific platforms, and trading for December contracts, among others, begins at certain times. Price correlation between futures and spot prices is generally in sync, though the two are not identical.
The Cost of Carry
The formula is derived from the concept of the cost of carry and involves the risk-free rate applied over the contract’s duration. The futures price combines the spot price and this cost, eliminating arbitrage opportunities.
Taking a look at historical data, on April 18, 2018, with a risk-free rate of 2.25% and a Bitcoin spot price of $8,171, the projected futures price for April was about $8,175.30. This calculation closely matched the actual futures price of $8,180.
Why was there a minor $5 difference? Factors such as brokerage fees and market perceptions can slightly alter the final payout.
Calculating Bitcoin Futures
The futures price calculation from the spot price uses a theoretical model:
Futures Price = Spot price ∗ ( 1 + r f − d ) \mathbf{\textbf{Futures Price}=\text{Spot price }^*(1+r_f-d)} Futures Price=Spot price ∗(1+rf−d)
where, rf = the annual risk-free rate, and d = dividend.
Unique to Bitcoin, this formula is adjusted in two ways: firstly, the annual risk-free rate is converted into a daily rate, and secondly, the dividend is omitted, as Bitcoin does not yield traditional dividends.
Bitcoin Futures Price = Bitcoin Spot price ∗ [ 1 + r f ∗ ( x 365 ) ] \begin{aligned}&\textbf{Bitcoin Futures Price}\\&\qquad\mathbf{=}\textbf{Bitcoin Spot price}\mathbf{^*\left[1+r^*_f\left(\frac{x}{365}\right)\right]}\end{aligned} Bitcoin Futures Price=Bitcoin Spot price∗[1+rf∗(365x)]
where x represents the number of days until contract expiration.
Real-World Dynamics
The theoretical formula falls short in capturing scenarios that can have a substantial effect on futures prices. Spot prices can swiftly integrate Bitcoin-related updates, and the anticipated volatility, alongside its influence over the remaining days until expiry, transforms futures pricing into an exercise of conjecture.
Beyond theoretical frameworks, actual Bitcoin futures pricing can exhibit significant fluctuations. Examining recent trends helps understand the unpredictability in futures price determination:
In a visual representation, the blue line denotes Bitcoin’s spot price, the green line shows futures expiring in April, and the red line represents those expiring in May. The graph indicates:
- The futures price can converge with the spot price (Arrow 1).
- The futures price might exceed the spot price (Arrows 2 and 3).
- The futures price can drop below the spot price (Arrow 4).
These variations arise due to the differences between the spot price and future prices at specific points, as marked on the graph.
Events that market participants foresee may be reflected in the spot price, highlighting potential near-term impacts. This reflects their perception of future events.
Bitcoin trades continuously, meaning its spot prices are vulnerable to major swings within minutes or hours due to local events. However, futures markets operate on limited schedules, potentially widening gaps between spot and futures prices if significant overnight developments occur.
Despite the challenges in price discovery and the wide-ranging impact of volatility on futures pricing, trading in futures is still seen as a high-risk, high-reward venture. The perpetual trading of spot prices adds another layer of complexity. Yet, the allure of Bitcoin futures remains strong, as the inherent volatility presents substantial profit opportunities.
Cryptocurrency and Initial Coin Offerings (“ICOs”) investments are highly speculative and risky. This article is not a recommendation for investing in cryptocurrencies or ICOs. As individual financial circumstances are distinct, consulting a qualified professional before making financial decisions is advisable. No guarantees are made regarding the accuracy or timeliness of the information provided. At the time of writing, the author holds no cryptocurrencies.
