Understanding PSEi futures requires a grasp of various pricing models, and among the most important is the cost of carry model. This model helps in determining the fair value of a futures contract based on the underlying asset's spot price and the costs associated with holding that asset over the life of the contract. In this article, we'll dive deep into what the cost of carry model is, how it applies to PSEi futures, and why it's essential for traders and investors in the Philippine stock market.

What is the Cost of Carry Model?

The cost of carry model is a financial valuation method used to determine the theoretical or fair price of a futures contract. It's based on the idea that the price of a futures contract should reflect the current spot price of the underlying asset, plus the costs of holding that asset until the expiration of the futures contract, minus any income earned from holding the asset. These costs include storage, insurance, financing, and other expenses, while income can include dividends or interest.

Breaking Down the Components

To truly understand the cost of carry model, let's break down its main components:

• Spot Price (S): This is the current market price of the underlying asset. For PSEi futures, it's the current level of the Philippine Stock Exchange index (PSEi).
• Cost of Carry (C): This encompasses all the expenses associated with holding the underlying asset until the expiration of the futures contract. These costs may include:
  • Financing Costs: The interest expense incurred to finance the purchase of the underlying asset.
  • Storage Costs: If the underlying asset is a physical commodity, storage costs are included.
  • Insurance Costs: Costs to insure the underlying asset against loss or damage.
• Income (I): This refers to any income earned from holding the underlying asset. For PSEi futures, this typically includes dividend income from the stocks that comprise the PSEi index.

The Formula

The basic formula for the cost of carry model is:

Futures Price (F) = Spot Price (S) + Cost of Carry (C) - Income (I)

This formula suggests that the futures price should be equal to the spot price, adjusted for the net costs of holding the asset until the futures contract expires. Let's delve into each component in the context of PSEi futures.

Applying the Cost of Carry Model to PSEi Futures

When applying the cost of carry model to PSEi futures, some adjustments and considerations are necessary. Unlike physical commodities, the PSEi is an index, not a tangible asset. Therefore, storage and insurance costs are irrelevant. However, financing costs and dividend income play crucial roles.

Spot Price (S) in PSEi Futures

The spot price (S) in the context of PSEi futures is simply the current level of the Philippine Stock Exchange index (PSEi). This index represents the average performance of a basket of the 30 largest and most liquid companies listed on the Philippine Stock Exchange. Monitoring the PSEi's real-time movement is vital for accurately assessing the potential fair value of PSEi futures contracts.

Cost of Carry (C) in PSEi Futures

In PSEi futures, the cost of carry primarily comprises the financing costs associated with holding a portfolio of stocks that mirrors the PSEi. Since investors don't typically purchase the actual basket of stocks when trading futures, the financing cost is more theoretical. It represents the return an investor would forgo by investing in the PSEi instead of a risk-free asset.

To estimate the financing cost, traders often use prevailing interest rates or the yield on Philippine government bonds. For example, if the prevailing interest rate is 5% per annum, the financing cost for a three-month PSEi futures contract would be approximately 1.25% (5% / 4).

Income (I) in PSEi Futures

The income (I) component in PSEi futures represents the dividend income expected from the stocks within the PSEi index during the life of the futures contract. Estimating this income requires analyzing the dividend yields of the constituent stocks and projecting their dividend payments.

For instance, if the average dividend yield of the PSEi is 2% per annum, the expected dividend income for a three-month PSEi futures contract would be approximately 0.5% (2% / 4). This income reduces the overall cost of carry, as it offsets some of the financing expenses.

Example Calculation

Let's illustrate with an example:

• Spot Price of PSEi (S): 7,000
• Financing Cost (C) for 3 months: 1.25% of 7,000 = 87.5
• Dividend Income (I) for 3 months: 0.5% of 7,000 = 35

Using the cost of carry formula:

Futures Price (F) = 7,000 + 87.5 - 35 = 7,052.5

In this scenario, the fair value of the three-month PSEi futures contract would be approximately 7,052.5.

Why is the Cost of Carry Model Important?

The cost of carry model is crucial for several reasons:

Fair Value Assessment

It provides a framework for assessing whether a futures contract is overvalued or undervalued relative to its underlying asset. By comparing the market price of the futures contract to its theoretical value derived from the cost of carry model, traders can identify potential arbitrage opportunities.

Arbitrage Opportunities

Arbitrage involves simultaneously buying and selling an asset in different markets to profit from a price discrepancy. If the market price of a PSEi futures contract deviates significantly from its fair value calculated using the cost of carry model, arbitrageurs may exploit this difference by buying the undervalued asset and selling the overvalued one, thereby profiting from the convergence of prices.

Hedging Strategies

The cost of carry model helps in developing effective hedging strategies. By understanding the relationship between spot and futures prices, investors can use futures contracts to mitigate the risk of adverse price movements in their underlying asset holdings. For example, a portfolio manager holding a basket of PSEi stocks can hedge against a potential market decline by selling PSEi futures contracts.

Trading Decisions

Traders use the cost of carry model to make informed trading decisions. If a futures contract is trading below its fair value, it may represent a buying opportunity, while a contract trading above its fair value may be a selling opportunity. However, it's essential to consider other factors such as market sentiment, technical analysis, and macroeconomic conditions before making any trading decisions.

Factors Affecting the Cost of Carry

Several factors can influence the cost of carry and, consequently, the fair value of futures contracts:

Interest Rates

Changes in interest rates directly impact the financing cost component of the cost of carry. Higher interest rates increase the cost of financing, leading to higher futures prices, while lower interest rates reduce the cost of financing, resulting in lower futures prices.

Dividend Yields

Fluctuations in dividend yields of the underlying stocks affect the income component of the cost of carry. Higher dividend yields increase the income, reducing the overall cost of carry and lowering futures prices, while lower dividend yields decrease the income, increasing the cost of carry and raising futures prices.

Market Sentiment

Market sentiment and expectations can also influence futures prices. If investors are optimistic about the future performance of the underlying asset, they may be willing to pay a premium for futures contracts, driving prices above their theoretical fair value. Conversely, if investors are pessimistic, futures prices may trade below their fair value.

Supply and Demand

The forces of supply and demand in the futures market can also impact prices. If there is strong demand for futures contracts, prices may rise, while excess supply can lead to price declines. These supply and demand dynamics can be influenced by factors such as macroeconomic news, geopolitical events, and trading activity of large institutional investors.

Limitations of the Cost of Carry Model

While the cost of carry model is a valuable tool, it has certain limitations:

Simplifications

The model assumes that all costs and income can be accurately quantified and that the market is efficient. In reality, estimating future dividend payments and financing costs can be challenging, and market inefficiencies may exist, leading to deviations from the theoretical fair value.

Transaction Costs

The model does not explicitly account for transaction costs such as brokerage fees and taxes, which can impact the profitability of arbitrage opportunities. These costs can reduce the potential profit from exploiting price discrepancies between spot and futures markets.

Market Volatility

In periods of high market volatility, the assumptions underlying the cost of carry model may not hold. Volatility can lead to rapid and unpredictable price movements, making it difficult to accurately assess fair value and execute arbitrage strategies.

Other Factors

The model does not consider other factors that may influence futures prices, such as regulatory changes, political events, and unforeseen circumstances. These factors can introduce uncertainty and affect market sentiment, leading to deviations from the model's predictions.

Conclusion

The cost of carry model is a fundamental concept for understanding the pricing of PSEi futures contracts. By considering the spot price of the PSEi, financing costs, and dividend income, traders and investors can estimate the fair value of futures contracts and identify potential trading opportunities. However, it's important to recognize the limitations of the model and consider other factors that may influence market prices. A thorough understanding of the cost of carry model, combined with sound risk management practices, can enhance trading performance in the Philippine stock market. Always remember to conduct thorough research and consider consulting with a financial advisor before making any investment decisions. Happy trading, guys!