How Are Bitcoin Futures Priced?

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How Are Bitcoin Futures Priced?

What Are Bitcoin Futures?

When Bitcoin initially appeared on the market in 2009, no one knew where it would go, much alone if the hype would persist. Authorities feared that since it was exchanged on a decentralized market, this digital currency might be used for unlawful activities, money laundering, and perhaps terrorism funding. However, the market has progressed significantly since then.

The value and interest in this coin have skyrocketed. Trading occurs on exchanges or on websites that enable peer-to-peer transactions. Most countries do not regulate Bitcoin, therefore financial institutions cannot facilitate transactions. Because of its popularity, various types of digital money and methods of trading Bitcoin have emerged.

Bitcoin futures contracts are now available to market participants. These futures contracts were introduced in December 2017 and have grown in popularity since then. 1 They provide investors with exposure to the underlying cryptocurrency in the same manner as a commodity would. As a result, Bitcoin futures contracts provide risk reduction and hedging opportunities. Continue reading if you want to understand more about these contracts. This article examines the pricing of Bitcoin futures contracts.

Key Takeaways

  • Bitcoin futures contracts were established for the first time in December 2017.
  • Investors may acquire and sell futures contracts on the Chicago Mercantile Exchange via brokers.
  • You may use the theoretical formula to calculate the futures price from the current price of Bitcoin.
  • Bitcoin is very volatile, which may have a significant influence on pricing.
  • Investors should keep in mind that big fluctuations in the spot price may have a substantial impact on Bitcoin futures pricing.

The Basics of Bitcoin Futures

Before we get into how Bitcoin futures are valued, it’s crucial to understand some of the fundamentals of these contracts.

Bitcoin futures contracts are traded on the Chicago Mercantile Exchange (CME), which provides monthly cash settlement contracts. 2 This implies that following contract settlement, an investor may accept cash rather than actual delivery of Bitcoin. To participate, interested investors may use a broker, such as, TD Ameritrade, or Interactive Brokers. 1

Every month, the CME issues new Bitcoin contracts. These contracts are available for a period of six months. Two additional December contract months are also listed on the market. 3 When market makers determine a starting price for these contracts, trading starts. As momentum builds, the supply-demand mechanism gains primacy in determining futures prices.

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Determining the Price of Bitcoin Futures

The underlying security determines the value of all futures contracts. Bitcoin futures prices are determined by the current value of the currency. This is the current market price for purchasing or selling Bitcoin with quick delivery. Any change in the latter has an impact on the former. Because of this link, the prices of the two move in lockstep, despite there is a difference between the two.

Calculating Bitcoin Futures

The following is the theoretical method for determining futures prices from spot prices:

FuturesPrice=Spotprice(1+rfd)mathbftextbfFuturesPrice=textSpot price*(1+r f-d)

where rf is the yearly risk-free rate and d is the dividend

This formula requires modification for two Bitcoin-specific aspects. The first is the shift from an annual to a daily risk-free rate, and the second relates to the fact that there is no dividend in the case of Bitcoin, therefore ‘d’ may be deleted.

BitcoinFuturesPrice=BitcoinSpotprice∗[1+rf∗(x365)] startaligned&textbfBitcoin Futures Price&qquadmathbf=textbfBitcoin Spot pricemathbf*left[1+r* fleft(fracx365right)right]endaligned

wherex = number of days to expiry

The Cost of Carry

The methodology is based on the cost of carriage principle. Anyone who has money to invest in a futures contract may alternatively put it into safe bonds to receive the lowest attainable risk-free rate of return. As a result, the formula contains a provision for calculating returns that are at least equal to the risk-free rate over time until the contract expires. If no arbitrage opportunity exists, the futures price is the sum of the spot price and the cost of carry, as shown in the calculation.

Let us compare this to current historical values. With a risk-free rate of 2.25%, Bitcoin’s current price of $8,171 as of April 18, 2018, the April futures price comes to roughly $8,175.30. This theoretically estimated figure is quite close to the actual contract price of $8,180 on that day.

So how can we account for the $5 difference? Brokerage fees and market perception of volatility are to blame for this, which might change the actual payment by a few points.

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Real-World Price Determination

Beyond any theoretical calculations, the price of Bitcoin futures tends to fluctuate wildly in either way in the actual world. Let’s look at how the prices of these futures contracts have behaved in the recent past to illustrate the unpredictability in the price discovery process of futures:

Image by Sabrina Jiang © Investopedia2021

The graph above depicts the current price of Bitcoin in blue, futures contracts expiring in April in green, and a Bitcoin futures contract expiring in May in red. The information in the graph allows us to make a few critical observations.

  • Futures prices may approach the current price (Arrow 1)
  • Futures prices may rise faster than spot prices (Arrows 2 and 3)
  • Futures prices may fall below spot prices (Arrow 4)

But why is this happening? This is due to the relative discrepancies between the blue graph, which represents the current price, and the green and red graphs, which represent future values, at the indicated points.

The theoretical method does not account for events that may have a significant influence on futures pricing. While Bitcoin-related changes may be rapidly reflected in spot prices, any anticipated volatility and its influence over the remaining days to expiration make futures pricing a guessing game.

Explaining the Price Differences

Because futures contracts are thought to closely track spot prices, you’re undoubtedly asking why these variances exist. While the theoretical formula works well in the ideal scenario without arbitrage, it fails to account for real-world volatility and price arbitrage. The $5 difference mentioned in the preceding section reflects this.

This occurs because market participants notice and account for the potential effects of volatility. If there are just two days till expiration, the futures price calculation algorithm simply informs us that the price of the Bitcoin futures contract will stay relatively close to its spot price due to the little amount of time left.

However, because to considerable volatility, its spot price might swing dramatically up or down within hours. Big events, such as a cryptocurrency prohibition, may also occur. Such events may influence market participants’ perceptions for the short term, which is reflected in the spot price.

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Bitcoin trades 24 hours a day, seven days a week, which means its spot values are subject to considerable volatility within hours—even minutes—based on local occurrences, while the futures market may be available just for a limited time. It’s conceivable that the futures price ended near the spot price one day, but a huge event overnight increased Bitcoin’s spot price by 12%, suggesting that investors may anticipate a greater disparity when futures begin the following day.

The Bottom Line

Despite discrepancies in the price discovery system and the huge volatility effect on futures pricing, futures trading remains a high-stakes game. Combining it with the 24-hour trading of spot prices adds another degree of complication to futures valuation. Nonetheless, bitcoin futures trading remains popular because the volatility and unpredictability provide possibilities for profit.

Investing in cryptocurrencies and Initial Coin Offerings (“ICOs”) is very dangerous and speculative, and neither Investopedia nor the author suggest that you do so. Because every person’s circumstance is different, a knowledgeable specialist should always be contacted before making any financial choices. Investopedia makes no guarantees or warranties about the accuracy or timeliness of the information provided on this site. The author owns no cryptocurrencies as of the day this post was published.

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