Pete Mulmat from the CME comes in discuss an important subject that all futures traders should understand: the rollover process. Like options, futures contracts have a specific expiration and if investors want to continue to hold their futures contracts beyond the expiration cycle, they would need to roll over the current position to the longer dated cycle. The open interest between the two months tend to normalize from the beginning of the roll date and the expiration of the old contract.
Pete explains how to calculate the roll value, which is simply equal to the deferred futures contract (month rolled from) minus the nearby futures (month rolling to). This number can be referred to as the basis and whether its positive or negative is largely dependent on the relationship between short-term interest rates and dividends. Futures at lower levels in deferred in months reflect positive carry as dividends earnings are greater than financing costs.
Pete is often asked if the roll value fairly reflect the prevailing market conditions. As a general rule, the “fair value” of an index futures contract may be calculated by considering the “cost of carry.” Said another way, what would it cost to buy and carry and a portfolio made up of stocks until term that reflects the value of the underlying index?
To determine whether the “roll” is cheap or rich, investors can calculate the fair value associated with the nearby and deferred futures contracts. Or Pete lays out the formula to calculate the implicit financing in the value of the roll. This implied financing rate is helpful because once calculated, we can compare it to the current financing rates to determine whether the roll appears rich or cheap. For instance, if the implicit financing rate is larger than the prevailing rate, then the roll is considered rich. Thus, the investors and traders may look to “sell the roll” by selling the current or front month and buying the later dated contract.
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