Question

Provide an example of and describe an investment asset, a consumption asset and one that might be a mix of the two. Explain the impact of this classification on the valuation of a futures/forward price? What must be included as costs in one type that is not a concern the other type. What is the main difference between the two when it comes to closing out the contract?

Answer 1

Here are the examples:

1. Investment Assets: Stock (shares) of companies, bonds

2. Consumption Asset: Corn, Crude Oil

3. Mixed: Gold- Gold is considered both as it is made a part of investment portfolios as a hedge against recession etc. Also, it is a consumption asset as it is used in making Jewellery, Electronic components etc. which are used for consumption.

The impact of this classification on futures/forward prices is that they introduce 2 additional factors in the pricing can be understood by looking at the general formula for Forward Price:

Forward price = spot price + cost of fund + storage cost

1. Dividend income (in case of investment Assets): Investment assets like many company stocks pay dividends (or any other type of income like coupons from bonds). For such assets, the pricing formula must incorporate the anticipated dividend payments during the course of the contract. As the holder of the forward contract would not be getting those incomes (unlike the holder of the asset) so the PV of the expected reduces the cost of fund equivalently thus giving the benefit of reduced forward price.

2. Storage Costs (In case of Consumption assets): For consumption assets, owning many of those assets requires them to be stored at a physical location appropriately & safely. This incurs storage costs to the owners of these assets. Thus the futures/forwards contracts must account for the storage costs being borne by the holder of the asset/storage cost being saved by the counterparty who will take physical delivery at a later date.

When it comes to closing out the contract, the main difference is that in consumption assets like commodity forward contracts, usually the party holding a long position in the contract needs to take physical delivery of the asset while the counterparty needs to provide the physical delivery (like 1000Kg Corn, etc. underlying asset of the contract)

Whereas contracts like stock futures are usually cash settled- meaning both the parties calculate the profit/loss incurred on thier positions based on spot price at the time of closure & one party paying the difference amount to the other party.