Adjusted future index

What Is Adjusted Future Index?

An Adjusted Future Index represents the theoretical cash equivalent of a futures contract at a future date, taking into account various adjustments beyond the simple futures price. It is a concept within the broader category of derivatives and valuation, essential for understanding the true cost or value of a futures position when considering factors like carrying costs and conversion factors⁷, ⁸. This metric aims to provide a comprehensive view of the financial commitment required to acquire or deliver an underlying asset through a futures contract, making it a critical tool in assessing potential profitability and managing exposure in financial markets.

The Adjusted Future Index is not a widely published financial index like the S&P 500 or Dow Jones Industrial Average. Instead, it serves as a calculated value to aid participants in the derivatives market in understanding the full financial implications of their contracts. It goes beyond the nominal futures price by incorporating elements that influence the actual cash outlay or receipt at the contract's expiration.

History and Origin

The concept of valuing future transactions dates back millennia, with early forms of forward contracts existing in ancient Mesopotamia and later in rice markets in 17th-century Japan. The modern history of futures trading, however, largely began in the United States in the mid-19th century. Farmers and merchants in Chicago, facing unorganized markets and price uncertainties for agricultural commodities, started using forward contracts to agree on prices for future deliveries. The first recorded forward contract in Chicago was made on March 13, 1851, for 3,000 bushels of corn⁶. These early agreements evolved into standardized futures contracts with the formation of the Chicago Board of Trade (CBOT) in 1848, paving the way for organized futures exchanges and clearer pricing mechanisms⁵.

As futures markets grew and diversified beyond agricultural products to include financial instruments, the need for more sophisticated valuation methods became apparent. The plain futures price alone often didn't capture the full economic reality of a transaction due to factors like varying delivery specifications, interest rates, and associated costs. The development of concepts like the Adjusted Future Index arose from the need for market participants to precisely quantify the total financial obligation or entitlement of a futures contract, thus enhancing market efficiency and transparency in complex derivatives trading.

Key Takeaways

• The Adjusted Future Index represents the total economic value of a futures contract, incorporating various costs and factors.
• It goes beyond the basic futures price by considering elements like carrying costs and conversion factors.
• This calculated value is crucial for participants in derivatives markets to assess the true financial commitment or return.
• The Adjusted Future Index aids in more accurate pricing, risk management, and evaluating trading strategies.
• It is a conceptual tool for valuation rather than a publicly traded financial benchmark.

Formula and Calculation

The Adjusted Future Index (or Adjusted Futures Price) is calculated to reflect the true cost of acquiring, financing, and delivering the underlying asset of a futures contract³, ⁴. While the precise formula can vary depending on the specific asset and contract terms (e.g., bonds vs. commodities), a general representation often incorporates the nominal futures price, a conversion factor, and carrying costs.

A simplified formula for a bond futures contract, for instance, might look like this:

Where:

• Futures Price: The quoted price of the futures contract on the exchange.
• Conversion Factor: A multiplier used in some futures contracts, particularly those on deliverable bonds, to adjust for the different deliverable securities. It converts the futures price to an equivalent price for a specific bond.
• Accrued Interest: Interest that has been earned on the underlying bond since its last coupon payment but has not yet been paid. This is added because the buyer typically pays this to the seller upon delivery.
• Rebate (or Net Cost of Carry): This broadly encompasses interest rates earned on margin, less any storage costs for physical commodities, or the cost of financing for financial assets. In some contexts, it can be viewed as an adjustment for the time value of money and other holding costs (or benefits like dividend yield).

For a commodity futures contract, the Adjusted Future Index might incorporate storage costs, insurance, and financing costs (related to interest rates) for holding the commodity until delivery.

Interpreting the Adjusted Future Index

Interpreting the Adjusted Future Index involves understanding that it provides a more accurate representation of the cost or value associated with a futures contract than the raw futures price alone. This is particularly relevant in markets where multiple deliverable assets exist (e.g., various government bonds for a single bond futures contract) or where significant carrying costs are involved, such as for storable commodities.

For instance, if the Adjusted Future Index for a particular bond futures contract is lower than the current spot price of the cheapest-to-deliver bond, it might suggest that the futures contract is relatively undervalued compared to holding the physical asset. Conversely, if the Adjusted Future Index is significantly higher, it could imply the contract is overvalued. Traders and investors use this adjusted figure to identify potential arbitrage opportunities or to better assess the fairness of pricing between the spot market and the futures market.

It provides a granular view of the total financial obligation, assisting in decisions related to hedging strategies and pricing complex derivatives products. A thorough understanding helps market participants make informed decisions, especially when managing exposure to market volatility.

Hypothetical Example

Consider a hypothetical futures contract for a specific precious metal that is expected to expire in three months.

• Futures Price (FP): $2,000 per ounce
• Contract Size: 100 ounces (meaning the nominal contract value is $200,000)
• Storage Costs: $5 per ounce per month (for 3 months = $15 per ounce)
• Financing Cost (based on current interest rates): Assume a relevant short-term interest rate implies a financing cost of $10 per ounce over the three months.
• Conversion Factor: For simplicity, assume a conversion factor of 1.0 (meaning one unit of the underlying asset per unit of the futures contract).

To calculate the Adjusted Future Index per ounce:

For the entire contract:

In this example, while the nominal futures price is $2,000 per ounce, the Adjusted Future Index suggests that the total economic cost of acquiring and holding that ounce until the contract expires is $2,025, taking into account the direct costs of storage and financing. This figure provides a more realistic basis for comparing the futures price with the current spot price or for evaluating arbitrage opportunities. This calculation highlights the importance of including all relevant carrying costs for a precise valuation.

Practical Applications

The Adjusted Future Index is a crucial concept with several practical applications across various facets of finance:

1. Pricing and Valuation: It enables more accurate pricing of futures contracts by factoring in all associated costs and benefits, such as carrying costs (storage, insurance, financing) or income (dividends, interest) from the underlying asset. This helps in determining fair value and identifying mispricings between the spot and futures markets.
2. Arbitrage Identification: Traders look for discrepancies between the theoretical Adjusted Future Index and the actual market futures price. If the market price deviates significantly, it can present an opportunity for arbitrage, allowing sophisticated investors to profit from the temporary imbalance.
3. Risk Management and Hedging: For entities looking to hedge against future price movements, understanding the Adjusted Future Index helps them quantify their precise exposure. For example, a farmer selling grain futures uses this adjusted price to understand the true revenue they can lock in, accounting for storage until delivery. Similarly, institutions managing exposure to market volatility through derivatives utilize this adjusted value to gauge their exact risk.
4. Portfolio Management: Professional portfolio diversification strategies involving derivatives often rely on these adjusted figures to assess the economic impact of futures positions on overall portfolio returns and risk profiles.
5. Regulatory Oversight: Regulatory bodies, such as the European Securities and Markets Authority (ESMA), oversee the integrity and transparency of financial benchmarks, which can conceptually extend to how derivatives prices, including adjusted futures prices, are determined and reported². This oversight helps ensure that benchmark administrators provide clear and consistent methodologies for various financial instruments.

Limitations and Criticisms

While the Adjusted Future Index provides a more comprehensive valuation than the raw futures price, it is not without limitations and criticisms. One primary challenge lies in the accurate estimation of all relevant carrying costs and other adjustments. For instance, future interest rates are inherently uncertain and must be estimated, which introduces potential inaccuracies. Similarly, exact storage costs for commodities or specific conversion factors for complex financial instruments may vary, leading to deviations in the calculated Adjusted Future Index.

Critics might also argue that relying too heavily on a theoretical Adjusted Future Index can overlook real-world market frictions, such as transaction costs, liquidity constraints, and idiosyncratic supply-demand dynamics that are not easily captured in a formula. Furthermore, academic research, such as that by Research Affiliates, has sometimes critiqued the construction and performance of certain financial index funds, particularly capitalization-weighted indices, suggesting that their methodologies can lead to buying high and selling low¹. While this specific critique applies to index construction rather than the Adjusted Future Index directly, it highlights the broader discussion within finance about whether theoretical models adequately capture real-market behavior and investment outcomes. The concept of an Adjusted Future Index is a tool for valuation and risk management, but its effectiveness depends on the accuracy of its inputs and a nuanced understanding of market realities.

Adjusted Future Index vs. Futures Price

The distinction between the Adjusted Future Index and the simple futures price is crucial for a complete understanding of derivatives valuation.

The simple futures price reflects the consensus between buyers and sellers on the market at a given moment for future delivery. However, it does not inherently account for the costs or income associated with holding the physical asset until the delivery date. The Adjusted Future Index fills this gap by incorporating these additional financial elements, offering a more holistic view of the economic commitment. This difference is especially relevant in contexts like commodity futures, where storage and financing costs are significant, or in financial futures where nuances like interest accrual or specific deliverable bond characteristics (handled by a conversion factor) must be considered.

FAQs

What does "adjusted" mean in Adjusted Future Index?

"Adjusted" refers to the process of modifying the nominal futures contract price to include additional financial considerations. These considerations often involve carrying costs (like storage and financing) or benefits (like dividends or interest) that impact the true economic value of holding the underlying asset until the contract's expiration. It provides a more accurate reflection of the total financial commitment.

Is the Adjusted Future Index publicly traded?

No, the Adjusted Future Index is not a publicly traded index like a stock market index. Instead, it is a calculated, theoretical value used by market participants, primarily in derivatives markets, for internal analysis, valuation, and risk management purposes.

Why is the Adjusted Future Index important for investors?

For investors, especially those involved in futures trading or hedging, the Adjusted Future Index is important because it offers a more precise understanding of the true cost or value of a futures position. By accounting for all relevant factors beyond the quoted price, it helps in making informed trading decisions, identifying potential arbitrage opportunities, and accurately assessing financial exposures, particularly in periods of market volatility.