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What is futures basis and cost of carry: why futures trade at a premium to spot
Futures basis is the difference between the futures price and the spot price. In equity markets, futures trade above spot because the cost of funding a position (the carry cost) exceeds the dividend yield of the underlying, and the basis shrinks to zero at expiry.
In one line
Futures basis is the difference between the futures contract price and the underlying spot price, explained by the cost of carry, which reflects the funding cost of holding a position minus any income (dividends) earned, so equity futures trade above spot when the risk-free funding cost exceeds the dividend yield of the underlying, and the basis converges to zero as the contract approaches expiry.
BazaarBaaziSource & method
Why futures should price above spot
Imagine you want exposure to a Nifty move for the next two months. One way is to buy the Nifty today in cash, which means your capital is locked up earning no interest while you wait. An alternative is to buy a Nifty futures contract, pay only the margin, and let your remaining capital sit in a safe instrument earning a return. Because the futures buyer gets the price exposure without tying up the full cash upfront, the seller of the futures (who effectively lends that exposure) must be compensated for the funding cost. That compensation is built into the futures price as a premium above the spot price.
The textbook formula for the fair value of a futures contract is approximately: Futures price = Spot price multiplied by (1 plus the risk-free rate minus the dividend yield) multiplied by the time fraction (days to expiry divided by 365). For equity index futures, the risk-free rate is usually proxied by the short-term government security or MIBOR rate. The dividend yield of a broad index like the Nifty is typically lower than the funding rate, so the formula produces a futures price above spot. This is called contango.
If, on the contrary, the dividend yield exceeds the funding cost (which can happen for individual high-dividend stocks near the ex-date), the fair-value formula produces a futures price below spot. This is called backwardation, and it is less common in equity index futures but observed sometimes in individual stocks with large expected dividends.
Basis and its convergence at expiry
The basis on any given day is the observed futures price minus the spot price. On the last day of the contract, the exchange settles it at the spot price (for cash-settled contracts like Nifty futures), so the basis must be exactly zero at expiry. This convergence is not just theoretical; it is enforced by the settlement mechanism. A trader who holds a futures contract to its expiry date will see the final settlement at the spot price of the last trading day.
In the days and weeks before expiry, basis typically shrinks steadily as time runs down. A futures contract with 45 days to expiry might trade 0.7% above spot (reflecting about 45 days of carry). With 10 days to expiry, the same contract might trade 0.15% above spot. This gradual narrowing is the basis bleeding away as the remaining time value diminishes.
Basis can deviate from fair value due to supply and demand in the futures market. If many participants want to be long futures (directional buyers or those rolling hedges), they bid up the futures price beyond fair value, widening the basis. If the market leans heavily short futures (hedgers covering equity exposure), the basis can compress below fair value or even go to a discount. Reading whether futures are trading at a premium or discount to their theoretical fair value tells you something about the positioning balance in the market.
Rollover and basis as a trading signal
Indian equity futures expire on the last Thursday of every month (for monthly contracts). A trader holding a futures position past expiry must roll it to the next contract if they want to maintain the exposure. Rolling involves selling the near-month contract and buying the next month at the prevailing prices, which means paying or receiving the spread between the two contracts.
The cost of carry embedded in the next-month contract is higher because it has more time remaining. Continuous futures traders effectively pay or collect the carry with every rollover. This is why carry cost is not merely a theoretical concept but a real, periodic cash cost for leveraged long positions held across multiple expiries. Monitoring the rollover cost over time helps traders assess the total cost of their leveraged exposure beyond the visible brokerage.
FAQ4 reader questions · AEO-eligible
Common questions on futures basis and cost of carry.
Why do futures prices trade above spot price?
Futures trade above spot because of the cost of carry: the holder of a futures position gets price exposure without tying up the full capital, and the seller must be compensated for the funding cost of providing that exposure. Since the funding rate typically exceeds the dividend yield of Indian indices, futures fair value is above spot. This is called contango.
What is basis in futures trading?
Basis is the difference between the futures price and the underlying spot price (Futures minus Spot). It reflects the cost of carry embedded in the contract and converges to zero at expiry, when the exchange settles the futures contract at the spot price.
What is backwardation in futures?
Backwardation is when futures trade below the spot price, which occurs when the expected income from the underlying (such as a large upcoming dividend) exceeds the funding cost, making it more expensive to hold the spot than the futures. It is less common for Indian equity index futures but can appear in high-dividend individual stocks near their ex-date.
What does the rollover cost represent for a futures trader?
Rollover cost is the effective carry paid when a futures position is moved from the expiring near-month contract to the next-month contract. Since the next month always embeds more carry (more time remaining), the rollover involves paying the spread between the two, which is the cost of extending the leveraged exposure by one month. This is a real, recurring cost for any long futures position held across multiple expiry cycles.
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