Pass Certification Examination for Mutual Fund - Specialized Investment Fund Distributors Difficulty: Beginner 2 Questions   5 min read
📌 Chapter 20.4 — Lot Size, Tick Size and Change in Contract Value for each Tick change

A regular query from HNIs looking at debt-oriented strategies involves why the price of a future contract for a Government Security often deviates from its current market price. As a distributor, you might find a client comparing the current yield on a 10-year G-Sec with the lower or higher implied yield of the corresponding futures contract.

This discrepancy is not an error in market quoting but a reflection of the cost of carry, which essentially bridges the price gap between today and a future delivery date. Understanding this prevents you from appearing uninformed when a client questions why the derivative price does not perfectly mirror the underlying bond quote.

In practical terms, the cost of carry is the net expense of holding an asset over a specific period, calculated by adding the cost of financing the purchase and subtracting any income received from the asset. For a G-Sec, the carrying cost is typically the interest paid on funds borrowed to buy the bond, minus the coupon income earned during the holding period.

When the funding cost is higher than the coupon yield, the futures price is theoretically higher than the spot price, a condition known as contango. Conversely, if the coupon is substantial enough to offset funding costs, the futures might trade at a discount, a state referred to as backwardation.

This distinction is vital when you advise clients on using IRFs as a hedging tool for their broader portfolios. If an investor ignores the cost of carry, they might miscalculate the effectiveness of their hedge, especially if they are rolling over positions across multiple months. For a distributor, explaining this ensures the client understands that hedging is not free; it carries a cost that manifests as the difference between the spot and futures prices.

When you perform a suitability assessment for an accredited investor looking at SIF strategies, being able to articulate why these price differentials exist builds significant professional credibility.

Failing to account for these dynamics can lead to poor decision-making regarding which delivery month to select for a hedge. Always remember that the futures price is a function of time and interest rate differentials, not merely a guess at where the bond price will be. Mastering this ensures that when a client questions the cost-efficiency of their derivative overlay, you are providing a structural explanation rather than a speculative one.

Nuance

⚠️ Nuance
Candidates often confuse the cost of carry with the simple concept of ’time value’. They frequently assume the futures price will always converge to the spot price linearly, ignoring that the cost of carry is highly sensitive to prevailing repo rates and the coupon structure of the underlying bond. A professional distributor must remember that volatility in short-term interest rates directly shifts the cost of carry, meaning the basis can widen or narrow unexpectedly even as the expiry date draws closer.

Check Your Understanding

Practice Question 1

An investor holds a bond paying a 7% annual coupon and finances the purchase at an 8% repo rate. How should the futures price compare to the spot price for a one-year contract, assuming no other costs?

Practice Question 2

When evaluating an investment strategy involving IRF hedging, what does a ’negative cost of carry’ imply for the price relationship between the spot and futures market?

This is a companion read for Section 20.4 — Lot Size, Tick Size and Change in Contract Value for each Tick change from Pass Certification Examination for Mutual Fund - Specialized Investment Fund Distributors by Akhilesh Gururani, available on Amazon Kindle.

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