Bitcoin takes up on the Future Market - Understand Bitcoin futures and Valuation !

CME Group, the world’s largest exchange operator by market value, is readying plans to offer futures on bitcoin, giving momentum to cryptocurrencies.

Bitcoin is set to step into the mainstream of finance now that CME Group has announced it will introduce trading in bitcoin futures by the end of the year. The move by the world’s largest exchange owner will up the game for the bitcoin and finally bring it some regulatory cover.

But for those who don’t know much of Fiannce, may ask;

What are Future Contracts?

Futures in general are counterparty contracts. This implies that the contract value comes into existence when two individuals consenting to enter into it. The trade is not your counterparty, the contracts are made when new limit orders in the orderbook are filled.

Futures contracts derive their value from an asset and more or less follow the movements of the underlying commodity i.e; Bitcoin.

Let’s see how does that works.

Bitcoin Futures Valuation

Futures price isn't generally equivalent to spot price that we see on Bittrex or Bitfinex etc. Most exchanges use numerous spot exchanges in an index. Since there is a timeframe between "now" and when a given futures contract expires for example after "seven days", then there's always uncertainty between the current price and what it will be seven days from now.

In hypothesis, the estimation of a future contract depends on a no arbitrage condition from the interest rates in every asset. We have Bitcoin and US Dollars. Bitcoin financing costs have a tendency to be short of US Dollar interest fees, so when you need to replicate the future estimation of bitcoin in US dollars, you need to obtain USD at, let's say, 5%, and put resources into Bitcoin at 1% return. This requires a premium on the future trade to have the capacity to hedge that trade.

For example;

Spot price of Bitcoin to USD is $500. A weekly futures contract expires in 7 days. What would it be advisable for it to exchange at? Utilizing a 5% Annual Percentage Yield USD rate and a 1% BTC rate, you borrow $500, and you invest this into 1 BTC. After 7 days, you will have paid $0.48 in USD premium, and earned 0.0002 BTC ($0.10 at current spot cost). A reasonable cost for the future contract would be more than $0.38 (the diff between $0.48 interest paid $0.10 expected interest received) above spot cost.

This is because you would have the capacity to secure the offer of 1 BTC that is being contributed at a higher cost. You know you need to pay back $500 in addition to premium, and you acquire a little interest on the bitcoin, so any future contract exchanging fundamentally over that $0.38 shortage in the spot play would give you an awesome arbitrage opportunity.

It is critical to take note, that Bitcoin Futures frequently exchange in high premium, or a discount, which mirrors the market estimation of what the future cost will be. At last, it's always the market that chooses the price and estimation of these monetary assets.