Interest Rates and the Huge S&P Futures Premium

By Lawrence G. McMillan

An item that has been affected by higher interest rates is the premium on S&P (and other) Index futures. The premium on a stock index futures contract is related to dividends (higher dividend payouts decrease the premium on the futures) and interest rates (higher interest rates increase the premium on the futures). We received this question recently, and I realized once again that newer traders may not have seen this before:

Question:
As I write this, the March S&P 500 futures are trading at 3868 while the cash S&P is at 3848. I : haven't seen that large of a "gap" before. Do these numbers have to equate at expiration? If so, is there any kind of arbitrage opportunity using options? ... any nuance would be enlightening.

Answer:
It has to do with interest rates. Larger interest rates produce larger premiums on the S&P futures : (while large dividends DECREASE the premium). There are no arbitrage opportunities, as the "computers" are always on top of this. And, yes, as time to expiration shortens, less and less interest can be earned, so the futures price and the index price will converge.

There is a rather lengthy explanation of this and the arbitrage opportunities in the book Options As A Strategic Investment (in the section “Futures Fair Value,” 5th Edition, Chapter 30, pages 514–518). One doesn’t have to do all the work to calculate this, though, for there is a website that does it for you. You can go to progamtrading.com and see what the current "fair value" is on any given day.

So, the above two topics are just a couple that have come to light recently in the wake of increased interest rates. Other might include: Traders who sell naked options (or use strategies such as our put ratio spreads) should now be buying T-Bills and earning interest on the collateral, rather than just letting cash sit in their accounts. This is a topic that we addressed not long ago, in the October 21, 2022, issue of The Option Strategist Newsletter.

Read the full article, published on 1/6/2023, by subscribing to The Option Strategist Newsletter now. Existing subscribers can access the article here.