Forward and Futures Pricing and Hedging › Limitations and Practical Considerations

The theoretical framework presented here assumes frictionless markets: perfect liquidity, no transaction costs, unrestricted borrowing and short-selling at the risk-free rate, and continuous trading. Real markets deviate from these assumptions in important ways. Understanding these limitations helps practitioners apply the theory appropriately and avoid pitfalls.

Transaction costs and market impact erode arbitrage profits. The cash-and-carry arbitrage requires buying spot, trading futures, and potentially financing or short-selling. Each leg incurs bid-ask spreads, commissions, and market impact. For the arbitrage to be profitable, the price discrepancy must exceed total costs. This creates no-arbitrage bands rather than a single price, and observed forward prices can deviate from theoretical values within these bands.

Short-selling constraints affect the reverse cash-and-carry arbitrage. For equities, short sellers must locate shares to borrow, pay lending fees, and post collateral. Some stocks are hard-to-borrow or unavailable for shorting entirely. When short-selling is costly or impossible, forward prices can trade above theoretical values without triggering corrective arbitrage.

Funding costs vary across participants. The arbitrage arguments assume everyone borrows and lends at the risk-free rate. In practice, hedge funds face different funding costs than pension funds, which differ from bank proprietary desks. This heterogeneity means the "fair" forward price differs across participants, and observed prices reflect marginal trading by the participant with the best funding access.

Margin and collateral requirements tie up capital. Futures positions require initial margin (typically 5-15% of notional value) plus variation margin as positions move. This capital has opportunity cost and may be constrained during market stress when margins increase just as trading opportunities arise. The daily settlement also means cash flow timing differs from forwards, which can matter for liquidity-constrained participants.

Model assumptions break down at extremes. The cost-of-carry model assumes known dividends, constant interest rates, and deterministic storage costs. In practice, dividends can be cut unexpectedly, rates move stochastically, and commodity storage costs depend on inventory levels and market conditions. During market dislocations, basis relationships can deviate dramatically from historical norms, causing hedges to fail precisely when they're needed most.

Despite these limitations, forward and futures markets generally price efficiently. Arbitrage may not be perfect or instantaneous, but it keeps prices close to theoretical values most of the time. The framework sets up more sophisticated analysis that incorporates transaction costs, funding constraints, and model uncertainty.