Perpetual Futures Funding Rate: Meaning and Calculation
Perpetual Futures Funding Rate is a fee exchanged between long and short traders, which is paid periodically in future contracts to keep the contract’s price close to the spot price. It helps to keep the price of the asset from drifting away from the actual market price.
Types of the Perpetual Futures Funding Rate
There are mainly two types of Perpetual Futures Funding Rate: Positive and Negative. It changes with market conditions. The price of the contract is known as the positive perpetual Futures Funding Rate when the contract’s price is above the spot price. On the other hand, it becomes a negative perpetual Futures Funding Rate when the contract’s price is below the spot price.
Positive Funding Rate
In this situation, the long traders dominate, which means the funding by long traders will be more than that of the short traders. They expect a rise in the price of the asset. This overall creates the Bullish sentiment in the market.
Negative Funding Rate
This case is just a contrast of the positive funding rate. Short sellers pay long holders when there is no optimism on the increase in future price. Thus, the short traders or short positions have higher demand than the long positions, and thus, the bearish market sentiment dominates.
Role of the Perpetual Futures Funding Rate
Helps in Price Alignment
Staying aligned with the spot price helps to maintain market stability. This mutual understanding between short and long positions helps to avoid large market discrepancies. Its perpetual and no-expiry feature helps to prevent the sudden skyrocketing of the price.
Helps to Maintain Balance
The periodic payments have a big role in maintaining this feature. The arbitrage traders who get small profits from the price differences lose those opportunities, and it lessens the number of participants in the market. It gradually creates an imbalance.
Act as a Market Sentiment Indicator
The domination of the market varies with different conditions. Here, the Perpetual Future Funding Rate helps to indicate whether it is long-positioned traders or short-positioned traders. The positive rate shows the bullish nature, resulting in a bull market, and the negative rate results in a bear market.
Maintains Perpetuality
Unlike the traditional rate, where on a specific date the final settlement needs to be done, perpetual rates have no expiry date. It helps to avoid the forced price convergence of the underlying asset.
Increases Flexibility and Liquidity
As there is no forced price fixing or convergence, there is no worry for traders on the final settlement. This indirectly encourages the participation of different types of traders in the market. It is mainly due to the variation in the market conditions, and thus in their positions.
How to Calculate the Perpetual Futures Funding Rate?
Generally, Perpetual Futures Funding Rates are divided into two parts, i.e., the premium index (P) and the interest rate component (I).
Interest rate is the fixed rate set by the exchange for borrowing or lending the asset. The premium index is the difference between the perpetual contract’s price and the asset’s spot price.
Using these metrics, perpetual funding rates can be calculated. It is the combination of both the premium index and the interest rate.
Therefore, Perpetual Futures Funding Rate = Premium Index + Interest rate
The funding rate can be determined as positive or negative through its outcome. It becomes positive if the premium index is higher than the spot price and vice versa.
Method to Calculate the Perpetual Futures Funding Rate
8 hours is the periodic time where funding rates in perpetual rates are calculated. Here is its procedure.
Funding Premium Index Data and Interest Rate
First of all, begin by collecting the Premium Index data (PI) that changes or varies at each interval. Determine the deviation between the perpetual contract (P) price, which is the current market price of the perpetual future, and the spot price (S), the real-time price of the underlying asset. Therefore, PI=(P-S) / S
The interest rate is the fixed value set by the exchange related to the underlying asset.
Applying to Each Value
In a simple way, the equation, FR= PI + IR, is used.
Whereas, the standard formula is FR= Avg. Premium Index + clamp (Interest Rate – Avg. Premium Index, 0.05%, -0.05%). This equation is used in major exchanges like Binance for the same purpose.
Where the Avg Premium Index is a measure of the Premium Index over a specific period.
Conclusion
The Perpetual Futures Funding Rate is considered one of the best tools for ensuring market stability and efficiency. Huge price gaps can be avoided with these perpetual future contracts. Due to the floating nature of the Perpetual Futures Funding Rate, its determination is done using a mathematical equation. This helps to make the right decisions and make the right move for the future, and know the trends in the market.
