The spot price of a commodity is typically used to establish the price of a futures contractat least as a starting point. Until the futures contract matures and the transaction actually occurs, futures prices also reflect predicted changes in supply and demand, the risk-free rate of return for the commodity holder, and the expenses of storage and shipping (if the underlying asset is a commodity).
How does the spot market effect the futures market?
The increase in liquidity is the key cause for the decrease in spot price volatility following the introduction of futures trading. Futures markets increase the amount of available information since they attract a larger number of participants due to lower transaction costs than spot markets.
What’s the connection between futures and spot prices?
A crucial factor in deciding the price of a futures contract is the spot price. It can reveal forecasts for future commodity price variations.
Spot Price vs. Future Price
The primary distinction between spot and futures prices is that spot prices are for immediate purchase and sale, but futures contracts postpone payment and delivery to predetermined future periods.
Typically, the spot price is lower than the futures price. Contango is the term for this circumstance. Contango is a regular occurrence for non-perishable items with high storage costs.
Backwardation, on the other hand, occurs when the spot price is higher than the futures price.
The futures price is expected to eventually converge with the current market price in either case.
More Resources
Thank you for taking the time to read CFI’s guide to spot prices and the differences between them and futures prices. Check out the following resources to learn more about capital markets and related topics:
What impact do futures have on prices?
Futures contracts are used by buyers of food, energy, and metals to set the price of the commodity they are purchasing. As a result, their risk of price increases is reduced. Futures are used by sellers of certain commodities to ensure that they will receive the agreed-upon price. They eliminate the possibility of a price decline.
Why do future prices tend to converge with spot prices?
Prior to expiration, the price of futures contracts will most likely be either a premium or a discount to the physical. These two prices will converge, or meet, as the contract approaches its expiration date. What causes this to happen?
There are several elements at play here, one of which is what’s known as “cost of carry.” That is, the price of a futures contract is equal to the cost of keeping the underlying until the expiration date. Interest less dividends (in the case of the SPI) or storage charges would generally be included in the cost of carry (in the case of a physical commodity like wool).
Prices will inevitably converge as the futures draw closer to expiration.
This is due to the fact that the futures price is essentially a price in the future (the price at expiry) that includes the cost of carry. The forces of supply and demand will react if this premium or discount becomes out of balance.
If the physical price of a commodity is significantly higher than the futures price, arbitragers, speculators, and hedgers will buy it “rather than the physical commodity, a “cheap” futures contract will be created, causing demand for the futures contract to rise, pushing the price up towards the physical. Furthermore, the high price of the physical will be under pressure owing to the fact that users will be able to acquire the digital version “Futures are “cheaper.” Because there is less demand for the physical, the price falls, causing the markets to converge or reach a state of equilibrium prior to expiry “equilibrium.”
Arbitragers may also enter the picture, buying futures and selling physicals to lock in a profit. If the market was in the opposite direction (futures were significantly more expensive than physical), the market would be selling futures and purchasing physical.
This activity may sometimes be observed in the SPI, where the premium is driven much over fair value (which is a subjective calculation), and then the arbitrage is unwound a few days later, bringing the market back to equilibrium.
As the cost of carry approaches zero, the futures price will automatically converge to the physical price as expiry approaches. This is especially true in a deliverable contract, in which players must be able to buy and sell in different markets. This has been going on for a long time, as futures were created as a way for producers to hedge their commodities. It’s now a massive market with a wide range of products, but the same principles apply regardless of what you’re trading.
The price convergence between the Index and the futures is automatic in cash settled contracts like the SPI since there is an exchange settlement system that ensures everyone gets the same price at expiry based on the cash, or spot price. This emphasizes the relationship between the spot and futures markets, as well as their final correlation. What we’re ultimately talking about is “Because futures contracts are designed to expire in accordance with spot or cash pricing, they are referred to as “contract design.”
This isn’t to say that you should buy futures if they’re selling below the physical price of a commodity or sell them if they’re trading higher. The market is more sophisticated than that, but under some conditions, this is an example of a method you may employ and continually analyze. Because markets are fluid and ever-changing, consider if leveraged derivatives fit your risk profile before you start trading, as the chance of loss is substantial.
When it comes to the expiration date, why do futures and spot prices converge?
Because the market will not allow the same commodity to trade at two different prices at the same time in the same place, convergence occurs.
What is the distinction between spot and futures markets?
A public financial market where financial instruments or commodities are traded for immediate delivery is known as the spot market or cash market. It differs from a futures market, which requires delivery at a later date.
Which is better, futures or spot?
“Which market is better to trade, spot or futures?” traders sometimes wonder.
If you’re searching for a longer-term investment, the short answer is spot markets. You should trade the futures market if you wish to hedge your trades or boost your leverage.
I hope that’s as plain an answer as you’ll find on the spot market vs. futures market issue anyplace on the internet.
Let’s unpack this topic further now that I’ve addressed the answer for those of you with a 10-second attention span.
When the future price is higher than the present price, are futures discounted?
If you were to attend a traditional Futures trading school, you would almost certainly be introduced to the futures pricing formula straight at the start. However, we have chosen to discuss it now, rather than at a later time. The reason is simple: if you trade futures based on technical analysis (which I believe the vast majority of you do), you don’t actually need to know how futures are valued, though having a basic understanding would be beneficial. If you want to trade futures using quantitative strategies like Calendar Spreads or Index Arbitrage, however, you should be aware of this. In fact, we’ll have a module dedicated to ‘Trading Methods,’ in which we’ll go through some of these strategies, so the discussion in this chapter will serve as a basis for the upcoming modules.
If you recall, we covered the ‘Futures Pricing Formula’ as the primary cause of the discrepancy between the spot and futures prices in some of the earlier chapters. So, I suppose it’s time to lift the curtain and reveal the ‘Future Pricing Formula.’
We know that the value of a futures instrument is determined by the underlying. We also know that the futures instrument follows the underlying. The futures price will fall if the actual price falls, and vice versa. The underlying price and the futures price, on the other hand, are not the same. As I write this, the Nifty Spot is trading at 8,845.5, while the comparable current month contract is trading at 8,854.7, as shown in the chart below. The “basis or spread” refers to the price difference between the futures and spot prices. The spread on the Nifty in the example below is 9.2 points (8854.7 8845.5).
The ‘Spot Future Parity’ is responsible for the price discrepancy. The discrepancy between the current and futures price that emerges owing to variables such as interest rates, dividends, time to expiry, and so on is known as the spot future parity. It is essentially a mathematical equation that equates the underlying price and its related futures price in a very broad sense. The futures pricing formula is another name for this.
Note that ‘rf’ is the risk-free rate you can earn for the whole year (365 days); because the expiry is at 1, 2, and 3 months, you may want to scale it accordingly for time periods other than 365 days. As a result, a more universal formula would be
The RBI’s 91-day Treasury bill can be used as a proxy for the short-term risk-free rate. The same information may be seen on the RBI’s home page, as illustrated in the screenshot below
The current rate is 8.3528 percent, as shown in the graph above. Let us work on a price example while keeping this in mind. If the spot price of Infosys is 2,280.5 and the current month futures contract is priced at 2,280.5, what should the current month futures contract be priced at?
Please note that Infosys is not scheduled to pay a dividend in the next seven days, so I’ve assumed a dividend of zero. The future price is 2283 when the aforementioned calculation is solved. Futures are referred to as having a ‘Fair value.’ However, as you can see in the figure below, the actual futures price is 2284. The ‘Market Price’ is the actual price at which the futures contract trades.
Market costs, such as transaction fees, taxes, and margins, account for the majority of the difference between fair value and market pricing. Fair value, on the other hand, shows where the futures should be trading at a particular risk-free rate and number of days till expiration. Let’s take this a step further and calculate the futures prices for mid- and long-term contracts.
Clearly, the determined fair value and the market price are not the same. This, I believe, is due to the applicable costs. Furthermore, the market may be taking into account some financial yearend dividends. The crucial element to remember is that as the number of days till expiration increases, the gap between fair and market value expands.
In reality, this brings us to another essential piece of market jargon: the discount and premium.
The futures market is said to be at ‘premium’ if it is trading higher than the spot, which is the natural order of things mathematically speaking. While the term “premium” is used in the equity derivatives market, the commodity derivatives market prefers the term “contango” to describe the same event. Both contango and premium, on the other hand, refer to the same thing: Futures are trading higher than Spot.
For the January 2015 series, here is a plot of the Nifty spot and its equivalent futures. The Nifty futures have been trading above the spot for the whole series, as you can see.
- The disparity between spot and futures is quite wide at the start of the series (highlighted by a black arrow). The x/365 component in the futures price method is likewise large because the number of days to expiry is big.
- The futures and the spot have converged at the end of the series (highlighted by a blue arrow). This is, in reality, a common occurrence. On the day of expiry, whether the future is at a premium or a discount, the futures and spot will always converge.
- If you fail to square off a futures position by expiry, the exchange will do it automatically, and the position will be settled at the spot price, as both futures and spot converge on the day of expiry.
Futures are not always more valuable than spot. There may be times when the futures trade cheaper than the related spot, owing to short-term demand and supply imbalances. When a futures contract trades at a discount to the spot, it is said to be trading at a discount. The same issue is referred to as “backwardation” in the commodities world.
What is the difference between futures and forward prices?
Because of the effect of interest rates on the interim cash flows from the daily settlement, futures prices can differ from forward prices.
- Forwards and futures prices will be the same if interest rates remain constant or have no association with futures prices.
- If futures prices are inversely connected with interest rates, buying forwards rather than futures is preferable.
- It is preferable to buy futures rather than forwards if future prices are favorably associated with interest rates.
- If immediate exercise results in a loss, the choice is no longer viable.
- If immediate exercise yields neither a profit nor a loss, the option is a good bet.
The maximum exercise value of an option is zero, or the amount by which the option is in the money.
The amount by which the option premium exceeds the exercise value is known as the time value of an option.
In addition to exercise value, an option has time value prior to expiration.
Why is the future price lower than the current price?
If the striking price of a futures contract is lower than the current spot price, it indicates that the present price is too high and that the predicted spot price will fall in the future. Backwardation is the term for this condition.