Introduction

In the world of derivatives trading, understanding the connection between forward and futures prices is essential. Both forward and futures contracts are agreements to buy or sell an asset at a predetermined price on a future date. This chapter delves into the intricate relationship between the prices of these contracts and how market forces influence their convergence.

Forward and Futures Prices

Forward and futures prices are essentially the agreed-upon prices for the underlying asset at a future date. However, they can differ due to factors like market sentiment, interest rates, and carrying costs. The forward price is established in an over-the-counter (OTC) market, while futures prices are determined through open exchange trading.

Normal vs. Contango Markets

In a normal market situation, the futures price is equal to or slightly higher than the expected future spot price, indicating an upward-sloping futures curve. This might be driven by factors like storage costs and convenience yields. On the other hand, a contango market occurs when the futures price is significantly higher than the expected future spot price. This can be a result of high storage costs, interest rates, or other carrying costs.

Backwardation

Conversely, a backwardation market exists when the futures price is lower than the expected future spot price. This situation is often indicative of a supply shortage or a strong demand for the underlying asset. Traders may engage in backwardation-based strategies to profit from such scenarios.

Example: Imagine a scenario where a commodity like oil experiences a sudden disruption in supply due to geopolitical tensions. This could lead to a situation where the futures price for oil contracts with near-term expiration dates is higher than contracts with later expiration dates – a case of backwardation. Traders who correctly anticipate this situation might buy the cheaper, near-term futures contracts and profit as the futures prices converge with the spot price over time.

Factors Affecting the Relationship

Several factors influence the relationship between forward and futures prices, including interest rates, carrying costs, dividends, storage costs, and market sentiment. Understanding these factors is crucial for making informed trading decisions.

Example: Consider a company that is expected to pay a significant dividend before the expiration of a futures contract on its stock. This dividend payment could affect the relationship between the forward and futures prices. The futures price might be adjusted downward to account for the expected dividend, as the investor holding the futures contract would miss out on the dividend payment.