Futures and Spot Price Relationship

In this chapter, we will explore the concept of convergence between futures and spot prices, which is a crucial aspect of understanding how futures markets function and their relationship with the underlying asset’s cash market.

The convergence of futures and spot prices refers to the tendency of futures contract prices to approach the spot price of the underlying asset as the contract approaches its expiration date. In an efficient market, the futures price should closely track the current spot price, eliminating any arbitrage opportunities.

Factors Influencing Convergence

Several factors influence the convergence between futures and spot prices:

Time to Expiration

As a futures contract approaches its expiration date, the difference between its price and the spot price tends to narrow. Traders and market participants will try to exploit any price discrepancies to arbitrage, causing the prices to converge.

Supply and Demand

Changes in supply and demand for the underlying asset can impact both the spot and futures prices. If there is a sudden surge in demand for the asset in the spot market, the spot price may rise, and the futures price will follow suit, converging towards the new spot price.

Cost of Carry

The cost of carry is the total cost of holding the underlying asset, including storage, financing, and insurance costs. In an efficient market, the futures price should reflect the cost of carrying the asset from the present to the delivery date. Any deviations from the cost of carry can lead to arbitrage opportunities and drive convergence.

Examples of Convergence

Example 1: Let’s consider a futures contract for crude oil that expires in one month. At the start of the contract, the futures price is $70 per barrel, while the spot price for crude oil is $72 per barrel. As the expiration date approaches, market participants realize that there is a price discrepancy, and they can arbitrage by buying crude oil in the spot market at $72 and selling a futures contract at $70. This arbitrage activity drives the futures price up and the spot price down until they converge at $72.

Example 2: Suppose a company needs to purchase 1,000 bushels of wheat in three months. To hedge against price fluctuations, the company enters into a wheat futures contract at $6.50 per bushel. Over the next few months, the spot price of wheat fluctuates due to supply and demand factors, reaching $7.00 per bushel a week before the contract expiration. As the contract nears expiration, the futures price will gradually rise and converge with the spot price of $7.00.