A:

It's a fairly safe bet that as the delivery month of a futures contract approaches, the future's price will generally inch toward or even come to equal the spot price as time progresses. This is a very strong trend that happens regardless of the contract's underlying asset. This convergence can be easily explained by arbitrage and the law of supply and demand.

For example, suppose the futures contract for corn is priced higher than the spot price as time approaches the contract's month of delivery. In this situation, traders will have the arbitrage opportunity of shorting futures contracts, buying the underlying asset and then making delivery. In this situation, the trader locks in profit because the amount of money received by shorting the contracts already exceeds the amount spent buying the underlying asset to cover the position.

In terms of supply and demand, the effect of arbitrageurs shorting futures contracts causes a drop in futures prices because it creates an increase in the supply of contracts available for trade. Subsequently, buying the underlying asset will causes an increase in the overall demand for the asset and the spot price of the underlying asset will increase as a result .

As arbitragers continue to do this, the futures prices and spot prices will slowly converge until they are more or less equal. The same sort of effect occurs when spot prices are higher than futures except that arbitrageurs would short sell the underlying asset and long the futures contracts.

To learn more about futures, see Futures Fundamentals.

RELATED FAQS
  1. What are some securities that have spot rates?

    Learn about the types of assets that have spot rates, and understand how the spot rate is used to determine the fair market ... Read Answer >>
  2. How can I calculate the notional value of a futures contract?

    Learn how the notional value of a futures contract is calculated, and how futures are different from stock since they have ... Read Answer >>
  3. What is the difference between forward and futures contracts?

    Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell ... Read Answer >>
  4. How do the investment risks differ between options and futures?

    Learn what differences exist between futures and options contracts and how each can be used to hedge against investment risk ... Read Answer >>
  5. What types of items can you buy futures for?

    Learn what items futures may be purchased for, what a futures contract is and discover how the futures markets have greatly ... Read Answer >>
  6. How are futures used to hedge a position?

    Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between ... Read Answer >>
Related Articles
  1. Investing

    Crude Oil Prices: Comparing Future Price Vs. Current Market Price

    Discover the differences between oil futures market prices and oil spot market prices and what leads to the differences between the two.
  2. Trading

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  3. Investing

    Introduction To Currency Futures

    The forex market is not the only way for investors and traders to participate in foreign exchange.
  4. Trading

    Combining Forex Spot And Futures Transactions

    The spot, futures and option currency markets can be traded together for maximum downside protection and profit.
  5. Trading

    Contango Vs. Normal Backwardation

    Learn about the futures curve and what its shape means for hedgers and speculators.
  6. Trading

    What Does Spot Price Mean?

    Spot price is the current price at which a security may be bought or sold.
  7. Trading

    Futures, Derivatives and Liquidity: More or Less Risky?

    Futures and derivatives get a bad rap after the 2008 financial crisis, but these instruments are meant to mitigate market risk.
  8. Trading

    Understanding the Spot Market

    A spot market is a market where a commodity or security is bought or sold and then delivered immediately.
  9. Investing

    What's The Difference Between Options And Futures?

    An option gives the buyer the right, but not the obligation, to buy or sell a certain asset at a set price during the life of the contract. A futures contract gives the buyer the obligation to ...
RELATED TERMS
  1. Wide Basis

    A condition found in futures markets in which the spot price ...
  2. Convergence

    The movement of the price of a futures contract towards the spot ...
  3. Narrow Basis

    A condition found in futures markets in which the spot price ...
  4. Futures

    A financial contract obligating the buyer to purchase an asset ...
  5. Spot Delivery Month

    The nearest month when a futures contract matures. The spot delivery ...
  6. Reverse Cash-and-Carry-Arbitrage

    A combination of a short position in an asset such as a stock ...
Hot Definitions
  1. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  2. Demonetization

    Demonetization is the act of stripping a currency unit of its status as legal tender and is necessary whenever there is a ...
  3. Investment

    An asset or item that is purchased with the hope that it will generate income or appreciate in the future. In an economic ...
  4. Redlining

    The unethical practice whereby financial institutions make it extremely difficult or impossible for residents of poor inner-city ...
  5. Nonfarm Payroll

    A statistic researched, recorded and reported by the U.S. Bureau of Labor Statistics intended to represent the total number ...
  6. Conflict Theory

    A theory propounded by Karl Marx that claims society is in a state of perpetual conflict due to competition for limited resources. ...
Trading Center