Why do futures' prices converge upon spot prices during the delivery month?

By Albert Phung AAA
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.

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