It's a fairly safe bet that the price of a future will inch toward its spot price as the delivery month of a futures contract approaches, and it could even match the price. This is a very strong trend that occurs regardless of the contract's underlying asset.
The convergence is easily explained by a combination of arbitrage interest and the law of supply and demand.
- The futures price of a commodity is set in advance between producer and buyer.
- The spot price is the commodity's value when it is ready for delivery.
- The difference in the two values is where arbitrage traders make their money.
Defining Futures Prices and Spot Prices
Investors in futures commit to buying or selling a quantity of something, generally a commodity like corn, at a set price for delivery at a future date. The origin of this market, and its practical use, is to help farmers and other producers of raw goods agree in advance with wholesale buyers on a reasonable price for a commodity.
Both sides benefit. Producers have a ready buyer and can proceed with their work, and get financing for their operations as needed. Wholesale buyers know what they'll be spending for supplies in the coming period, and can budget accordingly.
But that "reasonable" price may change repeatedly between the time that it is set and the time that the commodity is actually ready to deliver. A storm or a pest may reduce the supply of a crop and drive prices up. A recession may reduce consumer demand for precious metals and drive prices down.
Futures traders try to make a profit off of the difference between the futures price that has been set and the value of the commodity at the time it is actually ready for delivery.
How Arbitrage Affects Price
Suppose that the futures contract for corn is priced higher than the spot price as the contract's month of delivery approaches. When this happens, traders see an arbitrage opportunity. That is, they will short futures contracts, buying the underlying asset, and then make the delivery.
As arbitrageurs short futures contracts, futures prices drop because the supply of contracts available for trade increases.
The trader profits because the amount of money received by shorting the contracts exceeds the amount spent buying the underlying asset to cover the position.
As for the pressure 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 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 price and the spot price will slowly converge until they are equal, or close to equal. The same sort of effect occurs when spot prices are higher than futures, except that arbitrageurs would in that case short sell the underlying asset and long the futures contracts.
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