Commodity Spot Price vs. Futures Price: An Overview
Commodity spot prices and futures prices are each quotes for a contract, but the agreement between the buyer and the seller differs:
- The spot price is the current quote for immediate purchase, payment, and delivery of a particular commodity.
- The futures price for a commodity is an offer for a financial transaction that will occur on a later date.
- The spot price of a commodity is the local cash price for immediate delivery of the commodity.
- The futures price locks in the cost of a future delivery of the commodity.
- The difference between the spot price and futures price in the market is called the basis.
Commodity Spot Price
The main differences between commodity spot prices and futures prices are the delilvery dates.
In commodity spot prices, payment is required immediately, as is delivery. Hence, the deal is done "on the spot."
A commodity's spot price is the price at which the commodity could be traded at the time in the marketplace.
Broadly speaking, futures prices and spot prices are different numbers because the market is always forward-looking.
A commodity futures buyer is locking in a price for later delivery.
A commodity's futures price is based on its current spot price plus the cost of carry during the interim before delivery. Cost of carry refers to the price of storage of the commodity, which includes interest and insurance as well as other incidental expenses.
The spot price is for payment and delivery "on the spot." The futures price locks in the cost of a commodity in advance.
Commodity futures prices can be calculated as follows: Add storage costs to the spot price of the commodity. Multiply the resulting value by Euler's number (2.718281828…) raised to the risk-free interest rate multiplied by the time to maturity.
The difference in a commodity's spot price and the future price at any given time is attributable to the cost of carry and interest rates.
For example, assume the spot price of gold is $1,200 per ounce and it costs $5 per ounce to store the gold for six months. The six-month futures contract on gold, given a risk-free interest rate of 0.25%, is $1,206.51, or (($1,200+$5)*e^(0.0025*0.5)).
Spot Price, Futures Price, and Basis
The basis is the difference between the local spot price of a deliverable commodity and the price of the futures contract for the earliest available date.
"Local" is relevant here because futures prices reflect global prices for any commodity and are therefore a benchmark for local prices. The basis can vary greatly from one region to another based primarily on the costs of transporting the commodity to its delivery point.
Basis is used by commodities traders to determine the best time to buy or sell a commodity. Traders buy or sell based on whether the basis is strengthening or weakening.
Basis is a crucial concept for portfolio managers and traders because this relationship between cash and futures prices affects the value of the contracts used in hedging.
The basis, it must be noted, is not necessarily accurate. There are typically gaps between spot and relative price until the expiry of the nearest contract. Product quality also can vary, making basis an imperfect indicator.
As an example for basis in futures contracts, assume the spot price for crude oil is $50 per barrel and the futures price for crude oil deliverable in two months' time is $54. The basis is $4, or $54 - $50.
The prices of commodities futures are not always higher than spot prices. Futures prices take into account expectations of supply and demand and production levels, among other factors.
The futures market exists because producers want the safety that comes with locking in a reasonable price in advance, while futures buyers are hoping that the market value of their purchase rises during the interim before delivery.