Why Do Futures Prices Tend to Converge upon Spot Prices?
Futures are financial contracts that derive their value from their underlying assets. This contract sets a predefined value for the sale or purchase of securities at a given date. Unlike options, both buyers and sellers of futures are obligated to make a purchase or sale on the set date as per the contract’s terms.
On this note, there are two types of prices involved with futures trading. These are the spot and future prices. These two prices tend to converge as the future matures. But, why does this happen?
This blog will take you through the reasons why future prices converge upon spot prices.
What Are Spot Prices and Future Prices?
As we already know, trading with futures involves a process where buyers and sellers can set a price for a future transaction. This is a pre-defined price for transactions between buyers and sellers regardless of the current price of an underlying asset.
Out of these two, the spot price is the current market price of that stock. In contrast, the future price is the predefined price that traders set as per their market analysis. Traders study price movements closely. Following this, they enter into a contract for a price higher or lower than the underlying asset’s current market price. This is the future price.
The spot price and the futures price of an asset are usually different. This happens due to multiple factors like market interest rates, time to expiry, dividend yield, etc. When futures are trading at a higher price than spot prices, the asset is said to be trading at a premium. When the opposite situation happens, the asset is said to be trading at a discount.
Why Do Future Prices Converge upon Spot Prices?
The difference between spot prices and future prices is called basis or spread. As we know every future comes with a maturity date which is also its expiration date. When two traders sign a futures contract, the spot and future prices are different. But over time, the prices tend to converge.
In such instances, the basis reduces as a future matures until it reaches 0. This is when the convergence of future prices and spot prices happens. Here are two important reasons that lead to convergence of future prices with spot prices.
Arbitrage is the process by which traders buy and sell assets in different markets to capitalise on price differences. With short future contracts, traders can buy an underlying asset to make deliveries. Due to shorting of contracts by arbitrageurs, there is an increase in supply for underlying assets. This leads to a price drop, thus bringing spot prices close to future prices.
- Demand and Supply
Arbitrage creates an opportunity for risk-free trading. This directly influences the pressure on demand and supply for underlying assets. As the purchase of shares increases, their demand grows, leading to a convergence of future prices with spot prices.
What Does This Phenomenon Mean for Everyone?
The arbitrage and demand and supply phenomena are interlinked. Both of them work together to make spot and future prices come close to one another as the contract expires. Furthermore, it helps investors in hedging against market volatility.
Farmers who are sellers of commodities have an assurance that buyers on the other end of a contract will purchase them at the expiration date. Buyers also know the exact price of a commodity with futures and plan the cash accordingly.
Things to Consider for Investors to Make Profits from This Phenomenon
Here are certain points you must consider when trading with futures to account for the convergence phenomenon.
- If you are planning to earn profits via arbitrage, consider remembering that prices might not move according to your prediction. There is a high chance that the value of your future contract might be quite lower than spot price, however both the prices shall converge at future expiration. Thus new investors with low-risk appetites must be mindful of the risks.
- Unlike options, you have to buy or sell the securities even if the market is not in your favour. This can lead to tremendous losses.
- To gain from demand and supply phenomena, consider buying a security when its spot price is higher and sell them at the same time. However, this is a common strategy for many traders. This can lead to spot prices falling quickly. Consequently, traders receive a small window to make a profit.
Traders using futures must understand the phenomenon of convergence of spot and future prices. Consequently, investors must study the market movements closely before trading in futures. There are high chances of major losses or gains owing to market volatility. Seasoned investors with high-risk appetites can choose to use futures to hedge against losses or profit from speculation.
Frequently Asked Questions
Is it possible to exit futures at any time?
Despite futures being obligatory, traders can exit their positions. This means they can choose to avoid buying or selling securities as per the set contractual price. To do so, traders must use cash settlements to adjust their profits or losses against their margins till the date they decide to exit the contract.
What is the maximum duration to hold a futures contract?
The maximum duration to hold a future contract is three months. After the last expiration day, the contract will turn null and void. Traders only need to pay the difference between spot price and future price to settle the transaction of a futures contract.
What is the basis or spread for futures?
In futures trading, the basis is the difference between spot price and future price. This tends to decrease as a future matures and reaches zero at its expiry date. This solely happens due to the convergence of future and spot prices.
What is the formula to calculate the basis for futures?
The formula to calculate basis is as follows.
Basis= Spot price of an asset – future price of the same asset