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RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE

Discuss RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE within the Financial Management ( FM ) forums, part of the Resolve Your Query - Get Help and discuss Projects category; The price of a commodity (here we are not restricting ourselves to equity stock as the underlying asset) is, among ...

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RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE
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Sunanda K. Chavan
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RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE - October 8th, 2010

The price of a commodity (here we are not restricting ourselves to equity stock as the underlying asset) is, among other things, a function of:

• Demand and supply position of the commodity

• Storability – depending on whether the commodity is perishable or not

• Seasonality of the commodity

To understand the linkage between spot and futures price, let us consider an example.
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Example

If John is certain that the demand-supply position of wheat is such that 3 months from now, the price of wheat is likely to go up, he should be tempted to buy wheat now and sell the stock after 3 months at a higher price. For this purpose, he will hire a godown, stock the inventory, pay interest on the money invested I the stock as well as pay incidental charges in holding the inventory, like, handling charges, insurance charges, etc., collectively called the ‘carrying costs’. Let us assume that he buys a unit of wheat at Rs. 100 and the carrying costs aggregates Rs. 6 per unit. Logically, to earn profit, he would have to be sure that spot price of wheat; 3 months from now should be more than Rs. 106.

Now if others also have the same information that the wheat prices are likely to go up beyond the carrying cost, the number of buyers would increase. As the current demand for wheat increases because of this information, the current spot price also starts climbing. The current spot price would keep on increasing till the anticipated future spot price becomes equal to current spot price plus the carrying costs.


As we have already seen, the future spot price tends to equal the current spot price plus the carrying costs. Suppose the current spot price is Rs. 100 and the carrying costs are Rs. 6. the predicted futures price, say, 3 months from now is Rs. 110. There would be a tendency for the current spot price to rise from Rs. 100 to Rs. 104, as any increase beyond this level would mean a loss in the transaction.
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Thus, the current spot price would tend towards a level where there is no profit or no loss situation for both the buyer and seller alike. The conclusion, therefore, is that in a perfectly predictable and certain market, neither the buyer nor the seller would be interested in futures trading. If, future spot prices could be forecast with 100% certainty, the very idea of futures market would vanish. As a corollary, we can say that it is the element of uncertainty, which gives rise to a futures market.
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Re: RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE
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Rose Marry
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Re: RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE - April 19th, 2016

Quote:
Originally Posted by sunandaC View Post
The price of a commodity (here we are not restricting ourselves to equity stock as the underlying asset) is, among other things, a function of:

• Demand and supply position of the commodity

• Storability – depending on whether the commodity is perishable or not

• Seasonality of the commodity

To understand the linkage between spot and futures price, let us consider an example.
--------------------------
Example

If John is certain that the demand-supply position of wheat is such that 3 months from now, the price of wheat is likely to go up, he should be tempted to buy wheat now and sell the stock after 3 months at a higher price. For this purpose, he will hire a godown, stock the inventory, pay interest on the money invested I the stock as well as pay incidental charges in holding the inventory, like, handling charges, insurance charges, etc., collectively called the ‘carrying costs’. Let us assume that he buys a unit of wheat at Rs. 100 and the carrying costs aggregates Rs. 6 per unit. Logically, to earn profit, he would have to be sure that spot price of wheat; 3 months from now should be more than Rs. 106.

Now if others also have the same information that the wheat prices are likely to go up beyond the carrying cost, the number of buyers would increase. As the current demand for wheat increases because of this information, the current spot price also starts climbing. The current spot price would keep on increasing till the anticipated future spot price becomes equal to current spot price plus the carrying costs.


As we have already seen, the future spot price tends to equal the current spot price plus the carrying costs. Suppose the current spot price is Rs. 100 and the carrying costs are Rs. 6. the predicted futures price, say, 3 months from now is Rs. 110. There would be a tendency for the current spot price to rise from Rs. 100 to Rs. 104, as any increase beyond this level would mean a loss in the transaction.
-------------------------------

Thus, the current spot price would tend towards a level where there is no profit or no loss situation for both the buyer and seller alike. The conclusion, therefore, is that in a perfectly predictable and certain market, neither the buyer nor the seller would be interested in futures trading. If, future spot prices could be forecast with 100% certainty, the very idea of futures market would vanish. As a corollary, we can say that it is the element of uncertainty, which gives rise to a futures market.
Hi buddy,

It was really appreciable and i am sure it would help many people. Well, i found some important information on Relationship between Energy Spot and Futures Prices - Evidence from the Australian Electricity Market and wanna share it with you and other's. So please download and check it.
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