Spot and Futures Pricing

A __spot price__ is what something costs today. A bushel of this or that commodity can be delivered now for the spot price.

A __futures price__ is what it will cost you to get that same bushel at some future date. Suppose that it happens to be a commodity that is rather costly to store, and it's available right now. How do you think these two prices would compare?

No, think of which one would be best for you if you needed this commodity in the future.

No—if that was the case, whoever held it would lose money.

That's right! If it's as simple as that (and it never really is), then the market would be in __contango__, meaning that the futures price is higher than the spot price. The difference is called the __basis__. In fact, it doesn't have to be based on the spot price at all. A futures contract expiring in a month and another expiring in 10 months can be compared for contango as well, and this price difference is the __calendar spread__.

In a lot of cases, you need your commodity on a future date, and knowing the price in advance has value for risk management. So it's common to have to "pay" for this benefit with the market being in contango. But it's also possible for the payment to go backwards, and this is referred to as __backwardation__. What condition does this imply?

Not necessarily; it just means that the spot price is higher than the futures price.

Yes.

Now consider what a market in backwardation would mean for a commodity with a very stable spot price. Here you're considering a spot transaction at a price of 105 per bushel, and the futures price in six months is 100 per bushel. You're thinking of taking a long position. If the spot price remains unchanged over time, what position would be best for you?

No, if you went long at a spot price of 105 and it stayed 105, you wouldn't gain anything.

Exactly! A futures price of 100 must eventually rise if the future spot price will really be 105. Of course, you don't know that will happen, but a lot of producers are willing to settle for a lower futures price just to wipe out the uncertainty of price fluctuations. That has value, so it can occur. Another note that's hinted at here is the point that, at expiration, the spot price and the futures price converge. The basis falls to zero.

Actually, no—you would only benefit from one of these positions, not both.

When a contract expires, it's time to deliver. As much as you may want 100 barrels of oil or a bunch of lean hogs, many market participants just want the money. So while physical delivery still occurs in some markets, many contracts are settled with cash delivery. Much faster and easier. Think about a comparison using oil. If you had to deliver physical oil barrels to a certain long participant in another part of the world, the enormous cost of shipping would probably keep you from considering it. How do you think that would affect price discovery for oil?

The difference in this spread also tells you which direction it's going. A positive spread means the market is in backwardation, whereas a negative spread means that the market is in contango. So it's fair to think of the spread like the spot price minus the futures price.

Absolutely.

Probably not; the delivery costs would allow prices to persist.

Spot markets are prices for delivery, and they change from place to place. Futures markets allowing cash settlement allow orders to move around the world at the speed of light, eliminating price differences. So futures prices are global and spot prices are local. One last note is about quality when talking about physical delivery. Gold is gold, but each cow is a little different. There are two main types of coffee and quality varies. So just be aware of the differences in "a bushel of this" from place to place and from time to time.

To summarize: [[summary]]

They should be equal

The spot price should be larger

The futures price should be larger

Spot price is expected to fall

Spot price is higher than the futures price

Spot

Futures

Either spot or futures

Price would be the same everywhere

Price would be different in different places

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