Futures Pricing
- Spot Market
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This market deals with immediate delivery of commodities, typically within two days. Think of it like buying corn at a supermarket; you pay the cash price at the register.
- Futures Market
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This market predicts the price of a commodity for future delivery, incorporating all known information about next year’s crop or production.
Producers, hedgers, and speculators engage almost 24/7 to assimilate the latest information, a process known as price discovery. This helps determine the futures price. Futures prices provide valuable insights into the current price of a product yet to be produced, aiding global financial and physical market participants.
The difference between the spot price and the futures price is called ‘the basis’, and the sign convention matters because half the literature gets it backwards. By CME convention, basis = cash price futures price. If corn is $4.30 in the local cash market and the deferred contract trades at $4.55, the basis is — quoted as “25 under.” A negative basis is the normal state of a carrying-charge market; a positive one signals immediate local scarcity. Changes in the basis can signal producers to adjust their production plans: if forward prices indicate oversupply, a farmer might switch to a less abundant crop.
- Contango
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This occurs when futures prices are higher than current prices, often due to factors like inflation, insurance, storage costs, and investor psychology.
- Backwardation
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This happens when futures prices fall below current market prices, usually due to an expected short-term shortage, with production anticipated to resume soon. It highlights immediate supply and demand issues.
Futures “cost of carry” represents the total expenses incurred for holding a commodity until the futures contract’s delivery date, encompassing storage fees, insurance premiums, and the opportunity cost of capital, typically calculated as the interest on the funds tied up in the investment.