A futures price is a price for an asset at a specified time in the future. These prices are specified in futures contracts. The exchange on which the contracts are traded may choose to limit the daily fluctuation of futures prices. Futures are important because they give information about investors’ expectations of future market conditions. Oil and corn are common underlying assets for futures.
Futures contracts are derivative instruments based on assets including stock, commodities and rates. They are agreements to enter into transactions at a specified date. One party promises to deliver a certain amount of a good, called the underlying. The other party promises to pay for that delivery. The price the buyer will pay for the underlying is fixed in the original contract, and is called the futures price.
The spot price is the price of the underlying with immediate delivery. Theoretically, the futures price is the spot price plus the cost of carry to the delivery date. The cost of carry is the cost of storing the underlying for the time specified in the futures contract. This can be the cost for physical storage, as in commodity futures like corn contracts, where the underlying occupies silos until delivery. They also include the opportunity cost of selling the underlying in the future rather than the present; if the owner sold the underlying now, he could invest the proceeds or use the space in other ways.
If the futures price does not correspond with the spot price adjusted for cost of carry, then market forces will bring the two back into balance because investors will spot opportunities for profit, called arbitrage opportunities, and take advantage of them. If the futures price is higher than predicted, then investors will buy the underlying in the spot market. Then, they will sell futures contracts, shoulder the cost of carry and make a profit upon delivery. The increased spot demand and futures supply will drive up prices in the spot market and drive down prices in the futures market until the two reach equilibrium levels. If the futures price is too low, then the reverse will occur.
In the real world, however, the futures price is not always what theory predicts that it should be. The market has several factors that affect futures prices. These include transaction costs, which disrupt the process by which the prices would come to rest at the predicted equilibrium. Another factor is the difference between rates of borrowing and lending. The gap between the two means that the cost of carry can be any value within some range.
