The price of any 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.

If John is certain that the demand-supply position of wheat is such that three 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 three months at a higher price. For this purpose, he will hire a godown, stock the inventory, pay interest on the money invested in 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 aggregate Rs. 6 per unit. Logically, to earn profit, he would have to be sure that spot price of wheat, three months from now should be more than Rs. 106. Now, if others also have the same information that the wheat price is likely to go up beyond the carrying costs, 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 the 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 carrying costs are Rs. 6. The predicted futures price, say, 90 days 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 loss situation for both the buyers and the sellers 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 hundred percent certainty, the very idea of a futures market would vanish. As a corollary, we can say that it is the element of uncertainty which gives rise to a futures market.

Basis

The difference between the prevailing spot price of an asset and the futures price is known as the basis, i.e.

Basis = Spot price - Futures price

In a normal market, the spot price is less than the futures price (which includes the full cost-of-carry) and accordingly the basis would be negative. Such a market, in which the basis is decided solely by the cost-of-carry is known as a contango market.

Basis can become positive, i.e. the spot price can exceed the futures price only if there are factors other than the cost of carry to influence the futures price. In case this happens, then basis becomes positive and the market under such circumstances is termed as a backwardation market or inverted market.

Basis will approach zero towards the expiry of the contract, i.e. the spot and futures prices converge as the date of expiry of the contract approaches. The process of the basis approaching zero is called convergence.

As already explained above, the relationship between futures prices and cash prices is determined by the cost-of-carry. However, there might be factors other than cost-of-carry, especially in financial futures in which there may be carry-returns like dividends, in addition to carrying costs, which may influence this relationship.

The cost-of-carry model in financial futures, thus, is

Futures price = Spot price + Carrying cost — Returns (dividends, etc.)

Let us take an example to understand this relationship.

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The views expressed in the article are the author's and not of Sify.com.

The views expressed in the article are the author's and not of Sify.com.