Futures Trading: Pricing and Hedging

This chapter covers more advanced aspects of the economics of futures trading. It has two sections. The first deals with the relationship between spot and futures prices while the second discusses the relationship between the ‘basis’ or price spread and hedging effectiveness. The discussion will be based primarily on futures in commodities, but the discussion is also applicable to futures in financial instruments etc., with minor modifications which will be discussed in subsequent chapters. The relationship between spot and futures prices Intuitively, it is not difficult to see that spot and futures prices must be inter-related. After all they are prices of the same asset, albeit at different points in time, which means that the basic factors affecting supply and demand are the same. Also, the option of delivery (meaning that a futures contract can be closed by means of actually giving or taking delivery of the physical commodity or financial instrument) means that on the maturity date spot and futures prices must be in close proximity. This implies that the difference between the two prices must narrow over time and eventually be whittled down to nil or thereabouts. This leaves the question of how the difference is determined. There are several theories which attempt to explain the relationship between spot and futures prices. The essence of these is set out below. In the following discussion, readers should note that: • when the futures price is higher than the spot price, the futures price is said to be at a ‘contango’; and • when the futures price is lower than the spot price it is said to be at a ‘backwardation’. The expectations approach This school of thought, owing its origins to such luminaries as J. M. Keynes, J. R. Hicks and N. Kaldor, sees the futures price as the market expectation of the price at the future date. Thus, the October gold futures price in June is what the market in June expects or forecasts will be the gold price in October. Any major deviation of the futures price from the expected price is likely to be corrected by speculative activity.