The relationship between futures price and cash price, Financial Management

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The Relationship between Futures Price and Cash Price

Any commodity that can be bought in the market has a price, which is referred to as cash or spot price for immediate delivery. Similarly, in a futures market, the commodity is delivered at a later date as per the futures contract. There may be more than one cash price for a commodity at one point of time. For instance, petrol is quoted at different rates at different geographical locations. This variation in costs occur due to time and the costs associated with transporting petrol from one part of the globe/country to the other. The cash price varies from one country to another and one commodity to another and depends on the demand and supply of the commodity. If a good has two prices, at two different locations, a trader would normally buy the good from a cheaper market and sell it in a market where it is priced high and thus make a profit. It may be possible, the transportation costs involved and taxes paid will nullify the profit, unless the price difference is large enough to result in a profit.

Basis

We define Basis as the difference between the current cash price of the commodity and the futures price. That is,

Basis = Current Cash Price - Futures Price

The spot price for a physical commodity can differ from location to location, since transportation costs for physical commodities play an important role. Correspondingly, basis calculated also differs from location to location. We know that a single good cannot be sold at different prices at two different locations, as the traders will actively exploit any arbitrage possibilities. Therefore, to avoid arbitrage, the differences should be only to the extent of transportation costs.

Generally, basis is higher for contracts with longer maturity.

Futures markets can be either Normal or Inverted in nature. By normal markets, we mean that the prices for distant futures are higher than those for nearby contracts or for which the basis gradually increases. The inverted futures market is quite the opposite.

The basis for normal markets usually exhibits "Convergence". By "Convergence" we understand that the spot and futures prices converge to a point, where the basis would be zero towards the end of the life of the contract.

Basis is also a valuable indicator for predicting future spot prices of the commodities that underlie the futures contracts and it is more stable than the futures price or the cash price considered separately. The relatively low variability of the basis aids in decision-making for traders interested in hedging and certain types of speculation.

 


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