Adjusted future spread: Meaning, Criticisms & Real-World Uses

What Is Adjusted Future Spread?

The Adjusted Future Spread refers to the difference between the prices of two related futures contracts, where at least one of the contract prices or the spread itself has been modified to account for various factors. These adjustments aim to provide a more accurate or normalized view of the relationship between the contracts, removing distortions caused by factors like contract rollovers, financing costs, or physical commodity expenses. Within the realm of Derivatives Trading Strategies, understanding the Adjusted Future Spread is crucial for market participants seeking to analyze true price relationships rather than nominal differences.

This concept is particularly relevant in situations where standard futures contract prices might not fully reflect the underlying economic realities of holding or trading the asset. The adjustments can involve incorporating cost of carry components or normalizing price series across different expiration dates.

History and Origin

The concept of adjusting futures prices, and by extension futures spreads, evolved from the need for more accurate financial analysis in financial markets. Early futures trading, primarily in agricultural commodity markets, focused on simple forward agreements. As these markets matured and became more complex, particularly with the formalization of exchanges and the introduction of standardized futures contracts, the limitations of simply comparing nominal prices became apparent.

The development of modern derivatives markets necessitated greater precision in pricing and risk assessment. Regulatory oversight also played a significant role in fostering transparent and efficient markets. For instance, the Commodity Futures Trading Commission (CFTC), established in 1974, took over regulatory responsibilities from previous agricultural authorities to ensure fair practices and honest dealings in futures exchanges across various commodities.¹⁰, ¹¹, ¹²(https://www.cftc.gov/About/History/index.htm) This regulatory evolution encouraged more sophisticated pricing models, including those that account for carrying costs and facilitate clearer price comparisons across different contract months.

The advent of continuous futures price series, which are adjusted to remove artificial price gaps at contract rollovers, further solidified the idea of an "adjusted" price for analytical purposes. These methodological advancements allowed traders and analysts to gain deeper insights into market dynamics.

Key Takeaways

The Adjusted Future Spread modifies the price difference between futures contracts to reflect underlying economic factors or to normalize price series.
Adjustments often account for the cost of carry, including financing, storage, and insurance costs, or for technical factors like contract rollovers.
This analytical tool helps market participants in hedging, arbitrage, and speculation by providing a more accurate view of true price relationships.
It is particularly useful for analyzing long-term price trends and market structures, such as contango or backwardation.
Calculating the Adjusted Future Spread can involve complex formulas that incorporate various market data points and assumptions.

Formula and Calculation

The "Adjusted Future Spread" is not defined by a single universal formula, but rather represents a spread calculation where the constituent futures prices are themselves "adjusted" or where the spread is derived from an adjusted price series. The core idea is to account for factors that affect the theoretical price of a futures contract, primarily the cost of carry.

The theoretical futures contract price, incorporating cost of carry, is generally expressed as:

F = S \times e^{(r+s-c)T}

Where:

(F) = Futures price
(S) = Spot price of the underlying asset
(e) = The base of the natural logarithm (approximately 2.71828)
(r) = Risk-free interest rate (financing cost)
(s) = Storage costs (for physical commodities)
(c) = Convenience yield (benefit of holding the physical asset)
(T) = Time to expiration (expressed as a fraction of a year)

An Adjusted Future Spread could then be calculated by taking the difference between two such theoretically adjusted futures prices, (F_1) and (F_2):

\text{Adjusted Future Spread} = F_1 - F_2

Alternatively, the adjustment can be applied to create a "continuous" futures price series, especially for technical analysis. This involves splicing different contract months by adding or subtracting the price difference between the expiring contract and the next active contract at rollover points.⁹ This method effectively removes the price gaps that occur when moving from one contract to the next, allowing for a smoother chart representation of the market's historical movement.

Interpreting the Adjusted Future Spread

Interpreting the Adjusted Future Spread involves understanding what the adjustments reveal about the market's structure and expectations. When the spread is adjusted for cost of carry, it provides insights into whether the market is in contango or backwardation, reflecting current supply and demand dynamics and expectations about future spot prices.

A positive Adjusted Future Spread (where the far-month contract's adjusted price is higher than the near-month's) often indicates contango, suggesting that the costs of holding the asset outweigh any convenience yield. Conversely, a negative Adjusted Future Spread indicates backwardation, where near-term prices are higher, often due to strong immediate demand or supply shortages, and the convenience yield might be significant. Analyzing these adjusted spreads helps traders and analysts evaluate market efficiency and identify potential trading opportunities based on fundamental drivers.

Hypothetical Example

Consider a hypothetical scenario in the crude oil market.
Suppose:

Current Spot price of crude oil: $80.00
Risk-free interest rate (annualized): 3%
Monthly storage cost (as a percentage of spot price): 0.1%
Convenience yield: 0.05% (reflecting the benefit of holding physical oil for immediate use)

Let's calculate the adjusted price for a 3-month (0.25 years) futures contract and a 6-month (0.50 years) futures contract, assuming a simple compounding for illustrative purposes, or more precisely using the continuous compounding formula.

For the 3-month contract ((T_1 = 0.25)):
Annualized cost of carry percentage = 3% (interest) + 0.1% * 12 (storage) - 0.05% * 12 (convenience yield) = 3% + 1.2% - 0.6% = 3.6% (This is a simplified assumption for this example, true annualized figures would be used).
Using the precise formula for annualized rates (assuming a constant rate over the period):
Adjusted Cost of Carry Rate = (r + s - c) = 0.03 + 0.001 * 12 - 0.0005 * 12 = 0.03 + 0.012 - 0.006 = 0.036
Then, (F_1 = 80 \times e^{(0.036 \times 0.25)})
(F_1 = 80 \times e^{0.009} \approx 80 \times 1.00904 \approx 80.72)

For the 6-month contract ((T_2 = 0.50)):
(F_2 = 80 \times e^{(0.036 \times 0.50)})
(F_2 = 80 \times e^{0.018} \approx 80 \times 1.01816 \approx 81.45)

The Adjusted Future Spread between the 6-month and 3-month contracts would be:
Adjusted Future Spread = (F_2 - F_1 = 81.45 - 80.72 = 0.73)

This positive Adjusted Future Spread of $0.73 indicates a contango market structure, where longer-dated contracts are priced higher due to the costs associated with carrying the commodity over time. This analysis can help traders identify potential arbitrage opportunities or inform hedging strategies.

Practical Applications

The Adjusted Future Spread finds several practical applications across various facets of financial markets and Derivatives Trading Strategies:

Arbitrage Opportunities: By comparing the Adjusted Future Spread to theoretical fair values derived from cost of carry models, traders can identify potential arbitrage opportunities if market prices deviate significantly. If the actual spread is wider than the adjusted theoretical spread, a "cash and carry" arbitrage might be possible, involving buying the underlying asset and simultaneously selling a futures contract.
Hedging Strategies: Producers and consumers of commodities use Adjusted Future Spreads to structure more precise hedging strategies. By understanding the true cost differences between various delivery months, they can lock in prices that more accurately reflect their inventory costs and future needs, mitigating price volatility.
Market Analysis and Forecasting: Analysts use Adjusted Future Spreads to gauge market sentiment and expectations. A persistent contango (positive adjusted spread) in a commodity might suggest ample supply or anticipated higher future demand, while backwardation (negative adjusted spread) could indicate current supply tightness or strong prompt demand. Leading exchanges like the CME Group offer extensive resources to help market participants understand the nuances of futures spreads and their implications for trading and analysis.⁶, ⁷, ⁸
Continuous Price Series for Technical Analysis: For charting and technical analysis over long periods, Adjusted Future Spreads are crucial for creating continuous price series that eliminate artificial jumps or gaps that occur during contract rollovers. This allows for more reliable identification of trends, support, and resistance levels.

Limitations and Criticisms

While the Adjusted Future Spread offers valuable insights, it is not without limitations or criticisms. One primary challenge lies in the assumptions made for the adjustment factors. The calculation of cost of carry, for instance, relies on accurate estimations of interest rates, storage costs, and especially the convenience yield. The convenience yield, being an intangible benefit of holding the physical asset, can be difficult to quantify precisely, introducing subjectivity into the adjustment.

Furthermore, real-world market dynamics are complex. Factors like market liquidity, transaction costs (beyond explicit storage or financing fees), and unforeseen supply/demand shocks can cause actual futures spreads to deviate from their theoretically adjusted values. These deviations do not always imply arbitrage opportunities but can reflect genuine market inefficiencies or specific trading pressures.

Derivatives markets, while offering benefits like price discovery and risk management, also carry inherent risks, including market risk, credit risk, and liquidity risk.⁴, ⁵ Even with adjustments, the underlying volatility and complexity of derivatives mean that analyzing Adjusted Future Spreads requires a thorough understanding of these potential pitfalls. Over-reliance on theoretical models without considering market realities can lead to unexpected outcomes.

Adjusted Future Spread vs. Futures Spread

The key distinction between an Adjusted Future Spread and a standard Futures Spread lies in the degree of refinement applied to the price difference.

Feature	Futures Spread	Adjusted Future Spread
Definition	The direct price difference between two related futures contracts, typically with different expiration dates or underlying assets.³	The price difference between two related futures contracts, where at least one of the contract prices or the spread series itself has been modified to account for economic factors (e.g., cost of carry) or to create a continuous series for technical analysis.¹, ²
Calculation Basis	Uses the nominal, observed market prices of the futures contracts.	Uses prices that have been theoretically or statistically adjusted (e.g., for interest, storage, convenience yield, or rollover differences).
Purpose	To trade the relative price movement between two contracts, often for speculation or hedging.	To gain a more accurate economic or technical view of the relationship between contracts, removing distortions, and facilitating long-term trend analysis or fundamental valuation.
Complexity	Relatively straightforward subtraction of prices.	Involves additional calculations and assumptions for adjustments, such as using the cost of carry model or technical splicing methods for continuous charts.

While a standard Futures Spread offers a quick snapshot of market relationships, the Adjusted Future Spread aims for a more nuanced and fundamentally sound assessment, particularly useful for in-depth analysis and strategies that span multiple contract cycles.

FAQs

What does "adjusted" mean in Adjusted Future Spread?

In the context of an Adjusted Future Spread, "adjusted" means that the prices of the futures contracts forming the spread, or the spread itself, have been modified. This modification typically accounts for factors such as the cost of carry (interest, storage, insurance, convenience yield) or technical adjustments necessary to create a continuous price series across different expiration dates. The goal is to present a more accurate or normalized representation of the price relationship.

Why is an Adjusted Future Spread important for traders?

An Adjusted Future Spread is important because it provides a more realistic view of the underlying economic relationship between futures contracts, beyond their nominal market prices. This helps traders identify true arbitrage opportunities, refine hedging strategies by accounting for holding costs, and perform more reliable technical analysis on continuous price charts, which in turn helps in better risk management.

Can Adjusted Future Spread be negative?

Yes, an Adjusted Future Spread can be negative. A negative spread indicates a market condition known as backwardation, where the price of a nearer-term futures contract is higher than that of a longer-term contract, even after accounting for the cost of carry. This often occurs due to immediate strong demand for the underlying asset or perceived supply shortages in the near term.

How does the cost of carry affect the Adjusted Future Spread?

The cost of carry is a primary component of many adjustments within an Adjusted Future Spread. It represents the net cost (or benefit) of holding the underlying asset over a period. For example, in commodity markets, high storage costs and interest rates can widen the spread between different contract months, reflecting the expense of carrying inventory. Conversely, a significant convenience yield can narrow or even invert the spread. By factoring in the cost of carry, the Adjusted Future Spread provides a more accurate reflection of the fundamental value relationship between the contracts.