Futures price: Meaning, Criticisms & Real-World Uses

What Is Futures Price?

A futures price is the current price at which a buyer and a seller agree to trade an asset at a predetermined future date. This price is established on a futures exchange and forms the core of a futures contract, a standardized legal agreement within the broader category of derivatives. Unlike a spot price, which represents an immediate transaction, the futures price reflects market expectations for the asset's value at a specified point in the future. Participants use futures prices for a variety of purposes, including [hedging](https://diversification.com/term/hedging against potential price movements and speculation on future market direction. The constant negotiation of futures prices allows for efficient price discovery in various markets, from commodities to financial instruments.

History and Origin

The concept of agreeing on a price for a future delivery dates back centuries, with ancient civilizations using similar arrangements for agricultural goods. However, the formalization of futures trading and the establishment of centralized exchanges began in the mid-19th century in the United States, primarily driven by the agricultural sector's need to manage price uncertainty. The Chicago Board of Trade (CBOT), established in 1848, was instrumental in this evolution. In 1865, the CBOT formalized "futures contracts," which provided standardized agreements for trading grains, marking a pivotal moment in the development of modern futures markets. This standardization helped create a more orderly and transparent marketplace for farmers, merchants, and processors to manage future price risks.¹³ The Chicago Mercantile Exchange (CME), originally the Chicago Butter and Egg Board, followed suit, formally reorganizing in 1919 and later expanding into financial futures in the 1970s, including foreign exchange and interest rate products.¹²,¹¹

Key Takeaways

Futures price is the agreed-upon price for a future delivery of an asset, distinct from its immediate spot price.
It is determined by market forces on regulated futures exchanges and is a key component of a futures contract.
Futures prices incorporate the spot price, carrying costs (like storage and interest), and any benefits (like dividends or convenience yield) over the contract's life.
Market participants utilize futures prices for both risk management, such as hedging against adverse price movements, and for speculative trading.
The spread between the futures price and the spot price provides insights into market expectations regarding future supply and demand conditions.

Formula and Calculation

The theoretical futures price for a financial asset (that does not incur storage costs or provide dividends/benefits) can be approximated using the cost-of-carry model. This model suggests that the futures price should reflect the spot price plus the cost of holding the asset until the delivery date, typically accounted for by the risk-free interest rates.

For an asset with no carrying costs or benefits, the basic formula is:

[F = S_0 \times (1 + r \times T)]

Where:

(F) = Futures Price
(S_0) = Current spot market price of the underlying asset
(r) = Risk-free interest rate (annualized)
(T) = Time to expiration of the contract (as a fraction of a year)

For commodities, the formula is adjusted to include storage costs (c) and potential convenience yield (y), which is the benefit of holding the physical commodity:

[F = S_0 \times (1 + (r + c - y) \times T)]

This formula represents a simplified view, as actual futures prices are also influenced by supply and demand dynamics and market expectations.

Interpreting the Futures Price

Interpreting the futures price involves understanding its relationship to the underlying asset's current spot price and the factors influencing expectations for its future value. A futures price higher than the spot price indicates a state known as contango, suggesting that market participants anticipate the asset's price to rise or that holding costs (like storage and financing) are significant. Conversely, when the futures price is lower than the spot price, it's called backwardation, often implying current scarcity or expectations of future price declines.

The slope of the futures curve—the plot of futures prices across different expiration months—provides insights into market sentiment and expectations of future economic conditions, commodity availability, or interest rate movements. Traders and analysts constantly compare the futures price to the spot price to identify potential arbitrage opportunities or gauge market participants' collective outlook on future prices. Understanding these relationships is crucial for effective trading and risk management strategies.

Hypothetical Example

Consider a hypothetical example involving crude oil futures. Suppose it is July, and the current spot price of a barrel of crude oil is $80. An investor believes that geopolitical tensions might ease, leading to an increase in oil supply, while another investor is concerned about hurricane season impacting production.

A futures contract for crude oil expiring in December is trading at a futures price of $78 per barrel. Here's how this plays out:

Agreement: A buyer and seller agree to exchange 1,000 barrels of crude oil in December at the established futures price of $78 per barrel.
Market Expectation: The fact that the December futures price ($78) is lower than the current spot price ($80) indicates backwardation. This could imply that the market anticipates an increase in supply or a decrease in demand for crude oil by December, or it could reflect a high convenience yield for holding physical oil now.
Outcome at Expiration (December):
- Scenario A: Spot price is $75. The buyer of the futures contract buys oil at $78 (as per the contract) while the spot market price is $75. The buyer has a loss of $3 per barrel ($78 - $75), or $3,000 in total. The seller, who committed to sell at $78, gains $3 per barrel compared to the spot market.
- Scenario B: Spot price is $82. The buyer buys at $78 (as per the contract) while the spot market price is $82. The buyer has a gain of $4 per barrel ($82 - $78), or $4,000 in total. The seller loses $4 per barrel compared to the spot market.

This example illustrates how the futures price locks in a future transaction price, allowing both parties to manage their exposure to future market volatility.

Practical Applications

Futures prices are integral to many financial and commercial operations, serving diverse practical applications:

Price Discovery: Futures markets serve as central venues where a multitude of participants express their collective expectations about future asset values, making futures prices a primary source of current and anticipated pricing information. This is particularly evident in agricultural markets, where USDA projections for crop output can directly influence futures price movements.,,
*¹⁰ ⁹ ⁸ Hedging: Businesses and producers use futures prices to lock in costs or revenues for future transactions, mitigating the risk of adverse price fluctuations. For instance, an airline might buy jet fuel futures to fix its fuel costs for upcoming months.
Speculation: Traders analyze futures prices to forecast future market movements and take positions aiming to profit from anticipated price changes. This involves assessing factors that could influence the futures price, such as economic data, geopolitical events, and supply-demand imbalances.
Arbitrage: Differences between futures prices and the theoretical fair value (or between futures prices on different exchanges) create opportunities for arbitrage, where traders profit from mispricings by simultaneously buying and selling related assets.
Investment Portfolio Management: Fund managers use futures contracts to gain exposure to specific asset classes, manage portfolio duration, or implement tactical asset allocation strategies without directly buying the underlying assets.
Capital Allocation and Planning: Companies use futures prices to make informed decisions about future production, inventory management, and capital expenditures, as these prices provide critical data points for forecasting future input costs and sales revenues.

The Commodity Futures Trading Commission (CFTC), an independent U.S. government agency, plays a crucial role in regulating these markets to promote their integrity, resilience, and vibrancy, and to protect market participants from fraud and manipulation.,

#⁷#⁶ Limitations and Criticisms

While futures prices offer significant benefits for risk management and price discovery, they are not without limitations and criticisms. One primary concern is the potential for high leverage associated with futures trading. Since only a small percentage of the contract's total value (known as margin) is required to control a large notional amount of the underlying asset, even small adverse movements in the futures price can lead to substantial losses exceeding the initial margin.

Furthermore, the complexity of some derivatives, including certain futures contracts, can obscure risks., Th⁵e⁴ reliance on models for pricing and risk management also presents challenges, as these models may not always accurately capture extreme market events or sudden shifts in market volatility. Critics also point to the speculative nature of futures markets, arguing that excessive speculation can sometimes amplify price swings or disconnect futures prices from underlying fundamental values. This can create systemic risks if large positions unwind suddenly. Reg³ulatory bodies like the CFTC continuously monitor these markets to prevent manipulation and ensure fair practices, but the inherent risks of leveraged trading and complex financial instruments remain.,

#²#¹ Futures Price vs. Spot Price

The distinction between futures price and spot price is fundamental in finance. The futures price represents an agreement to buy or sell an asset at a predetermined price on a specified future date. It reflects the market's expectation of the asset's value at that future point, taking into account factors like carrying costs (e.g., storage, interest) and any benefits (e.g., dividends). Transactions at the futures price occur on an organized exchange, with contracts typically cleared through a clearinghouse.

In contrast, the spot price is the current market price at which an asset can be bought or sold for immediate delivery. It represents a transaction that takes place "on the spot." The spot price reflects the immediate supply and demand for the asset in the present market. While futures prices are forward-looking and involve a commitment for a future date, the spot price is backward-looking in that it reflects present market conditions. The relationship between the futures price and the spot price provides valuable insights into market expectations and forms the basis for various trading strategies.

FAQs

What determines the futures price?

The futures price is determined by the interplay of supply and demand for the specific futures contract on an exchange. Key factors include the current spot price of the underlying asset, the time remaining until the contract expires, prevailing interest rates, storage costs (for commodities), and any income generated by the asset (like dividends for stocks). Market expectations regarding future price movements also play a significant role.

Can the futures price be different from the spot price at expiration?

Ideally, at expiration, the futures price converges to the spot market price of the underlying asset. This convergence happens because, as the delivery date approaches, the time value component of the futures price diminishes, and the option to buy or sell for future delivery effectively becomes equivalent to buying or selling for immediate delivery. Any significant difference would present an immediate arbitrage opportunity that market participants would quickly exploit, thereby closing the gap.

Why do people use futures prices?

People use futures prices primarily for hedging and speculation. Hedgers, such as farmers or manufacturers, use futures prices to lock in a price for a future sale or purchase of a commodity, thereby reducing price risk. Speculators, on the other hand, trade futures contracts to profit from anticipated changes in the futures price of an asset, aiming to capitalize on their market predictions.

What is "contango" and "backwardation" in relation to futures prices?

Contango occurs when the futures price is higher than the current spot market price for the same asset. This is often seen in markets with carrying costs (like storage for commodities) or when the market expects future prices to increase. Backwardation is the opposite, where the futures price is lower than the current spot price. This can signal current scarcity of the asset or market expectations that its price will decrease in the future.