Difference Between Spot Price and Future Price
Difference Between Spot Price and Future Price
Futures are derivative products whose value depends largely on the price of the underlying stocks or indices. However, the pricing is not that direct. There remains a difference between the prices of the underlying asset in the cash segment and in the derivatives segment. This gap exists because of several factors like time, interest rates, and market expectations.
To understand this better, it's important to first look at how the spot and futures prices differ in structure and purpose.
Key Differences Between Spot Price and Future Price
While both spot and futures prices are connected to the same underlying asset, they serve different purposes and behave differently in the market. Here’s a quick comparison to understand how they differ:
Meaning
Time component
Purpose
Volatility
Price Influencers
| Spot Price | Futures Price | |
|---|---|---|
Meaning | The current market price of an asset for immediate delivery. | The agreed-upon price for delivery of the asset at a future date. |
Time component | Reflects the price as of today. | Includes the time until expiry and factors like interest and cost of carry. |
Purpose | Used for real-time buying or selling. | Used for speculation, hedging, or locking in prices for the future. |
Volatility | Can be more volatile due to real-time market movements. | May reflect broader market expectations and trends. |
Price Influencers | Demand and supply in the cash market. | Spot price, interest rates, storage costs, and expected price movements. |
Settlement | Immediate (typically T+1 or T+2 depending on market). | Occurs on a predetermined future date (contract expiry). |
Understanding Contango and Backwardation
Futures prices can sometimes be higher or lower than the spot price of an asset. This variation depends on market expectations, time to expiry, and carrying costs. Two common terms used to describe this relationship are contango and backwardation.
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Contango: Contango is a situation where the futures price is higher than the spot price. This often occurs when there are costs associated with holding the asset, such as storage, insurance, or financing. These costs get added to the spot price, pushing the futures price up. Contango is common in commodity markets where carrying costs are significant.
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Backwardation: Backwardation happens when the futures price is lower than the spot price. This may reflect a strong short-term demand or limited supply in the current market. In such cases, market participants may be willing to pay more today than at a later date.
Both contango and backwardation are natural outcomes of how the market perceives future conditions. They also help explain why futures prices don’t always move in sync with spot prices.
Spot Price vs Future Price: An Illustration
To better understand the difference between spot and futures prices, consider a simple example from the commodity market.
Suppose the spot price of gold today is ₹60,000 per 10 grams. This is the price at which gold can be bought or sold in the market for immediate delivery.
Now, assume that a futures contract for gold maturing in three months is trading at ₹61,200 per 10 grams. This price reflects not just the current value of gold but also includes carrying costs, such as storage charges, insurance, and interest, along with market expectations for the coming months.
The ₹1,200 difference between the futures and spot price is a result of these factors. If this contract is in contango, it means the market expects the future price to be higher than today’s due to such costs and assumptions.
This simple example shows how futures prices often differ from spot prices — not because of any error, but because they reflect future expectations and associated costs.
The difference between the spot and futures prices, as seen in the above example, isn’t random. It can often be explained using simple pricing models that factor in the costs and returns of holding an asset over time. One of the most widely used frameworks for this is the Cost of Carry Model.
What Is the Cost of Carry Model?
The Cost of Carry Model assumes that markets tend to be perfectly efficient. This means there are no differences in the cash and futures price. This, thereby, eliminates any opportunity for arbitrage – the phenomenon where traders take advantage of price differences in two or more markets.
When there is no opportunity for arbitrage, investors are indifferent to the spot and futures market prices while they trade in the underlying asset. This is because their final earnings are eventually the same.
The model also assumes, for simplicity’s sake, that the contract is held till maturity, so that a fair price can be arrived at.
In short, the price of a futures contract (FP) will be equal to the spot price (SP) plus the net cost incurred in carrying the asset till the maturity date of the futures contract.
FP = SP + (Carry Cost – Carry Return)
Here, Carry Cost refers to the cost of holding the asset till the futures contract matures. This could include storage cost, interest paid to acquire and hold the asset, financing costs etc. Carry Return refers to any income derived from the asset while holding it like dividends, bonuses etc. While calculating the futures price of an index, the Carry Return refers to the average returns given by the index during the holding period in the cash market. A net of these two is called the net cost of carry.
The bottom line of this pricing model is that keeping a position open in the cash market can have benefits or costs. The price of a futures contract basically reflects these costs or benefits to charge or reward you accordingly.
Now, do note that while the Cost of Carry Model works well for assets that can be stored or carried, not all futures contracts fit into this framework. In some cases, the futures price is shaped more by what the market expects the spot price to be at a future date. This is where the Expectancy Model comes in.
What Is the Expectancy Model of Futures Pricing?
The Expectancy Model of futures pricing states that the futures price of an asset is basically what the spot price of the asset is expected to be in the future. This means, if the overall market sentiment leans towards a higher price for an asset in the future, the futures price of the asset will be positive. In the exact same way, a rise in bearish sentiments in the market would lead to a fall in the futures price of the asset. Unlike the Cost of Carry model, this model believes that there is no relationship between the present spot price of the asset and its futures price. What matters is only what the future spot price of the asset is expected to be. This is also why many stock market participants look to the trends in futures prices to anticipate the price fluctuation in the cash segment.
What Is Basis?
At a practical level, you will observe that there is usually a difference between the futures price and the spot price. This difference is called the basis.
If the futures price of an asset is trading higher than its spot price, then the basis for the asset is negative. This means, the markets are expected to rise in the future.
On the other hand, if the spot price of the asset is higher than its futures price, the basis for the asset is positive. This is indicative of a bear run on the market in the future.
Conclusion
Spot and futures prices may be linked to the same underlying asset, but they often differ due to various factors such as time, cost of holding, and market expectations. This difference is a natural part of how derivative markets function.
Understanding the key differences between spot and futures prices, along with concepts like contango, backwardation, and the models that explain futures pricing, can help build a stronger foundation for anyone interested in how the markets operate.
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FAQs on Difference Between Spot & Futures Pricing
Do options contracts have spot prices and futures prices?
Yes, options contracts have spot and future prices. The spot price is the existing market price. Whereas the future price is the predetermined price for the delivery of underlying assets.
What is a contango in futures trading?
Contango refers to a condition when the futures price of commodities is higher than the spot price. Contango generally happens when the price of an asset is expected to rise over time.
Where should I trade commodities, the spot market or the futures market?
You may trade in the spot market if you want immediate delivery of assets. However, if you want to get the underlying asset after some time, you can trade in the futures market. You can also sell the futures contract without taking the delivery of assets.
This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in securities market are subject to market risks, read all the related documents carefully before investing. Brokerage will not exceed SEBI prescribed limit. The securities are quoted as an example and not as a recommendation. SEBI Registration No-INZ000200137 Member Id NSE-08081; BSE-673; MSE-1024, MCX-56285, NCDEX-1262.
