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As long as you understand what “the futures price converges to the spot price” means.
oh thanks for the replies
i was really mad at the answer when they say futures converge to spot. i mean lets say i bought a 30 days forward at $6 when the spot is $5. i stored the commodity at my place incurring storage costs and u tell me futures converge to spot!!! what the hell did i earn for my storage costs then?!
then i realised the futures converge to spot is just to prevent arbitrage. but is my thinking as of above correct? advice???
I guess you need to specify the timeline.
Future converges to the Spot rate at time t when the Futures was actually supposed to expire.
At time 0 - you entered into a futures contract a month later for say 6$. You paid whatever (storage, etc. etc. on it).
At time t - If the futures price is Ft -> it should be equal to the St -> else there is an arbitrage opportunity.
the way i understand futures converge to spot is that from investopedia.
ok lets say there is a 1min future @ 1.10, spot at $1. so it effectively have no storage costs to speak of. so now anyone can just short the future, long spot and gain a $0.10 profit. is this right?
then how does backwardation happen then? convenience yield?
Backwardation occurs because producers , who hold real options where they can choose to produce , go long futures to hedge . The hedging pressure creates downward effects on futures prices which is called “normal” backwardation by Keynes.
There is normal backwardation and – for want of a better term – abnormal backwardation. (“Abby . . . someone.” “Abby, who?” “Abby . . . normal.”) The latter isn’t caused by hedging producers. High convenience yield can cause backwardation.
As for futures prices converging to spot prices, be certain that you understand that if you enter into a futures contract today, the futures price to which you agree today will not converge to the spot price, nor will the spot price converge to your futures price.
Futures prices converge to prevailing spot prices on expiry only . futures prices are marked to market each day , so each and every day the contract that the parties entered into is re-priced. The re-pricing happens every day up to settlement when the re-priced price equals the prevailing spot at the time , and the actual delivery or exchange can take place arbitrage free, or financial settlement is possible arbitrage free
yes! this is what i thought so as well! else there is no point to holding a future. there gotta be some returns!
i omitted the mark to market part, but i can see where u come from and it makes sense as well. thanks!
My point is that your original price doesn’t change, nor does the market care what your original price was. What changes – as janakisri pointed out – is the price of new futures that expire on the same day as yours: that price has to converge to the (moving-target) spot price or else there will be an arbitrage opportunity.
My point was definitely not that there is no point in holding a future. There most certainly is.
i put in some dates…
on Jan 1 i bought a future that expires on Feb 1 @ $1.10. from Jan 2 to Jan 30, there will be also be futures that will expire on Feb 1. but as the days to Feb 1 draw closer, (Now lets say we know for sure the spot rate on Feb 1 is $1) the prices of the future will decrease e.g. from Jan 1 $1.10 to maybe Jan 15 $1.05, eventually converging to spot of $1 on Feb 1.
ok so now my question is this, i bought a future at $1.10 on Jan 1 expiring on Feb 1, on Feb 1 itself, Spot is selling for $1. so do i have any return?
your one month return is negative 10% . you most likely have deposited margin with the exchange. Since the futures have been very volatile ( dropping steadily throughout the month ) , and your position is substantially underwater , expect a call from your broker to contribute some more margin .
The exchange decides to increase margins when the market is very volatile
At the end of each day , all the accounts are netted . Your position account and the margin account are balanced . You can take a P &L hit by exiting (i.e selling your long position in the contract) because of your astounding 10% loss .
if you’re out of the futures business at any point , any balance in the margin account is returned to you with thanks.
The margin account could have actually been reduced if you were short the futures contract, because the position would have gained. But no luck there
I get that futures price should converge to the spot price at expiry, but then In the examples in currency risk management chapter (the total return on portfolio calculation) ,I see that there is a difference between the futures price and the spot price at the time the investment is liquidated.Isnt there an arbitrage opportunity there ?
The futures contract is an agreement to deliver the underlying in the future. If you recall from Level II valuing of futures (you loved that part, didn’t you?), the value today is the spot price less the PV of the futures price (with one slight difference for currency futures; not important for this duscussion). Thus, we expect that the futures price will be higher than the spot price, by the risk-free rate. If the difference were something else, then there’s an arbitrage opportunity: cash-and-carry or reverse cash-and-carry. (Yes, I’m ignoring storage costs and convenience yield on commodity futures; they complicate things, but also work in the direction of, “probably not” on the arbitrage question.)
But we are talking about the maturity date here-the date when the investment is liquidated.Why is there a difference between spot price and futures price at contract expiration ?
There shouldn’t be any price difference at expiry. If there were: arbitrage. (Of course, what purpose is there to entering into a futures contract today for delivery today?)
Appreciate your help @s2000.
Let me be more precise. I am talking about the total return calcuation questions ( hedged ) in which we calculate the translation loss/gain and then the return on futures contract.I am confused because if the spot price and futures price converge, why are they expecting us to find the returns in two parts,shouldnt the Spot price equate future price and we directly compare the futures contract price to the spot price…