SPOT VS FUTURES: UNDERSTANDING PRICING DIFFERENCES

What is the Spot Price?

The spot price refers to the current market price at which an asset, such as a commodity, security, or currency, can be bought or sold for immediate delivery. In financial markets, the spot price represents the most up-to-date valuation of an asset, reflecting real-time supply and demand dynamics.

Spot markets, also known as “cash markets” or “physical markets,” involve the immediate settlement of transactions. In practice, immediate usually means within two business days, particularly in the case of currencies and some commodities. But conceptually, the spot price implies a near-instantaneous exchange, with delivery and payment occurring in close succession.

Spot prices are visible across numerous asset classes:

• Commodities: Gold, crude oil, and natural gas have widely tracked spot prices, reported daily or even minute-by-minute.
• Foreign Exchange (Forex): The spot price refers to the current exchange rate for a currency pair, such as EUR/USD.
• Equities: In share dealing, the spot price is the real-time valuation of a stock on the exchange.

The spot price is determined by the interaction of buyers and sellers on the market. Prices can fluctuate rapidly due to factors like geopolitical developments, changes in interest rates, central bank actions, or fundamental supply chain disruptions.

Because it reflects the value of an asset "right now", the spot price is used as a benchmark across various forms of trading. However, depending on the structure of the market and the time horizon in question, other types of pricing—most notably futures pricing—can differ significantly and serve different purposes.

Investors and traders monitor spot prices to gauge market trends, value investments, and compare against future pricing to understand expectations, inflation implications, and investor sentiment. In some instances, arbitrage opportunities may arise when spot prices differ from the perceived “fair value” indicated by futures contracts.

Overall, the spot price acts as the foundational reference from which many financial derivatives are priced and assessed.

What are Futures Prices?

Futures prices represent the agreed-upon value for the delivery of an asset at a specified future date. These prices are determined on futures exchanges through contracts that stipulate the quantity and quality of the underlying asset, a delivery date, and a price.

Unlike spot prices, which are anchored in present-day market dynamics, futures prices attempt to predict or incorporate expectations about where the value of an asset might be at some point in the future. As such, futures pricing is not only influenced by current supply and demand but also by factors such as:

• Cost of carry: This includes storage costs, insurance, interest rates, and other expenses incurred from holding the asset until the future delivery date.
• Interest rates: In many financial theories, such as the cost-of-carry model, interest rates are fundamental to calculating fair futures prices.
• Expected demand and supply shifts: Anticipated changes in market conditions, production levels, geopolitical current events, or seasonal factors all influence futures valuation.

For example, if traders anticipate that oil prices will rise due to unrest in an oil-producing region, the futures price for oil may exceed the current spot price. On the other hand, if there is an expectation that a forthcoming wave of supply will lower prices, futures may trade at a discount.

Futures contracts are traded on highly liquid exchanges such as the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE), and they standardise many aspects of the trade to ensure consistency and liquidity. These include:

• Contract size and tick value
• Maturity date and settlement terms
• Grading or quality parameters for commodities

Importantly, the vast majority of futures contracts are not held until physical delivery. Instead, they are often rolled over or closed out by taking an opposite position in the market before expiration. This means most futures trading is used for speculation or hedging rather than actual commodity delivery.

Hedgers—such as farmers, airlines, or producers—use futures to lock in prices ahead of time to manage price risk. Speculators, in contrast, trade directionally on the expected future price movements to realise profits.

In summary, futures pricing encompasses a range of expectations and embedded costs, making it inherently forward-looking compared to the more instantaneous nature of spot pricing. This explains why divergences between spot and futures prices frequently arise in financial markets.

Why Spot and Futures Prices Differ

Understanding why spot and futures prices do not always align is essential for traders, investors, and analysts. The differences primarily arise due to the time horizon involved, as well as cost and market expectations baked into futures contracts. This price gap is commonly known as the "basis."

The Role of the Cost of Carry

One of the most fundamental reasons for the price difference is the cost of carry. This refers to all the expenses associated with holding (carrying) the asset until the delivery date in the futures contract. These expenses include:

• Storage Fees: Particularly relevant for physical commodities like oil, metals, or grain.
• Insurance and Security: To protect the value of held assets.
• Financing Costs: Opportunity costs or interest paid for the capital tied up in owning the asset.

All these costs contribute to a futures price that may be higher than the spot price in what is called a contango market. Essentially, the higher costs of carrying the asset justify a premium on future delivery contracts.

Market Expectations and Sentiment

For financial and commodity futures, markets are also influenced by expected price changes. For example, if inflation is forecast to rise, traders might expect higher future prices across asset classes, pushing futures prices above current spot values. The opposite scenario—where futures trade at a discount—is referred to as backwardation, and it may reflect expectations of oversupply, falling demand, or temporary shortages today not expected to persist.

Market Arbitrage and Efficiency

Where enough liquidity and access to capital exist, traders may take advantage of price discrepancies between spot and futures markets through arbitrage strategies. These involve the simultaneous purchase of an asset in one market and its sale in another to exploit these differences. Although arbitrage opportunities can diminish the gap over time, structural and behavioural factors often ensure the spot-futures differential remains an active feature of markets.

Interest Rate Influence

Futures pricing for financial instruments, especially bonds and currencies, is also significantly affected by interest rates. According to interest rate parity and other pricing models, the future value of an asset today should account for the time value of money. For instruments like currency pairs, interest rate differentials between countries heavily impact futures premiums or discounts.

Real-World Example

Consider the crude oil market. Suppose the spot price is $70 per barrel, but the 6-month futures contract is trading at $73. This $3 differential reflects storage costs, insurance, and projected market tightness. Alternatively, if the same futures contract trades at $67, it could be a signal that short-term market disruptions are pushing up spot prices temporarily, with future expectations more bearish.

It’s crucial to note that the relationship between spot and futures is dynamic. Changes in interest rates, policy announcements, seasonal demand, geopolitical events, and investor positioning continually affect both prices. Some asset classes like gold, oil, and major currencies frequently exhibit changing degrees of contango and backwardation within short time frames.

Ultimately, the spot-futures difference provides insight into investor sentiment, supply chain expectations, and macroeconomic factors. While arbitrage keeps these differences in check to some extent, structural inefficiencies, risk premiums, and behavioural biases can sustain differentials longer than expected.