Why do futures prices converge on spot prices during the delivery month?
Prior to expiry, the price of futures contracts will most likely either be at a premium to the physical or a discount. As the contract approaches expiry these two prices will converge, or meet. Why does this happen?
There are a number of factors involved here; one of the main reasons is what’s called cost of carry. That is the futures price is equal to the cost of holding the underlying to the period of expiry. The cost of carry would normally include interest less dividends (in the case of the SPI) or storage costs (in the case of a physical commodity like wool).
As the futures get closer to expiry, the prices will naturally converge .This is because the futures price is in effect a price in the future (the price at expiry) that takes into account the cost of carry. If this premium or discount gets out of equilibrium the forces of supply and demand will react.
For example if a physical commodity is way above the futures price, this will bring in arbitragers, speculators and hedgers who will buy the “cheap” futures contract, rather than the physical commodity; this will create demand for the futures contract pushing the price up towards the physical. In addition the high price of the physical will be under pressure due to the fact that users can buy the “cheaper” futures. Less demand for the physical means the price comes down again pushing the markets towards convergence or prior to expiry a form of “balance”.
Arbitragers may also come into play and actively buy the futures and sell the physical hence locking in a profit. If the market was the other way around (where futures were at a premium far in excess of the physical) the market would be selling the futures and buying the physical.
This activity can sometimes be seen particularly in the SPI where the premium gets driven far in excess of fair value(in itself a subjective calculation),and then a few days later the arbitrage is unwound bringing the market back to equilibrium
So come to expiry time, with the cost of carry approaching zero the futures price will naturally converge to the physical price. This is especially evident in a deliverable contract where the participants must be able to buy in one market and sell in another. This has been happening for many years as futures originally began as a means for producers to hedge their commodities. It is now an enormous market full of varied products but the same principal applies no matter what you’re trading.
In cash settled contracts such as the SPI, the price convergence between the Index and the futures is automatic as there is an exchange settlement procedure so everyone gets the same price at expiry basis the cash, or spot price. This further highlights the relationship, and ultimate correlation, between the spot market and the futures market. What we are essentially discussing is “contract design”, as futures contracts are designed to expire in line with the spot or cash prices.
This doesn’t mean you should go out and buy futures if it’s below the physical price of a commodity or sell them if futures are trading higher. The market is more sophisticated than that but this is one example of a strategy you could use and monitor constantly in some circumstances. Markets are fluid and constantly changing so decide if leveraged derivatives fit your risk profile before you commence trading as the risk of loss is significant.