Page 229 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Mechanism in Futures Contracts:

1. Buy a future to agree to take delivery of a commodity. This will protect against a rise in
price in the spot market as it produces a gain if spot prices rise. Buying a future is said to
be going long.
2. Sell a future to agree to make delivery of a commodity. This will protect against a fall in
price in the spot market as it produces a gain if spot prices fall. Selling a future is said to be
going short.
A futures contract is a contract for delivery of a standard package of a standard commodity or
financial instrument at a specific date and place in the future but at a price that is agreed when the
contract is taken out. Certain futures contracts, such as on stocks or currency, settled in cash on
the price differentials, because clearly, delivery of this particular commodity would be difficult.
The futures price is determined as follows:
Futures Price = Spot Price + Costs of Carrying
The spot price is the current price of a commodity. The costs of carrying of a commodity will be
the aggregate of the following:
1. Storage
2. Insurance

3. Transport costs involved in delivery of commodity at an agreed place.
4. Finance costs, i.e., interest forgone on funds used for purchase of the commodity.
Basis = Futures – Spot Price

Figure 8.1: Futures Contracts – Contango and Backwardation

Futures
Price

Contango

Spot
Price

Backwardation

Delivery Time Time
Although the spot price and futures price generally move in line with each other, the basis is not
constant. Generally, the basis will decrease with time. And on expiry, the basis is zero and
futures price equals spot price. If the futures price is greater than the spot it is called contango.
Under normal market conditions futures contracts are priced above the spot price. This is known
as the contango market. In this case, the futures price tends to fall over time towards the spot,
equalling the spot price on delivery day. If the spot price is greater than the futures price it is
called ‘backwardation’. Then the futures price tends to rise over time to equal the spot price on
the delivery day. So in either case, the basis is zero at delivery. This may happen when the cost
of carry is negative, or when the underlying asset is in short supply in the cash market, but there
is an expectation of increased supply in future, for example agricultural products. The direction
of the change in price tends to hold for cycles of contracts with different delivery dates. If the
spot price is expected to be stable over the life of the contract, a contract with a positive basis will
lead to a continued positive basis although this will be lower in nearby delivery dates than in

224 LOVELY PROFESSIONAL UNIVERSITY