Why is there a difference between spot price and future price?

Spot Price vs. Future Price: Understanding the Difference

In financial markets, prices play a crucial role in determining the value of assets. Among the various types of prices, spot prices and future prices stand out as distinct indicators of current and anticipated market conditions.

Spot Price: A Snapshot of the Present

Spot prices represent the prevailing market value of an asset at a specific point in time. They reflect the balance between immediate supply and demand and are often used for immediate transactions. Spot prices are quoted for assets such as stocks, commodities, and currencies.

Future Price: A Window into the Future

Future prices, on the other hand, are estimates of the price at which an asset is expected to trade on a future date. They incorporate market expectations, including forecasts of future supply, demand, interest rates, and economic conditions. Futures are traded on futures exchanges, where buyers and sellers enter into contracts to deliver or receive assets at a predetermined price and date.

Divergence Between Spot Prices and Future Prices

Due to the inherent time element involved, spot prices and future prices often differ. This divergence arises from several factors:

• Carrying Costs: Futures prices include the cost of carrying the asset until the delivery date. These costs may include storage, insurance, and financing. As a result, future prices are typically higher than spot prices, reflecting the additional expenses incurred.
• Market Expectations: Future prices embed market participants’ expectations of future supply and demand. If investors anticipate an increase in demand and limited supply, future prices will be higher than spot prices. Conversely, if supply is expected to increase or demand to decline, future prices will be lower.
• Interest Rates: Interest rates play a role in determining the divergence between spot and future prices. Higher interest rates make it more expensive to borrow money and store assets. This leads to lower future prices because investors prefer to hold their assets in cash to earn interest.

Implications for Investors

Understanding the relationship between spot prices and future prices is essential for investors. Spot prices provide insights into the current market conditions, while future prices offer a glimpse into market expectations. By analyzing both spot and future prices, investors can make informed trading decisions, hedge against price fluctuations, and capitalize on arbitrage opportunities.

Conclusion

Spot prices and future prices are two distinct but complementary metrics that reflect different aspects of the financial market. While spot prices capture the immediate market value, future prices provide a forecast of future market conditions. Understanding the divergence between these prices allows investors to navigate the markets effectively and make sound financial decisions.