How futures price affect market price

May 28th, 2008

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In our previous article, Who is to blame for surging food and oil prices?, we mentioned that institutional investors,

… through the futures market, affecting futures price, which in turn affected the spot prices (i.e. the real world market price).

Now that we have explained the basics of futures in Introduction to futures and Pricing of futures, we can now explain how those Index Speculators can affect real world market price through the futures market.

What happens, if the Index Speculators push up the price of a commodity futures above its theoretical price? When that happens, there will be an arbitrage opportunity.

Let’s say the price of a July futures is $110 when its theoretical price is $105 (i.e. spot price  of $100 + carry cost of $5). In that case, you can sell the overpriced July futures at $110 and buy the underlying at $100. When the futures expires in July, you can then sell the underlying at $110. Your arbitrage profit will be $5 ($110 futures price – $100 spot price – $ carry cost).

What if the futures price is below its theoretical price? Let’s say, the futures price is now $103 instead. You can short sell the underlying at $100, earn the carry cost $5 (e.g. interests) by holding the proceeds of the sale as cash. When the time comes to close out your short position in the underlying, you can buy the underlying at $103 when the futures expires. Your arbitrage profit will be $2 ($100 short sell proceed + $5 carry cost – $103 close out short sell position).

All these are at least true in theory. In reality, for whatever reasons, futures price can veer out of its theoretical price. It can even fall below the spot price! That phenomenon is called “backwardation.”

And one last thing. Critics of Michael Masters’ theory that Index Speculators are behind the price inflation of commodity prices will point to the fact that inventory levels had not risen considerably as a result.

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  • Pete

    I think you lost me on that one Ed 😉 … i might need to read it a few more times

    Thanks for these information-articles, they are quite good in explaining how these things work. Even for those who are familiar with these things, it helps to reinforce our understanding.

  • Pete

    I think you lost me on that one Ed 😉 … i might need to read it a few more times

    Thanks for these information-articles, they are quite good in explaining how these things work. Even for those who are familiar with these things, it helps to reinforce our understanding.

  • Alex

    One thing I’m interested in with futures – how are the underlyings hoarded? Do they store the grain somewhere?

  • Alex

    One thing I’m interested in with futures – how are the underlyings hoarded? Do they store the grain somewhere?

  • Hi Alex!

    Say, you buy July futures for grain. The person taking the other side of the trade is selling that futures to you. If it is a grain producer, then this means they are selling their future production (in July) or running down their inventory of grains in their silo. For speculators, since they are not producing any grain themselves, they could have already hedged themselves by buying the June futures for grain and closing out their positions before they expires.

  • Hi Alex!

    Say, you buy July futures for grain. The person taking the other side of the trade is selling that futures to you. If it is a grain producer, then this means they are selling their future production (in July) or running down their inventory of grains in their silo. For speculators, since they are not producing any grain themselves, they could have already hedged themselves by buying the June futures for grain and closing out their positions before they expires.

  • Clearly, you know more about futures contracts than I do. So let me bounce this “speculation” off you.
    Paul Krugman asserts that if there is no hoarding of the underlying there can’t be a “bubble” at least as he understands “bubble.” This has generated a storm of comment on his blog, none of which is as detailed or helpful as yours. More on oil and speculation
    My thought is that the index speculators intend to make money solely by being better arbitrageurs than the next guy. They try to be fully hedged and neither notice nor care whether the price of the underlying trends up or down or reaches new heights or new lows. So why have commodities prices gone up? The huge influx of money into this market drove up the price level–just as an influx of money into stock mutual funds will drive up equity prices. Does this make sense?

  • Clearly, you know more about futures contracts than I do. So let me bounce this “speculation” off you.
    Paul Krugman asserts that if there is no hoarding of the underlying there can’t be a “bubble” at least as he understands “bubble.” This has generated a storm of comment on his blog, none of which is as detailed or helpful as yours. More on oil and speculation
    My thought is that the index speculators intend to make money solely by being better arbitrageurs than the next guy. They try to be fully hedged and neither notice nor care whether the price of the underlying trends up or down or reaches new heights or new lows. So why have commodities prices gone up? The huge influx of money into this market drove up the price level–just as an influx of money into stock mutual funds will drive up equity prices. Does this make sense?

  • Hi Roger!

    In Paul’s argument the ‘supply’ refers to above-ground inventory. We have heard a counter-argument- all these excess ‘supply’ do not show up in the inventory levels because oil producers are not increasing production (i.e. supplies are hoarded below ground).

    Another argument against Paul’s argument- assuming that much of the current demand is due to speculative froth, then the downward sloping demand curve is an inaccurate representation of reality. Some will counter-argue that speculative demand is such that, as price increases, demand increases i.e. the demand curve becomes upward sloping.

    Our position is that when one reduce the intricate dynamic interaction of oil supply/demand with money supply/demand into a simple 2-line demand/supply graph for oil, it will become an over-simplication of the problem.

    And yes, we agree with you that monetary inflation is the reason for such price inflation of commodities. See How is inflation sabotaging our ability to measure the value of things?

  • Hi Roger!

    In Paul’s argument the ‘supply’ refers to above-ground inventory. We have heard a counter-argument- all these excess ‘supply’ do not show up in the inventory levels because oil producers are not increasing production (i.e. supplies are hoarded below ground).

    Another argument against Paul’s argument- assuming that much of the current demand is due to speculative froth, then the downward sloping demand curve is an inaccurate representation of reality. Some will counter-argue that speculative demand is such that, as price increases, demand increases i.e. the demand curve becomes upward sloping.

    Our position is that when one reduce the intricate dynamic interaction of oil supply/demand with money supply/demand into a simple 2-line demand/supply graph for oil, it will become an over-simplication of the problem.

    And yes, we agree with you that monetary inflation is the reason for such price inflation of commodities. See How is inflation sabotaging our ability to measure the value of things?

  • Zoo

    … all these excess ?supply? do not show up in the inventory levels because oil producers are not increasing production (i.e. supplies are hoarded below ground).

    Hi CI, does this feed into the whole argument about oil producers choosing to hold oil supplies because they are pegged to the US dollar and the US dollar is depreciating? In this situation, why would oil producers sell lots of their oil now when the relative value of money exchanged for it is so low? It would be more profitable to hold onto your oil and sell it in 2012 or so when things might be better…?

    Also, I saw an article from Friday in which the Commodities Future Trading Commission announced that it’s going to finally regulate and force traders using their markets to disclose their trading positions:

    FSA helps US clampdown on oil speculators

    I wonder whether this is going to help, or if there are still loopholes unplugged for the crack-up boomers! This will be interesting to watch.

    Another noteworthy thing in that article was that BP was recently fined $303 million by the CFTC for manipulating the propane market in 2004. That just goes to show that it IS POSSIBLE for speculators to manipulate the futures market, contrary to what some blog commentators out there are saying.

  • Zoo

    … all these excess ?supply? do not show up in the inventory levels because oil producers are not increasing production (i.e. supplies are hoarded below ground).

    Hi CI, does this feed into the whole argument about oil producers choosing to hold oil supplies because they are pegged to the US dollar and the US dollar is depreciating? In this situation, why would oil producers sell lots of their oil now when the relative value of money exchanged for it is so low? It would be more profitable to hold onto your oil and sell it in 2012 or so when things might be better…?

    Also, I saw an article from Friday in which the Commodities Future Trading Commission announced that it’s going to finally regulate and force traders using their markets to disclose their trading positions:

    FSA helps US clampdown on oil speculators

    I wonder whether this is going to help, or if there are still loopholes unplugged for the crack-up boomers! This will be interesting to watch.

    Another noteworthy thing in that article was that BP was recently fined $303 million by the CFTC for manipulating the propane market in 2004. That just goes to show that it IS POSSIBLE for speculators to manipulate the futures market, contrary to what some blog commentators out there are saying.

  • Hi Zoo!

    Hi CI, does this feed into the whole argument about oil producers choosing to hold oil supplies because they are pegged to the US dollar and the US dollar is depreciating?

    Yes, this was what we had in mind when we mentioned that.

    As one infamous Middle Eastern politician said, “They take our oil and give us a worthless piece of paper.” This argument makes sense because it is cheaper to hoard oil by keeping them below ground than to dig them up and exchange them for a depreciating currency.

  • Hi Zoo!

    Hi CI, does this feed into the whole argument about oil producers choosing to hold oil supplies because they are pegged to the US dollar and the US dollar is depreciating?

    Yes, this was what we had in mind when we mentioned that.

    As one infamous Middle Eastern politician said, “They take our oil and give us a worthless piece of paper.” This argument makes sense because it is cheaper to hoard oil by keeping them below ground than to dig them up and exchange them for a depreciating currency.

  • Hello Mr Contrarian :

    i don’t understand : are you agreeing with the critics of Michael Masters ? or are you agreeing with Michael Masters ?

    also if speculators exercise their arbitrage opportunity by buying the underlying doesn’t that then have an upward pressure on the spot price ?

    Thank you for laying these concepts out so clearly for us learners.

    Best Regards…

  • Hello Mr Contrarian :

    i don’t understand : are you agreeing with the critics of Michael Masters ? or are you agreeing with Michael Masters ?

    also if speculators exercise their arbitrage opportunity by buying the underlying doesn’t that then have an upward pressure on the spot price ?

    Thank you for laying these concepts out so clearly for us learners.

    Best Regards…

  • Hi Celal!

    i don’t understand : are you agreeing with the critics of Michael Masters ? or are you agreeing with Michael Masters ?

    To be honest, we are more inclined to agree with Michael Masters than to agree with his critics. But at the same time, it is good to have an open mind to hear what their critics has to say. The reason why we are more inclined to agree with Michael Masters stems from our Austrian School of economic thought- see our guide: What is inflation and deflation?.

    also if speculators exercise their arbitrage opportunity by buying the underlying doesn’t that then have an upward pressure on the spot price ?

    This is true, at the very least in theory. In reality, the futures market can behave very strangely, due to some reasons. For example, there backwardation can occur- that is, the futures price can go below the spot price. There are some theories and explanations to account for such anormaly.

    Thank you for laying these concepts out so clearly for us learners.

    No worrries. You’re welcome. 🙂

  • Hi Celal!

    i don’t understand : are you agreeing with the critics of Michael Masters ? or are you agreeing with Michael Masters ?

    To be honest, we are more inclined to agree with Michael Masters than to agree with his critics. But at the same time, it is good to have an open mind to hear what their critics has to say. The reason why we are more inclined to agree with Michael Masters stems from our Austrian School of economic thought- see our guide: What is inflation and deflation?.

    also if speculators exercise their arbitrage opportunity by buying the underlying doesn’t that then have an upward pressure on the spot price ?

    This is true, at the very least in theory. In reality, the futures market can behave very strangely, due to some reasons. For example, there backwardation can occur- that is, the futures price can go below the spot price. There are some theories and explanations to account for such anormaly.

    Thank you for laying these concepts out so clearly for us learners.

    No worrries. You’re welcome. 🙂