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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