how future prices in and commodities effect the spot prices of and commodities?

 

  • JFM 1:01 pm on March 12, 2010

    Futures prices affect spot prices through arbitrage. Arbitrage is the practice of taking advantage of a price differential between two or more markets to make a risk-free profit.

    In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate (the "asset with a known future-price", as above). Thus, for a simple, non-dividend paying asset, the value of the future/forward,F(t) , will be found by accumulating the present value at time t to maturity T by the rate of risk-free return r. (see the wikipedia article below for the formula).

    If the spot price and the futures price deviate from this formula, you can make a risk-free profit. Examples are available at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/futurearb.htm

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