Spot price
The spot price is the current market price at which a commodity can be bought or sold for immediate delivery, derived from supply and demand. Commodity derivatives exchanges need daily spot prices because the futures contracts on their platforms are built on the spot market. Exchanges disseminate these prices and use them to determine the final settlement price, which matters most when a futures contract is cash settled or when a short seller defaults on delivery.
Basis
Basis = Spot price - Futures price
- Because commodity derivatives rest on the spot market, basis tracks how closely the two prices move together.
- Spot 1,02,000 and futures 1,04,040 give a basis of minus 2,040.
Contango and backwardation
| Contango | Backwardation | |
|---|---|---|
| Prices | Futures price higher than spot price | Futures price lower than spot price |
| Basis | Negative | Positive |
| What participants may expect | Spot price to rise in the near future | Spot price to fall in the near future |
Contango is the usual state for a commodity that costs money to store: the futures price carries the storage and financing cost on top of spot. Backwardation, futures below spot, signals that participants expect spot to come down, or that immediate supply is tight. Match the word to the direction, not to a feeling about which is good or bad.
Cost of carry
Buying a commodity today and holding it until the delivery date of a futures contract costs money: storage, insurance, transportation, financing and other relevant expenses. That total is the cost of carry, and it is what separates a fair futures price from the spot price.
F = Spot + Spot x Cost of carry rate x (Months to delivery / 12)
- Ten grams of gold at 1,02,000 in the spot market, cost of carry 8% a year, three-month contract.
- F = 1,02,000 + 1,02,000 x 8% x 3/12 = 1,02,000 + 2,040 = 1,04,040.
The same gold with the same 8% carry, but delivery in six months: F = 1,02,000 + 1,02,000 x 8% x 6/12 = 1,02,000 + 4,080 = 1,06,080. Double the holding period, double the carry.
Delivery
Financial instruments settle in demat form. Commodity futures are deliverable contracts: on expiry, the contract is settled by delivery of the commodity from seller to buyer, which is why exchanges maintain approved warehouses and why the spot-based final settlement price matters when a seller fails to deliver.
- Spot price is the current price for immediate delivery, set by supply and demand, published daily by exchanges and used for the final settlement price of futures.
- Basis equals spot price minus futures price.
- Contango: futures above spot, participants may expect spot to rise. Backwardation: futures below spot, participants may expect spot to fall.
- Cost of carry covers storage, insurance, transport, financing and other costs of holding the commodity until delivery; fair futures price equals spot plus carry for the period. Commodity futures settle by physical delivery.