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How do Futures prices relate to the underlying asset?​

Futures prices are derived from the underlying asset, but they can differ due to factors like interest rates, storage costs, and expectations about future supply and demand. The relationship between futures and the underlying asset is driven by cost of carry, arbitrage opportunities, and market sentiment.

Spot Price vs. Futures Price

Spot Price – The current market price of the underlying asset for immediate delivery.
Futures Price – The agreed-upon price for delivery of the asset at a future date.

Key Relationship:

Futures Price = Spot Price ± Carrying Costs ± Market Expectations

If futures are trading higher than the spot price, it’s called contango.
If futures are trading lower than the spot price, it’s called backwardation.

Factors Affecting Futures Prices

1. Cost of Carry (Storage, Interest Rates, and Insurance Costs)

  • Futures prices typically include the cost of carrying the asset until expiration.
  • This includes storage costs (for commodities), interest rates, and insurance costs.
  • Higher carrying costs → Higher futures prices.

Example: Gold Futures (GC)
  • If gold spot price = $2,000/oz, and storing it costs $10 per month,
  • A 3-month futures contract might be priced at $2,030 ($2,000 + $10 × 3 months).

2. Expectations of Future Supply & Demand

  • If traders expect higher future demand or lower supply, futures prices may rise above spot (contango).
  • If traders expect oversupply or lower demand, futures prices may drop below spot (backwardation).

Example: Crude Oil Futures (CL)
  • If OPEC announces production cuts, traders may expect higher future oil prices, pushing futures prices up.
  • If global demand weakens, future prices may trade below spot (backwardation).

3. Interest Rates & Opportunity Cost

  • Holding futures requires less capital than owning the asset outright (no need for full cash upfront).
  • Traders may prefer futures over spot purchases, leading to a premium in futures prices.
  • Rising interest rates increase futures prices, as carrying the underlying asset becomes more expensive.

Example: S&P 500 Futures (ES) & Interest Rates
  • If interest rates increase, investors may choose futures over stocks to avoid tying up capital.
  • This demand can push S&P 500 futures prices higher relative to the cash index.

4. Arbitrage Opportunities

  • If futures prices deviate too far from the underlying asset, traders exploit arbitrage opportunities.
  • Arbitrage ensures futures prices stay closely aligned with fair value.

Example: Stock Index Arbitrage
  • If S&P 500 futures are too high vs. cash index, traders short futures and buy stocks, pushing futures back in line.

Key Takeaways 

Futures prices are linked to the underlying asset but can differ due to costs and expectations.
Cost of carry (storage, interest rates) increases futures prices.
Market expectations about supply & demand impact futures prices.
Arbitrage traders keep futures prices close to fair value.
Contango = Futures price above spot; Backwardation = Futures price below spot.
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