Fundamentals of Futures - Price Discovery RSS Feed

The Process of Price Discovery

CME Group — Wed, 24 Sep 2008 10:25:00 EST

In the cash market (OTC), banks will “set” the prices between buyers and sellers. Exchanges, however, do not set prices. Rather, prices are “discovered” through the open exchange between buyers and sellers.

1.Buyers bid prices at which they are willing to purchase
2.Sellers ask prices at which they are willing to sell

Spot Pricing: OTC or Cash Market

CME Group — Wed, 24 Sep 2008 10:20:00 EST

The spot price is the price quoted for immediate settlement (payment and delivery). Depending on the type of underlying asset, spot prices relate to future price movements for different reasons:

1.Non-perishable commodities = difference reflects future cash flows (interest, earnings)
2.Perishable commodities = difference reflects storage costs and obsolescence

Convergence of Spot and Futures Price

CME Group — Wed, 24 Sep 2008 10:15:00 EST

As the delivery period for a futures contract is approached, the futures price converges to the spot price for the underlying asset. When the delivery period is reached, the futures price nearly equals the spot price as traders exploit the difference between the future and spot prices. This activity increases as the expiration date of the future approaches.

Arbitrage in the Markets

CME Group — Wed, 24 Sep 2008 10:05:00 EST

Arbitrage is the simultaneous purchase and sale of equivalent commodities (either cash or futures) in different markets in order to profit from price discrepancies.

1.Further refines the process of price discovery
2.Adds to liquidity in the market
3.Disappear quickly (minutes or seconds)