Spot and Futures prices - Financial futures
If you want to buy a security, you have a choice. You can buy it for immediate delivery
at the spot price. Alternatively, you can place an order for later delivery; in this case you
buy at the futures price. When you buy a financial future, you end up with exactly the
same security that you would have if you bought in the spot market. However, there are
two differences. First, you don’t pay for the security up front, and so you can earn
interest on its purchase price. Second, you missout on any dividend or interest that is
paid in the interim.
Spot and futures prices- commodities
The difference between buying commodities today and buying commodity futures is
more complicated. First, because payment is again delayed, the buyer of the future earns
interest on her money. Second, she does not need to store the commodities and,
therefore, saves warehouse costs, wastage, and so on. On the other hand, the futures
contract gives no convenience yield, which is the value of being able to get your hands on
the real things. The manager of a supermarket can’t burn heating oil futures if there’s a
sudden cold snap, and he can’t stock the shelves with orange juice futures if he runs out
of inventory at 1 P.M. on a Saturday.
Forward contracts
Each day lot of futures contracts are bought and sold. This liquidity is possible only
because futures contracts are standardized and mature on a limited number of dates each
year.
Fortunately there is usually more than one way to skin a financial cat. If the terms of
futures contracts do not suit your particular needs, you may be able to buy or sell a
forward contract. Forward contracts are simply tailor-made futures contracts. The main
forward market is in foreign currency.
It is also possible to enter into a forward interest rate contract. For example, suppose that
you know that at the end of six months you are going to need a three-month loan. You
worry that interest rates will rise over the six-month period. You can lock in the interest
rate on that loan by buying a forward rate agreement (FRA) from a bank. For example,
the bank might offer to sell you a six-month forward rate agreement on three-month
LIBOR (London Inter Bank offered Rate) at 7 percent. if at the end of six months the
three month LIBOR rate is greater than 7 percent, the bank will pay you the difference; if
three-month LIBOR is less than 7 percent, you pay the bank the difference. The total
principal amount of FRAS outstanding is several trillion times.