The Difference Between Cash and Futures Prices

Futures are contracts to buy or sell specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.

Futures are normally traded in contracts and are a legally binding agreement between a buyer and a seller. The seller must deliver the specific agreed upon asset at a future date but for the price agreed today.

Futures markets allow companies and individuals to protect themselves against fluctuations in the price of an asset that they are interested in. This allows them to sell an asset in advance giving them the ability to make plans for the future in the knowledge that they have a fixed price.

Futures have been with us for a long time. The first use of futures can be traced back to 1650’s during the Tokugawa era in Japan. Feudal lords used to collect rents from their tenants in the form of rice.

Not only would they trade the rice that they had collected but also, they would often trade their future rice delivery. This was the start of what became the Dojima Rice Market. Even today rice futures can be traded but the range of the market has expanded to include many other things.

Because of the costs involved with the physical ownership of an asset such as storage and transportation the price between the cash market and the futures market differ. The difference in price is normally called the cost of ownership.

Ownership implies the cash market where you have additional costs, which leads to a difference between the cash price and the futures price where you don’t have these costs.

As the delivery date nears, the difference between the cash price and the futures price will narrow and on actual delivery date the two prices will be very similar.

Like many other markets you also do not need to necessarily own the asset before you sell it. You can sell a futures contract just as easily as you can buy it.

Because futures have been around for such a long time nearly all markets around the world that trade in futures are highly regulated. The fundamental principle of a future is fairly simple.

You buy or sell something at today’s price for delivery in a future date. This can prove to be extremely valuable to farmers and organizations to protect themselves against future fluctuations in price.

Here are few examples of futures exchanges market:

1) Chicago Board Of Trade (CBOT Established 1848 and founded by 82 Chicago Merchants)

2) Chicago Mercantile Exchange (CME Established 1919. Originally The Chicago Butter and Egg Board which was founded in 1898 which then developed into the CME)

3) London International Futures and Options Exchange (LIFFE Established 1982 and is now one of the world largest exchanges)

Source: Martin Chandra
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