Question

We also discussed that the spread (difference) between two futures prices for a storable commodity should be given by the cost of carry between the two delivery months. Let us think about the spread between the corn futures prices for March delivery and May delivery, i.e. a 2-month difference in delivery time. Now assume the cost of carry is $0.025/bu/month, and the futures prices are $3.74/bu for March delivery and $3.82/bu for May delivery. Can we have this spread between the two futures prices given the cost of carry of $0.025/bu? Why? Explain in detail, step-by-step, what will happen with the two futures prices and the difference between them.

Answer 1

Answer:

Market Principal notes that there should be no arbitration in the efficient market unless there is some arbitration so an efficient market system can quickly neutralize the situation.

The futures market for May, in the example above, is trading at $3.82 while the spot price is $3.45. The spot price month is listed but carriage costs and transportation are given as $0.20 and $0.03 per month.

This gives us a total price of $3.68 and this means the futures market is priced at a premium of $0.14.

3.82-= 0.14 (3.45 + 0.20 + 0.03)

This is not normal, of course, and traders will start shortening futures prices when going on the spot contracts for long. This would drive down the price of the futures while increasing the spot price, which should stabilize at $3.75.

Nevertheless, it is necessary to remember that in such equation there is also a borrowing fee which must also be taken into account. If the interest rate is 6 percent a year so it also takes into account a monthly finance fee of 0.5 percent of the contract value.