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Futures curves II

Futures Curves II. Created by Sal Khan.

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  • blobby green style avatar for user Alex Narayan
    The price of the contract when it comes time to deliver converges to the spot price but how does that make sense when a futures contract states the price at which the commodity is to be transacted at?

    The value of the contract taken out today for delivery in 4 months is about 34 dollars an ounce. But in four months the value of that contract is closer to the spot price but the parties involved still agreed to buy or sell the commodity at 34 dollars an ounce, is that not what the price is? Or does this go back to mark-to-market and the margins somehow?
    (9 votes)
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    • leaf green style avatar for user Ryan
      Technically each day every single futures contract is closed and a new one is opened.

      For example, lets say you buy a futures contract for delivery in 4 months that is currently trading at 34 dollars. At the end of the first trading day the contract closes at 35 dollars. That dollar is added to your margin account by the clearinghouse, the contract is closed and a new one is opened up for trading the next day at 35 dollars. This process repeats itself all the way up until delivery. So, the actual delivery will happen at the spot price, but your account will have gains or losses equal to the difference between the spot price and your original purchase price. So, in the end it works out to being the same.
      (13 votes)
  • mr pink red style avatar for user 425brandon
    For some reason I'm not quite getting this and how the two graphs relate. Is the graph on the right showing the reality of what happened and the left showing what you paid at that time (for instance, the guy that paid the 4 month future price at $34 actually paid more than he should have?)
    (4 votes)
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    • aqualine ultimate style avatar for user Abdulaziz.Saja
      The green dot on the left graph represents a 4-month future contract for silver delivery @ $34. The right graph shows the movement of the spot price of silver as time goes on (the real price so to say). What Sal is saying is that the future contract itself will be out of the money (nobody would want to buy it) as it approaches the 4-month maturity limit cuz why would anyone buy a future contract that is expiring in let's say a week with a delivery price of $34 when silver is trading now @ roughly $32? So the contract itself will converge with the spot price meaning that the value of the contract will decrease by $2 so that even if the delivery price is what it states ($34) the buyer would still only pay $32.

      Hope that clears it up :)
      (6 votes)
  • orange juice squid orange style avatar for user FishHead
    Are futures and options similar in that you're essentially paying a premium for the time values?
    (4 votes)
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    • duskpin seed style avatar for user davinci.rishi
      Yes, but the option comes with a premium because it limits the potential loss an investor can make to the amount of the premium paid. If an investor buys a call option and the price of the underlying reduces, the call option will expire worthless; however the investor will have lost only the premium paid. In a futures contract, in a similar situation, the investor will lose money equal to the difference between the agreed price in the futures contract initially, and the current market price.
      (3 votes)
  • blobby green style avatar for user muhtarmurawut
    i still don't get the idea in this video. especially about convergence?
    (3 votes)
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    • duskpin seed style avatar for user davinci.rishi
      The futures price for a commodity and its current spot price will differ today. The difference between the futures price and the spot price will reduce as time progresses because the uncertainty and the risk associated with the time period goes down as time elapses.
      Put it like this: if the futures price to buy gold were $1400/oz for a week from today, and the spot price were $1450/oz, would you go for the futures contract? Probably not, because you'd think: how much could the price fluctuate in a week's time? But if the same price was quoted for a year from today, you'd be dealing with a much higher degree of uncertainty, a much higher level of risk, and thus, the price of the futures contract would also be further away from the spot price, probably something like $1300/oz.
      (1 vote)
  • aqualine seed style avatar for user K B
    How the prices of futures are determined?
    (1 vote)
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  • leaf green style avatar for user Jon lim
    Just to clarify, in the beginning of the video, you mentioned spot price is the current price now. So essentially is the spot price essentially the market price of a commodity? just in a different nomenclature?
    (1 vote)
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  • blobby green style avatar for user Cata Chi
    I read all questions still not get the video. The first graph green dot meaning we agree to pay 34 dollar to delivery in 4 months. The second graph is 'how much future contract worth' ? for green dot, how do you know after 4 months it will go to 32 dollars month 0 spot price? what it it go to 30 dollars?
    (1 vote)
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  • blobby green style avatar for user Donovan Woods
    I thought that the "futures" price is the exercise price that is fixed. When you say the 'futures' price is converging to the spot over time, are you referring to the price that the contract is traded on in the secondary market? What am I not understanding?
    (1 vote)
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  • starky ultimate style avatar for user Max
    Since futures usually get closer down to the commodity price, that price would have to go up significantly in order to make a profit on the future, right? So investing in the commodity would have a higher return. Is this difference in return due to cantango?
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      If you invest in the commodity, you will end up paying less than if you used a future. However, if you invest in the commodity, you will also have to pay for storage, and since the purchase is delayed, you can invest your money in other things in the meantime.
      (1 vote)
  • piceratops seedling style avatar for user Nishita
    This might be a stupid question, but I am struggling to understanding this concept of convergence of futures prices upon spot prices. Does that mean that (using the previously cited example) if the apple farmer and pie shop agree today to buy/sell X amount of apples for say $100 two months from now, then in 2 months the market or spot will equal about $100? If that's the case, wouldn't we always be able to predict future market prices of commodities, simply by looking at futures quotes?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      No, that's not what it means.
      What it means is that if you and the farmer want to make a contract for tomorrow instead of two months from now, that price you agree on for tomorrow (future price) is going to be really close to the price today (the spot price)
      Likewise, it means that if you sell a 2 month futures contract today at a high price, and it turns out that two months from now the spot price is low, the price of that contract has to fall to match the spot price at that time. It won't fall all of a sudden. It will converge gradually as the expiration date gets closer and it becomes clearer and clearer what the actual spot price is going to be.
      (0 votes)

Video transcript

Voiceover: I want to use this video to try to get a better intuition for futures curves and in particular to understand that the futures curves shows a snapshot in time of the different market prices for the, essentially the delivery price at different future dates and when I say that, I know it was a kind of confusing statement. In this futures curve right over here, when you have a delivery date that's 0 months from now, that's essentially today, that's the market price. That is the actual market price of that commodity. In this example, the commodity is silver. So if you were to go out and buy silver today, it would cost you roughly $32, let me say that this is per ounce. It would cost you $32 per ounce. When I say one out here, this is one month in the future. I'm not talking about the price. I'm not talking about the spot price of silver in a month. I'm talking about the price today in the market, if you were to agree to buy or sell silver in a month. The futures price for a delivery one month out, that's what that is right now. So I want to make it very clear. This is not showing you how the spot price of silver will move over the next eight months. It's telling you today. If you wanted to transact in silver right now, you would transact at $32 an ounce. If today you agree to transact in silver a month from now, you would transact, you would buy or sell, it looks at around $33 an ounce. If today you were to agree to buy or sell silver four months from now, you would do it at $35 an ounce. If today, I don't want to be redundant, but if today you were to agree buy or sell silver eight months from now and you were to lock in the price, you would lock in a price, it looks it about I don't know, $36 an ounce. So this is really a snapshot in time and if for example, let's say tomorrow, the price of silver, there's this huge silver shortage or people realize a new application for silver that can change the world then what you would have tomorrow is that this whole curve would probably shift up. The whole curve would shift up something like that, so no matter when you decide to actually transact in the silver, it'll actually get more expensive but I want to make it very clear that this is just a snapshot in time and to better understand that, I've also drawn over here how the prices can move it over time and I've drawn different durations. So in purple right over here, I've drawn the spot price. So this is the spot price today and over here, this is the spot price today but then I've shown how it changes in time. So this is kind of closer to a traditional stock chart. This just tells us that look, the stock price started at $32 and went up a little bit, went down a little bit. It kind of just goes up and down, oscillates a bit over the next eight months. So this is actual movement over time. This is a snapshot of delivery dates at some point in the future. So the spot price just moves around and let's just take this green contract right over here. So when we start on the first day, the green contract, if you agree to transact in silver four months from now, you're agreeing to transact at about $34. So that's where you would transact right now, that four month out contract, but as you move few - as you move more and more forward in time, you're getting closer and closer to that delivery date. If you move one month into the future, now that contract is only going to be three months out. You move two months in the future, now that contract is only two months out. All the way until, if you move four months out, this contract will now be essentially the spot price because you're now agreeing to transact now. That'll happen four months from now, but you'll now be agreeing to transact at that moment and so at that moment, that price should be the same as the spot price, so you'll have this convergent with the spot price and the same thing for the eight month out contract, it should converge over the next eight months.