The process of futures and spot prices approaching one another is called convergence. Normally, the contract price of a futures contract is higher than the current price of the underlying asset (normally a commodity).
The futures contract price is higher because of the effect of the time value of money. As the expiration date nears, the spread between the spot price and the futures contract price becomes smaller and smaller. On the delivery date of the contract, the futures and spot prices should be equal.
What Is Convergence?
Convergence is the movement of the price of a futures contract toward the spot price of the underlying cash commodity as the delivery date approaches.
Convergence simply means that, on the last day that a futures contract can be delivered to fulfill the terms of the contract, the price of the futures and the price of the underlying commodity will be equal. The two prices must converge. If not, there is an opportunity for arbitrage and risk-free profit.
Convergence happens because the market will not allow the same commodity to trade at two different prices at the same place at the same time. For example, you rarely see two gasoline stations on the same block with two very different prices for gas at the pump. Car owners will simply drive to the place with the lowest price.
In the world of futures and commodities trading, big differences between the futures contract (near the delivery date) and the price of the actual commodity are illogical and contrary to the idea that the market is efficient with intelligent buyers and sellers. If significant price differences did exist on the delivery date, there would be an arbitrage opportunity and the potential for profits with zero risk.
The idea that the spot price of a commodity should equal the futures price on the delivery date is straightforward. Purchasing the commodity outright on Day X (paying the spot price) and purchasing a contract that requires delivery of the commodity on Day X (paying the futures price) are essentially the same thing. Buying the futures contract adds an extra step to the process:
- Buy the futures contract
- Take delivery of the commodity
Still, the futures contract should trade at or near the price of the actual commodity on the delivery date.
If these prices somehow diverged on the delivery date, there is probably an opportunity for arbitrage. That is, there is the potential to make a functionally risk-free profit by purchasing the lower-priced commodity and selling the higher-priced futures contract—assuming the market is in contango. It would be the opposite if the market were in backwardation.
Contango and Backwardation
If a futures contract’s delivery date is several months or years in the future, the contract will often trade at a premium to the expected spot price of the underlying commodity on the delivery date. This situation is known as contango or forwardation.
As the delivery date approaches, the futures contract will depreciate in price (or the underlying commodity must increase in price), and in theory, the two prices will be equal on the delivery date. If not, then traders could make a risk-free profit by exploiting the difference in prices.
The principle of convergence also applies when a commodity futures market is in backwardation, which happens when futures contracts are trading at a discount to the expected spot price. In this case, futures prices will appreciate (or the price of the commodity falls) as expiration approaches, until the prices are nearly equal on the delivery date. If not, traders could make a risk-free profit by exploiting any price difference via arbitrage transactions.