Examine Spot Prices versus the Futures Index - dummies

By David Stevenson

Whenever you watch TV reports about increasing commodity prices, the spot price of the commodity usually gets a mention (sometimes followed by an off-the-cuff, grim warning about future riots and the collapse of global civilisation!).

Although spot prices are certainly useful as a reference price, most commodity market participants (investors in mining companies, industrial buyers and hedge funds) focus on a very different set of numbers — the price of futures contracts with durations ranging from a few days or a month forward through to many years hence. These futures prices are absolutely essential when understanding the changing prices on the key commodity indices.

In the jargon of the commodity trade, these commodity indices measure the total return of something called a non-leveraged (no loans involved) futures portfolio. This term means that the full contract value of a futures contract — not just the margin requirement — nominally secures each position in the index. Talk of non-leveraged futures may sound confusing but in reality the key issue is that you’re investing in a futures contract.

Imagine a futures index for gold where the spot price of each ounce is $1,900. You have two parties to a futures contract:

  • Producers of gold want to make sure that they have a good idea of the price their future production of gold is going to fetch and may even sell the rights to future production now in order to lock-in prices.

  • Buyers of gold such as Indian jewellers want to lock-in a decent price now for in three months’ time.

These two sides agree a price for 3 or even 12 months in the future, or anything in-between. To secure the purchase, the gold buyer may pay an option price — after all, in this case the jeweller is simply buying a futures-based option on a commodity — and then deposit the rest of the final payment as a deposit in the form of Treasury bills.

This way, the buyer locks-in the price and the producer receives payment. Add up all these non-leveraged futures contracts and you have a futures index.