What Is a Futures Contract? Chapter 2.

 A futures contract is a legally binding agreement between two parties in which:

• One party agrees to buy, and
• The other party agrees to sell

…a specific quantity of an underlying asset at a pre-agreed price on a specified date in the future.

These contracts are standardized and traded on exchanges, which ensures:

• liquidity, and
• ease of execution for both buyers and sellers.

Importantly, by buying or selling a futures contract, you're entering into a binding agreement, even if all you’ve seen is a price chart and the order book.

However, you're not required to hold the contract until it expires — you can exit it partially or entirely at any time by closing or reducing your position.

That’s how it all started historically, and that’s still how it works.

Why Do Futures Prices Differ From Spot Prices?

There is a specific pricing model in futures markets called the Cost of Carry model, much like the Black-Scholes model in options pricing.

This model explains the relationship between futures prices and spot prices of underlying assets.

The cost of carry reflects the combination of several factors — not just the time remaining until expiration.

📐 General Futures Pricing Formula:

F = S × e^(r + c - y) × T

Where:

• F — futures price
• S — spot price of the underlying asset
• r — risk-free interest rate
• c — cost of carry (e.g., storage costs)
• y — yield from owning the asset (e.g., dividends)
• T — time to contract expiration

This is a generalized model that incorporates all major variables affecting futures pricing.

Key Factors Affecting Futures Pricing:

1. Risk-Free Interest Rate (r)
2. By buying a futures contract instead of the underlying asset, you retain capital that can be invested at a risk-free rate. This adds to the futures price.
3. Storage Costs (c)
4. These include insurance, warehousing, and other physical storage-related expenses. For commodities like oil or wheat, these can significantly increase the futures price.
5. Yield from Ownership (y)
6. If the underlying asset pays dividends (stocks) or coupons (bonds), owning the futures contract means missing out on that yield. Hence, futures may trade at a discount.
7. Risk Premium & Market Expectations
8. If market participants anticipate future price volatility, they may price in a premium or discount to compensate for risk.
9. Speculative Activity
10. The futures market often attracts speculators. Their collective expectations of future price movements can lead to temporary deviations from theoretical prices.

Conclusion:

A futures contract is not just a price forecast tool — it's a sophisticated financial instrument whose price reflects:

• Time value
• Interest rates
• Asset yield
• Storage costs
• Market psychology and risk

Now you know why futures prices differ from spot prices — and even the name of the pricing model to reference in a conversation.