In general, the **fair price** for a [[forward contract]]
is the **current cash price** + **the costs of buying now** - **the benefits of buying now**.
-> However, this can vary depending on the particular situation.
``the current cash price + the costs of buying now - minus the benefits of buying now.``
## Forward price
To understand the “forward price” better, let’s take an example:
You have a friend who wants to buy land to build a restaurant. He’s considering buying it now or buying it in 1 year through a forward contract.
If he buys it now, he’ll have to pay the asking price of $100k
But if he buys it through a [[forward contract]]
There is also a tiny oil well on the property that pumps oil at $500 per month, and the oil provides a monthly revenue source.
He’ll have to pay the costs of buying now, including the interest on the cash price, the real estate taxes, and the interest on the taxes.
He also knows that if he buys it now, he will have to borrow $100k from the local bank with an interest rate of 8%.
8% * $10k = $8k
If he buys the land now, he’s charged $2,000 in property taxes due in nine months. He would need to borrow $2,000 from the bank for the remaining three months of the forward contract to pay the taxes.
$2000 + ($2000 * 8% * 3/12) = $2000 + $40
He will get $6000 in oil money from a little oil well on the property plus interest on that revenue.
($500 * 8% * 11/12) + (500 * 8% * 10/12) + ... + ($500 * 8% * 1/12) = $220
The total benefits of buying now are the oil income plus the oil revenue’s interest rate:
$6000 + $220 = $6220
The current cash price: $100000
+ cost of borrowing: + $10040
- benefits buying now: - $6220
Traders in “forward” or “futures” contracts sometimes refer to the “basis,” the difference between the “cash price” and the “forward price.”
$100 000 - $103 820 = -$3820
In most cases, the basis will be a negative number. The cost of buying now will outweigh the benefits of buying now. However, in our example, the “basis” will turn positive if the oil price rises enough.
How should the fair forward price for exchanges for exchange-traded futures contracts be calculated? That depends on the cost and benefits associated with the position in the underlying contract.
### main factors for the fair forward price
There are 4 main factors to consider when calculating the fair forward price of a contract:
1. The [[interest rate]]: This is the cost of borrowing or lending money.
2. The [[storage cost]]: This is the cost of storing the underlying commodity.
3. The [[convenience yield]]: This is the benefit of having the commodity now rather than later.
4. The [[dividend yield]]: This is the benefit of receiving dividends from the underlying asset.
In **most cases**, the **fair forward price** will be **lower** than the current **spot price**.
* *-> This is because the **costs of buying** now typically **outweigh the benefits**.
If you buy a physical [[commodity]], you will have to pay the current price together with the interest on this amount. Additionally, you will have to store the commodity until the [[maturity]] of the [[forward contract]].
The fair forward price for a physical [[commodity]] is the current cash price + the interest on this amount, the storage costs, and the insurance costs all multiplied by the time to maturity of the forward contract.
C = commodity price
t = time to maturity of the forward contract
r = interest rate
s = annual storage costs per commodity unit
i = annual insurance costs per commodity unit
The forward price F can be written as F = C × (1 + r × t) + (s × t) + (i × t)
Initially, it may **seem** that there are **no benefits** to buying a physical commodity, so the basis should always be negative.
But sometimes the opposite occurs . A [[futures contract]] will **trade at a discount** to the spot price.
If the spot price of a commodity is greater than a futures price, the market is backward or in [[backwardation]].
**[[Backwardation]] : When?**
This seems illogical because the [[interest rate]] and [[storage cost]] will always be positive.
How about considering a company that needs a [[commodity]] to keep its factory running? If the company cannot obtain the commodity, it may have to take the very costly step of temporarily closing the factory. In the company's view, the cost of such drastic action may be prohibitive.
To avoid this situation, the utmost important interested company may be willing to pay an inflated price to obtain the [[commodity]] right now.
If commodity supplies are tight, the price that the company may have to pay could result in a backward market . The spot price will be greater than the price of a [[futures contract]].
The benefit of obtaining a commodity right now is sometimes referred to as a [[convenience yield]]. It can be challenging to assign an exact value to the [[convenience yield]]. however, if interest costs, [[storage cost]], and insurance costs are known, a trader can infer the [[convenience yield]] by observing the relationship between the cash price and futures price
Some of the risks associated with trading commodities in a [[backwardation]] market include:
1) The possibility of having to make physical [[delivery]] of the commodity. If the [[futures contract]] expires and the market is still in [[backwardation]], the trader may have to pay for [[storage cost]] and insurance costs while holding the [[commodity]].
2) The possibility of the market moving out of [[backwardation]] before the contract [[expiration date]]. If this happens, the trader will be stuck with a [[futures contract]] at a higher price than the spot price of the commodity.
3) The possibility of the market going into [[contango]] before the contract expires. This could lead to the trader having to sell the commodity at a lower price than the spot price.
4) The possibility of the market going into [[contango]] and staying there until the contract expires. If this happens, the trader will have to pay storage and insurance costs on the commodity while it is in storage.