Question

We also discussed that the difference between a spot price and a futures price (i.e. the basis) for storable commodities should be given primarily by cost of carry and transportation cost. Let us say that the spot price for corn in Lincoln is $3.45/bu, while the futures price for May delivery is $3.82/bu. Now let us assume that the cost of carry is $0.03/bu/month, while the transportation cost between Lincoln and the delivery area of the futures market is $0.20/bu. Based on these costs for carry and transportation, does it make sense to have the basis given by the spot and futures prices above? Why? Explain in detail, step-by-step, what will happen with the spot price, futures price, and the basis.

Answer 1

The principal of the market states that there should be no arbitrage in the efficient market and there is any arbitrage then mechanism of an efficient market will quickly neutralize that situation.
If any asset price futures is trading at an above than natural premium than its spot price then traders and speculators will start to short or sell futures of that asset while going long or buying on the spot price.
The selling pressure will bring down the futures price of that asset while buying will push up the spot price of the same asset which will negate any natural premium.

In the above example, the futures price for May is trading at $3.82 while the spot price $3.45. The month of the spot price is mentioned but transportation and cost of carry are given as $0.20 and $0.03 per month.
This gives us $3.68 as a total price and that means the futures price is trading at $0.14 premium.
3.82 - ( 3.45 + 0.20 + 0.03 ) = 0.14

Obviously, this is not natural and traders will start shorting futures price while going long on the spot contracts. This will push down futures price while raising the spot price and that should stabilize at $3.75.

However, It is important to note that there is also a financing charge which also needs to be taken into consideration in such calculation. If the interest rate is 6% per year then a monthly financing charge of 0.5% of contract value is also taken into account.