Spot Price Explained — Determining Futures Prices | by LBank Exchange | Aug, 2023

From the LBank blog.

Spot Price Explained — Determining Futures Prices

The spot price represents the present market value at which a designated cryptocurrency asset, such as Bitcoin or Ethereum, can be promptly bought or sold. Conversely, futures pricing maintains an inherent connection to the intrinsic worth of the underlying assets it pertains to. This type of pricing demonstrates movements that can mirror those observed in the prevailing market price of the asset, commonly referred to as the spot price.

The dynamic interplay between these two pricing structures has given rise to a method by which the pricing of futures contracts is ascertained, contingent upon the value of the underlying asset. Typically, disparities between the trajectories of future pricing and spot pricing can arise from various factors, including current interest rates, and the respective maturity dates of the futures contracts. Let us explore the significance of the spot price and its profound influence on the pricing of futures contracts.

The spot price is the present market value assigned to an asset with the option for immediate purchase or sale and subsequent settlement. In essence, it reflects the valuation at which sellers and buyers currently assess an asset.

While spot prices are subject to temporal and geographical variations, they tend to exhibit a notable degree of uniformity within the crypto markets. This uniformity mitigates the potential risks for traders to exploit arbitrage opportunities arising from substantial price discrepancies for the same asset across different markets.

Spot prices often assume prominence when examined within the framework of forward and futures contracts. One of the core concepts behind the derivatives is the ability to “lock in” the desired spot price of a commodity for a specified future date. This proactive approach is necessitated by the inherent volatility in supply and demand dynamics, which continually drive fluctuations in prices.

The spot price assumes a pivotal role in the computation of a futures contract’s valuation. It holds the capacity to offer insights into anticipations concerning forthcoming fluctuations in commodity prices, thereby exerting a significant influence on these futures market determinations.

The primary distinction between spot prices and futures prices lies in their respective timelines for transactions. Spot prices pertain to immediate buying and selling, while futures contracts involve postponing payment and delivery until specified future dates. Typically, the spot price is positioned below the futures price, a phenomenon referred to as contango. Conversely, there exists a condition known as backwardation, wherein the spot price surpasses the futures price.

Two essential terms to grasp in spot and futures prices are contango and backwardation. These terms refer to the shape of the forward price curve for a commodity. Contango occurs when near-month futures contracts are cheaper than those expiring further out, usually due to costs associated with storage and carrying the physical commodity. Backwardation, conversely, emerges when near-month contracts are more expensive, often reflecting supply-demand imbalances. In a situation like contango, the spot price is less than the futures price. In backwardation, the spot price is greater than the futures price.

Discrepancies often exist between the spot and futures prices of an asset. To illustrate, consider Ethereum, which may command a spot price of $2,000, while its corresponding futures price could reach $2,300. This scenario is not unique to ethereum; the variance in trading valuations can be observed across different assets. For instance, Bitcoin might be valued at $20000 within the spot market, yet the options’ strike price in the futures market could be set at $19500. This contrast may signify a more pessimistic outlook held by traders regarding Bitcoin’s future prospects.

The computation of futures prices relies on a straightforward mathematical equation that establishes a balance between the underlying asset price and the futures price.

The formula for determining futures pricing is outlined as follows:

Futures price = Spot price * (1 + rf) — d

In this context, “rf” signifies the risk-free rate, and “d” represents the dividend associated with the asset.

The “rf” component denotes the prevailing interest rate achievable over the course of a year under typical circumstances. Nonetheless, traders possess the flexibility to adjust this variable in proportion to the contract’s expiration — spanning one, two, or three months. The adapted formula assumes the following format:

Future price = Spot price * [1 + rf(X/365) — d]

In this formulation, “X” represents the number of days remaining until the contract’s expiry date.

The spot price of a cryptocurrency is the immediate buying or selling value of a coin or token. Although spot prices can exhibit disparities across different exchanges, major cryptocurrencies generally maintain consistent spot prices.

It is important to differentiate spot prices from futures prices, which means predetermined prices for the future trade of a cryptocurrency. The spot price serves as a foundational reference for determining futures prices, establishing a fundamental interrelation between the two.

Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.

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