Futures Spread

  

Categories: Derivatives, Trading

A futures contract involves setting up a deal now that will close at some point in the future. You're basically locking in a price at some future date. Unlike an option, you don't have the choice whether to close the deal. You've committed to the transaction...it's just not happening right now. As the name says: it's happening in the future.

A futures spread involves taking two opposite positions on the same underlying asset (usually, in this case, a commodity). So you create one futures contract to buy corn at a certain price in the future. At the same time, you create a separate futures contract to sell corn.

Why would you do that? It sounds like betting both black and red in roulette at the same time, right?

The idea is that you've spotted some price discrepancy in the market. You're using the futures spread to arbitrage the gap between the prices. You don't know if one price will go up or if the other will go down. But you know that at some point, the prices will converge. So you're playing the spread. As the price gap narrows, you'll make money.

Often, the legs of a futures spread have different time frames. You have a short-term futures contract to sell corn and a long-term future to buy corn. Or vice versa. You're taking advantage of different prices for the commodity over time. This variation of the strategy is called a "calendar spread."

Related or Semi-related Video

Finance: What is a Future Value calculat...7 Views

00:00

Finance a la shmoop, what is a future value calculation?

00:08

[Meditating]

00:10

Yeah all right that was supposed to be a Swami sorry yeah maybe this should be

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more like a mirror mirror on the wall street thing who's the futurist value of [Girl talking to the mirror]

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them all, yeah maybe not.. All right well hopefully you get the

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gist a present value that is where you take a pot of profit supposedly being [Pot of gold at the end of a rainbow]

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given to you at some point in the future 'n' years away it carries some risk and [Leprechaun at the other end of the rainbow]

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there is a current safe or risk-free guaranteed rate of return that this risk [Coins with risk on going to the Leprechaun]

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has to sit upon got it so that present value is some discount to whatever [Present value definition written on a 100 dollar bill]

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future values are coming your way, like you have an 8% risk premium that sits on

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top of a 3% safe rate of return like a government bond that guarantees you 3% [Government bond certificate]

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and if the US government bonds are wiped out well it means that we've been nuked

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and while you're just a zombie glowing in the dark so you don't worry about [3 zombies walking towards the screen]

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your investment returns at that point. All right so here's an example you're

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promised 10 grand in five years and well now you

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have to discount it back to its present value as ten grand over that 1+1 0.08 [Calculation is shown]

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plus point three, that's 1.11 to the fifth power there in the

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denominator which is combined during the math area it's a hair under 6 grand so [Loading symbol then the answer appears]

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that's the present value of 10 grand five years from now discounted back for

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risk and time all right so future value is the inverse thing I'm

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not quite the inverse math but we're getting there [The calculation is crossed out]

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Here you're just taking a given compounded number in whatever form and

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coming up with its future value like you're buying a bond that pays 5% a

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year interest and you want to know how much cash it will have thrown off in the [Money falling from the bond certificate]

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next 10 years before its principal then comes due and pays all right well you'll [Lots of money starts falling]

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add up the flows of cash and we'll say 100 grand invested that's 5 grand a year

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in interest or $2,500 twice a year all right and you nerd lingers in the back [People sat in class]

02:01

are asking whom but what about the cash you get sooner rather than later

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you could reinvest that make yet more money shouldn't that money go into the [Girl at the back of the class]

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future value calculation, well yes that distributed money just gets recompiled

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and thrown into the stone soup of future value financial calculations thank you [Guy throws cash into the pan full of soup]

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nerd lingers but a key point here in noting what the concept is of a [A bowl of soup with money in it]

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future value calculation is that there is risk and there is a risk-free rate

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and they kind of get married and sit on top of each other in a g-rated way [Guy sits on a girls knee and she kicks him away]

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they're all financial leeches against what the total future value might be so

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if we have this calculation of a hundred grand invested you can see we have ten

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years of giving five grand a year that's 50 grand in total fee add everything up [Timeline showing the investment]

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then you get your hundred grand back at the end and your total cash returns to

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you will be yes a hundred fifty thousand dollars but it's worth more than that [The total returns calculation is shown]

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because you receive the money along the way and you could invest it and gain

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more dough yeah god it's how compounding works, got it? So when in doubt consult [Hand waving over a crystal ball]

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the crystal ball or the magic mirror if you've got one. Mirror mirror on the

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future value, something like that...

Up Next

Finance: What is Spread To Treasuries?
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Spread to treasuries is an indication of risk associated with a given debt or bond offering.

Find other enlightening terms in Shmoop Finance Genius Bar(f)