Convergence

What Is Convergence?

Convergence is the movement of the price of a futures contract close to the spot price of the underlying cash commodity as the delivery date draws near.

Grasping Convergence

Convergence essentially means that, on the last day that a futures contract can be delivered to satisfy the terms of the contract, the price of the futures and the price of the underlying commodity will be equivalent. The two prices must combine. If not, there is an opportunity for arbitrage and risk-free profit.

Convergence happens on the grounds that the market won't permit a similar commodity to trade at two distinct prices at a similar place simultaneously. For instance, you rarely see two gasoline stations on similar block with two altogether different prices for gas at the pump. Vehicle owners will basically head to the place with the most reduced price.

In the world of futures and commodities trading, big differences between the futures contract (close to the delivery date) and the price of the genuine commodity are counter-intuitive and as opposed to the possibility that the market is efficient with intelligent buyers and venders. In the event that critical price differences existed on the delivery date, there would be a arbitrage opportunity and the potential for profits with zero risk.

The possibility that the spot price of a commodity ought to rise to the futures price on the delivery date is direct. Purchasing the commodity outright on Day X (paying the spot price) and purchasing a contract that requires delivery of the commodity on Day X (paying the futures price) are basically exactly the same thing. Buying the futures contract adds an extra step to the cycle:

1. Buy the futures contract
2. Take delivery of the commodity

In any case, the futures contract ought to trade at or close to the price of the real commodity on the delivery date.

Assuming these prices some way or another separated on the delivery date, there is presumably an opportunity for arbitrage. That is, there is the possibility to create a practically risk-free gain by purchasing the lower-priced commodity and selling the more expensive futures contract — expecting the market is in contango. It would be the inverse in the event that the market were in backwardation.

Contango and Backwardation

On the off chance that a futures contract's delivery date is several months or years later, the contract will frequently trade at a premium to the expected spot price of the underlying commodity on the delivery date. This situation is known as contango or forwardation .

As the delivery date draws near, the futures contract will devalue in price (or the underlying commodity must increase in price), and in theory, the two prices will be equivalent on the delivery date. In the event that not, then traders could create a risk-free gain by taking advantage of the difference in prices.

The principle of convergence likewise applies when a commodity futures market is in backwardation, which happens when futures contracts are trading at a discount to the expected spot price. In this case, futures prices will appreciate (or the price of the commodity falls) as expiration draws near, until the prices are almost equivalent on the delivery date. If not, traders could create a risk-free gain by taking advantage of any price difference through arbitrage transactions.

Features

• The price of the futures contract and the spot price will be generally equivalent on the delivery date.
• Convergence is the movement in the price of a futures contract toward the spot or cash price of the underlying commodity after some time.
• Risk-free arbitrage opportunities rarely exist in light of the fact that the price of the futures contract meets toward the cash price as the delivery date draws near.
• In the event that there are huge differences between the price of the futures contract and the underlying commodity price on the last day of delivery, the price difference makes a risk-free arbitrage opportunity.