Commodity classroom. How futures contracts are priced

Commodities futures contract provides various direct and indirect benefits to participants across the value chain, including investors and traders. One key benefit is that futures contract helps in price discovery and offers a hedge against price risk. For you as an investor, having an understanding on the futures contract prices helps in timing your entry and exit and in hedging strategies. Here is what you should know on futures contract pricing.

Futures contract are basically a derivative contract between two parties to buy or sell an underlying (commodity) at a specific date in the future at a particular price. That is, you lock the price of a commodity, say, gold today to take delivery at a later date. The price of a futures contract is market-driven. That is, it depends on certain key factors, including demand and supply of the commodity, macro and micro economic factors, both domestic and international events, including policy and regulatory changes, currency movements, seasonality of commodities and geo-political events. The open interest of the trade participants too has an impact on the price movement. The futures price of a contract also depends on the spot price of the underlying commodity.

While at the beginning of the contract, the spot and futures price may have a wide gap, but as the contract approaches delivery, both prices converge. Now, you as a trader of futures contract have the option to either take the delivery of the underlying commodity or settle in cash at final settlement price. The difference between the buy price and this settlement price tells you whether you have gained or lost.

Settlement price

Final settlement price, also called as due date rate (DDR), is the average of the spot prices of the last few trading days when the contract nears maturity. This is the price at which all open position at expiry of a futures contract is settled. All futures contract traded in the country, except energy contracts, are compulsory physical delivery contracts. Which means, unless you want to take physical delivery, it is better to roll-over your contract. Do note that futures contract are traded in standardised contracts.

Now, for contracts that expire, the final settlement price is determined by polling of spot prices of the last few days and taking a simple average on them. This is applicable for both agri and non-agri futures contract. However, in the case of energy contracts such as crude oil and natural gas, the final settlement price is based on the settlement price of the global contract that it mirrors. For instance, the MCX WTI crude oil contract reflects the NYMEX WTI crude futures. The reason for benchmarking against international prices for contracts including crude oil or gold is because India is the price taker.

The prices are polled from market participants, including investors, traders, brokers, importers and exporters and processors, across the centres (of the exchanges) in different cities.

On the other hand, the daily profits or losses of the members are settled using the daily settlement prices. Daily settlement price for commodities futures contracts is its close price on the trading day.