the Wealthy Canadian

I used to hear about futures prices and think that if March Gold Futures were trading at some price then come March the price of Gold should, reasonably, be that price.  That is not actually the case.

You can buy gold in one of two ways.

1. In the cash market, where you will pay the spot price.
2. In the futures market where you will pay the futures price.

The cash market is similar to a jewelry store.  You can go buy a gold ring today, pay cash for it and give it to your girlfriend immediately.

The futures market is sort of like going to the jeweler and saying that you will need to buy a gold ring in about three months time.  You don’t need it today, but you want to buy it today, just to make sure that you know what price you will have to pay and that they will have it for you.  What price should the jeweler sell the ring to you for?  The same price as the spot price?  No.  Remeber that the jewelry store will have to:

• store the gold for you (they promised you that exact amount and quality of gold so they have to make certain they have it when you go to collect),
• finance the cost they paid for the gold (they aren’t doing well enough to promise everyone a gold ring on the promise that they’ll buy it in the future)
• insure it (if it goes missing they still have to pay for it)

All of those are called the “cost of carrying” the physical asset.  Add all of those costs up and it may cost an extra $10/ month for them to hold onto the gold for you.  You agree because you cannot afford to buy the ring today.

Therefore,  in a normal “cost of carry market” the price for the gold ring in three months time will be the spot price plus the cost of carrying.  This normal market also has the fancy term , “contango.”

As the time goes by the futures price and the spot price will converge.  It costs 10 bucks per month to store it, so a three month agreement will cost an $30 over the spot price, but a two month agreement will only cost $20, one month is only $10, or you can buy it today without any carrying charges.

Of course, that is not always the  way it works.  Sometimes speculators get in the game, or there is a sudden shortage (or abundance) of gold, and the spot and futures prices will deviate from this contango pricing.