Spot Price vs Forward Price: What the Gap Is Made Of

The spot price is what the reference asset costs for delivery now, Rs 2,000.00/- on these figures. The forward price is what it costs for delivery on a later date, Rs 2,130.00/- for one year out. The whole of the Rs 130.00/- between them is the cost of holding the reference asset for that year, so the gap is an arithmetic cost rather than a view about the future.

Two prices. One thing. Neither of them wrong. Almost every mistake made with these two numbers starts in the same place. Somebody assumes that a single item can only have one correct price at a time, and then hunts for a reason why this one apparently has two.

The two figures are prices for two different transactions. One transaction hands the reference asset over now and takes the money now. The other agrees a number now and does everything else on a stated day in the future. Different transactions, different prices, both true at the same instant on the same clock. Once that much is accepted, the only remaining question is a narrow and completely answerable one: what does it cost to bridge the time between the two? The answer to that question is the entire difference between Rs 2,000.00/- and Rs 2,130.00/-, and it is worked out below rather than asserted.

Everything below uses one invented reference asset at a spot price of Rs 2,000.00/-, with financing running at 6.50 per cent a year, and holding it hands its holder nothing at all during the year.

What is the spot price, for a reader arriving here first?

The spot price is the figure a single unit of the reference asset changes hands at, for delivery now. On these invented numbers it is Rs 2,000.00/-. Somebody hands over the money, somebody hands over the reference asset, and the transaction completes inside the ordinary short window that anything struck for immediate delivery runs through. A price is a figure that a transaction is actually done at. It is not a value, not an estimate and not what anybody reckons the thing is worth.

Hold that word carefully. Four labels run right through this subject, and blurring any two of them does real damage. A price is a figure that gets quoted or agreed. A premiumMoney handed over at the outset so that somebody can take up a position. A forward arrangement carries none. changes hands at the outset so somebody can take up a position, and a forward arrangement carries none. A payoffWhatever a position hands over once its settlement day arrives, measured before the entry cost is stripped out again. is whatever a position hands over once its settlement day arrives. A profitThat same payoff with everything spent on the way in stripped back out. Where entry cost nothing at all, the two figures coincide. is that same payoff with the entry cost stripped back out. Rs 2,000.00/- belongs squarely in the first of the four labels, and naming which label applies before reaching for any figure is the habit that keeps a cost from being mistaken later on for an outcome.

Now the part that trips people, and it is worth slowing down for. The word now, in the phrase delivery now, does not mean this instant. Nothing anywhere settles in an instant. The phrase means the transaction was struck for immediate delivery and is simply taking its normal course through whatever settlement arrangements apply to it. How long that course runs is set by the Securities and Exchange Board of India (SEBI) at sebi.gov.in, it differs by what is being transacted, and it changes.

What is the forward price, for a reader arriving here first?

The forward price is the figure two parties settle on today, covering an exchange that will not happen until a named day further out. On these numbers it is Rs 2,130.00/- for a date one year ahead. The two parties write that number down today, and when the named day arrives one of them supplies a unit of the reference asset and the other supplies Rs 2,130.00/-, whatever the spot price has done in the meantime.

Both sides are boundCommitted to go through with it. Reading the price on the agreed morning and deciding the deal has soured gives neither side any way out. the moment the number is written down, and neither may decline when the day comes. There is no escape clause on either side of this. If the spot price has collapsed to Rs 1,600.00/-, the buyer still pays Rs 2,130.00/-. If it has climbed to Rs 2,400.00/-, the seller still accepts Rs 2,130.00/-. The obligation is perfectly symmetrical even though the outcome will be violently lopsided, and there is no version of this arrangement in which somebody holds a choice.

And nothing is paid to agree it. Readers skip this property more often than any other, and everything below turns on it. No premium is handed over to strike a forward price. No deposit. Nothing at all. Two parties exchange promises, and promises are free to make. So Rs 2,130.00/- is a price, in exactly the same sense that Rs 2,000.00/- is a price. The forward price is not the cost of anything, not a fee, not a charge, and not something one party buys from the other. Both figures sit in the same one of those four labels, and that is precisely why they can be compared at all.

Here is the everyday version, and it repays a minute. A household planning a wedding for next winter walks over to the caterer in August and pins down the rate a plate. Not a grain of rice has been cooked. Not a rupee has left anybody's hands. The household and the caterer have put one figure on paper and accepted that the figure now holds them both. Come the wedding, the household pays that rate whether food has become dearer or cheaper, and the caterer takes it on identical terms. A forward price is exactly that, struck between two named parties across a kitchen table, and the arithmetic below is the same arrangement with the cost of waiting made explicit.

What is the difference between the two actually made of?

The difference has an answer that can be produced from the three inputs rather than argued about. Asked the useful way round: a buyer wants one unit of the reference asset in hand one year from today. There are two routes to that outcome, and only two.

1. Route one, agree a price today for delivery next year. The buyer signs a forward agreement, hands over nothing today, and pays the agreed number on the date. Whatever that number turns out to be, no money has been parted with for twelve months.
2. Route two, buy it today with borrowed money and sit on it. The buyer pays Rs 2,000.00/- now, which the buyer does not have, so it is borrowed at 6.50 per cent a year. Twelve months later the buyer is holding the reference asset and owes the lender the principal plus a year of interest.

Both routes end with one identical unit of this reference asset resting in one identical pair of hands on one identical day. So the second route settles exactly what the first one has to cost, and it settles it by multiplication rather than by opinion. Taking 6.50 per cent of Rs 2,000.00/-, the year of borrowing runs to Rs 130.00/-. Stacked on the amount started from, the total reads Rs 2,130.00/-. Rs 2,130.00/- is what having the reference asset in hand one year out costs somebody who takes route two, and route one therefore has to be priced at the same figure.

Notice what is absent from that expression, and notice it deliberately rather than in passing. There is no term for what either party thinks. There is no term for what the market thinks. No probability, no distribution and no expected value was ever needed to build the number, so none of the three is in it. Two prices, one rate, one period. Those four numbers are the whole apparatus.

Two ordinary things had to be true for that argument to work, and neither of them is exotic. The first is that the reference asset can be bought today and held. The second is that holding it costs money to finance while handing back not a rupee to whoever is holding it in the meantime. Take away the second and the arithmetic changes. The direction of the gap, worked through below, turns on exactly that.

The shaded cell in the bottom right is the only one carrying a rupee figure, and that is not a design flourish. Shifting the payment date costs nothing by itself. Shifting the delivery date costs nothing by itself. The combination is what costs something. The seller has to have the reference asset available on the later date, so somebody is financing it in the meantime, and financing is not free.

A number reachable only one way is a number that cannot be checked, so the same arithmetic runs backwards. Subtracting the two prices: Rs 2,130.00/- less Rs 2,000.00/- leaves Rs 130.00/-. Multiplying instead: Rs 2,000.00/- times 0.065 is Rs 130.00/-. The same Rs 130.00/- appears whether the financing is added on or one price is taken away from the other, and that agreement is what shows the gap contains financing and nothing else. If there were anything else in it, a premium for uncertainty, a margin for somebody's opinion, a cushion, the two routes would not land on the same figure.

One more consequence falls straight out of that, and it is the reason anybody bothers pinning the number down at all. Suppose somebody offers to sell the reference asset forward, one year out, at Rs 2,090.00/-. The offer is accepted. The acceptor then turns round, raises Rs 2,000.00/- on credit, takes a unit off the market this morning, keeps it for twelve months, hands it over under that same agreement, and collects Rs 2,090.00/-. The financing bill is Rs 130.00/-, so Rs 2,130.00/- is owed and Rs 2,090.00/- has been received. Rs 2,130.00/- owed against Rs 2,090.00/- received is the wrong way round. Reversing the seat shows who gains: whoever sold that unit at Rs 2,090.00/- has handed Rs 40.00/- away for nothing. The forward price is the level at which nobody is giving anything away. The level anybody expects is a different thing entirely.

Is the gap a fixed number of rupees, or a proportion?

Readers get this question wrong more often than any other in the comparison, and getting it wrong is not harmless. Having met Rs 130.00/- once, it is very natural to file it away as the gap, a fixed quantity attached to this reference asset, the way a delivery charge might be. The gap is nothing of the kind. The gap is a slice of the price for delivery now, sized at 6.50 per cent of whichever figure that price is standing at, so it shifts every time that figure shifts, on days when the rate has not budged and not one person has revised an opinion.

Work it at two more levels rather than taking that on trust. Feed Rs 1,600.00/- through the same multiplier: financing for the year comes to Rs 104.00/-, so the price for the later date reads Rs 1,704.00/-. Now Rs 2,400.00/-: financing totals Rs 156.00/-, taking the later price to Rs 2,556.00/-. Three spot prices, three different gaps, one unchanged rate of 6.50 per cent a year throughout.

The last column, read downwards, does not move. The middle column, read downwards, travels Rs 52.00/- from top to bottom, from Rs 104.00/- up to Rs 156.00/-. Same rate, same year, same reference asset, and a gap that is half as wide again at the bottom of the table as at the top. The reason is not subtle once stated: financing a larger amount for the same length of time simply costs more. Borrowing Rs 2,400.00/- for a year is dearer than borrowing Rs 1,600.00/- for a year, and by exactly the proportion the rate implies.

The second expression is worth more than it looks. Auditing a quoted price for a later date, rather than simply swallowing it, has no other route. Given two prices, the rate reads straight back out. Rs 130.00/- measured against the Rs 2,000.00/- it was struck on returns 0.065, and 0.065 across twelve months is the 6.50 per cent a year the worked example began with. Suppose that division had returned 14 per cent a year where financing is known to run at 6.50 per cent a year. Something inside that quote is not financing, and finding out what would be the next thing to do. Hardly anybody performs the step, and the rarity is exactly what makes performing it worth something.

The two lines never cross and never converge on this record's figures, and both facts have the same single cause. Financing is only ever added to the price for delivery now, never taken off it, so the two lines cannot cross for as long as nobody holding the reference asset collects a paisa from it. What is being added is a slice of a base that is itself moving, so the two lines cannot stay a constant distance apart either.

When does each of the two prices actually get paid?

Everything in this sequence is organised around four moments, and two of them are easiest to see side by side here. When is the obligation struck? When does the money actually move? When does the reference asset move? And what sits in the space between? Asked of each price in turn, those four questions stop the comparison being abstract.

For the price for delivery now, all three moments collapse into one: the obligation, the money and the reference asset all land today. The buyer agrees Rs 2,000.00/-, pays Rs 2,000.00/-, and receives the unit. There is no space between anything, so there is nothing to finance and nothing to add.

For the price for a later date, the obligation lands today and the other two land a year from today, with a completely empty stretch in between. The buyer agrees Rs 2,130.00/- and then, for twelve months, nothing whatever happens. No money is collected. No unit is delivered. Nothing is even recorded. On the morning the number is agreed, not one rupee has been spent by either party, and that emptiness is not a gap in the arrangement, it is the arrangement.

Here is the household version, and it is exact rather than approximate. One household walks to the ration shop today and buys a sack of rice: money out tonight, rice in the kitchen tonight. Another household walks to the same shop and agrees today what it will pay for a sack in March: no money out tonight, no rice tonight, and a number written down on paper. Both households have done something real. Only one of them is lighter in the pocket this evening. And the shopkeeper who agreed the March number has to think about what it costs to have a sack of rice available in March. The cost of having a sack ready in March is the whole of the Rs 130.00/- in a smaller and more familiar dress.

One more thing follows from that empty stretch. Because nothing moves for twelve months, each side is carrying the other by name for the whole of that period. The counterpartyThe specific party sitting opposite once an arrangement is signed. The word denotes one identifiable business, never a market in general. has to still be there and still be able to perform on the day. Whether a counterparty performs is a real consideration and is set out under counterparty risk.

Does the gap say anything about where the reference asset is going?

No. Not a syllable. Three separate reasons make that true, and each is worth having in full rather than the assertion repeated louder.

First reason: the calculation never asks anybody anything. Go back to the two routes. Route two bought the reference asset today and borrowed the money, and every input to that route is observable today: a price of Rs 2,000.00/-, a rate of 6.50 per cent a year, a period of one year. At no point does the arithmetic pause to consult a view. There is no line in it where somebody's opinion could enter even if they wanted to insert one.

Second reason: the number moves when the rate moves, and says nothing new about the reference asset when it does. Suppose financing fell to nil overnight while the spot price sat exactly where it was. The gap would collapse to nothing and the price for the later date would come to rest at Rs 2,000.00/-, level with the price for delivery now. Has anybody's view of the reference asset changed? Not one person's. A quantity that swings on a financing rate while opinion holds perfectly still is a cost, not an opinion.

Third reason: the gap moved in the table above while nobody said a word about anything. Look back at the table. The gap ran from Rs 104.00/- to Rs 156.00/-, a travel of Rs 52.00/-, purely because the base underneath it moved from Rs 1,600.00/- to Rs 2,400.00/-. If a widening gap meant rising confidence, then that table would be a record of confidence rising, and it plainly is not: it is one multiplication performed three times.

What would put the price for a later date below the price for delivery now?

The question is a good one and the answer is precise, so it deserves the mechanism rather than a shrug. Go back to route two one final time. Somebody buys the reference asset today with borrowed money and holds it for a year. Their bill at the end is the borrowing. But suppose the thing they are holding sent them money during that year. A receipt of that kind comes off the bill. The holder is no longer carrying the full financing out of their own pocket.

A payment received while the reference asset is held subtracts from the carry, and a large enough payment would take the carry below nil and put the price for the later date underneath the price for delivery now. That is the entire mechanism, and it turns on one thing and nothing else: whether holding the reference asset pays its holder anything.

A holder of this record's reference asset picks up nothing at all over the twelve months, so these figures cannot be made to produce that case. What can be said is the direction: the case exists and it turns on a receipt during the holding period. Working it through is a separate subject.

Two near misses get offered as answers to that question, and neither works. A very strong view that the reference asset is about to fall will not put the later price below the price for delivery now. The calculation has nowhere for a view to sit. And a shorter period will not do it either: shortening the wait shrinks the financing towards nil and squeezes the two prices together, but it never pushes one under the other. Only a receipt during the holding period can flip the order, and this record does not have one.

Who actually uses this, and for what?

The comparison earns its keep only if it changes what somebody does on a Tuesday afternoon. Four ordinary hands put it to use.

A treasurer at a business that has to have the reference asset next year uses the gap as a budgeting number, not as an outlook. The question in front of them is not whether the price is going up. The question is what it costs to have the thing available on the day they need it, and that is a financing question with a financing answer. When somebody quotes them a price for the later date, their first move is to strip the price for delivery now out of it and divide the remainder by that same price, then look at whether the answer resembles a financing rate at all. On these figures that division returns 0.065, matching the rate, so the quote reconciles. An answer coming back far larger holds something besides financing inside it, and establishing what that something is comes before agreeing to anything.

An analyst reading somebody else's note uses the gap as a check on the writer. When a note says the gap between the two prices shows the market expects a rise, the analyst can now do the arithmetic in their head and see that the claim has no content: the gap is the financing rate applied to the price for delivery now, and it would be there on a day when everybody in the market was certain the thing was about to halve. The arithmetic is not a small skill, and it is the difference between reading a note and being led by one.

A lender looking at a business that has agreed a lot of these reads the timing rather than the price. The important fact about an agreement struck at Rs 2,130.00/- is not the number. The important fact is that nothing has moved yet and a full year of nothing is still to come, with the business committed, its counterparty committed and neither having posted anything. Timing and performance are what a lender reads here, and the Rs 130.00/- is the least interesting thing in the arrangement for that purpose.

And the household version stays useful even at a wedding scale. A household that fixes a rate a plate in August is doing exactly what a treasurer does, at a size they can feel. The caterer's number carries the cost of having the thing ready in December, and the household's useful question is whether that cost looks like a cost. The household is not buying somebody's forecast of December prices, and that is the whole point. Nobody at that kitchen table is selling one.

One point of vocabulary gets muddled the moment quantities get bigger than one unit. If a business agrees forty of these at Rs 2,130.00/-, the notionalThe headline size an arrangement gets measured against, found by multiplying the number of units by the agreed figure. None of it need have travelled anywhere. is Rs 85,200.00/-, and not a rupee of that has gone anywhere at all. The exposureThe amount that genuinely shifts as the reference asset shifts, being the number of units multiplied by the price for delivery now. is what genuinely shifts with the reference asset, forty units measured at Rs 2,000.00/-, and it comes to Rs 80,000.00/-. Print either figure under the other one's name and the arrangement has been misdescribed in language that sounds precise.

Which parts of this are set by an authority in India?

What is not settled here?

Having compared two prices, the natural next question is which one to transact at. The straight answer is that the question is put together wrongly.

The two figures are prices for two different transactions, so which one applies depends entirely on when the reference asset is needed, and that is a fact about the buyer rather than a fact about either price. Needed this week, only one of the two figures is even available. Needed next November, the other one is the one that can be acted on. Neither price is the better price, in the same way that neither a bus ticket for today nor a bus ticket for next month is the better ticket. The two tickets go on different days.

Behind that sits a second question, and it is whether anybody ought to be entering either arrangement in the first place. Answering it would take a result, a run of years and a likelihood of something happening, and an arithmetic identity between two prices supplies none of the three. Neither arrangement has turned out yet, so neither can be ranked by how it turned out. Grasping how a figure is assembled has never been a reason to go and transact at it.

Four things would have to be established before that question even became answerable. Why the position is being carried at all. Which other positions already sit beside it. How much collateral, if any, has gone in. And what comes due on the morning the money finally changes hands. Not one of the four is an opinion about a price, and none can be settled by staring at the distance between Rs 2,000.00/- and Rs 2,130.00/-.

The reference asset, both prices attached to it, the rate financing it and every party mentioned are invented.
Educational material. Not advice on any investment, tax, budget or market position.