What Drives Futures Prices?
Futures contracts are legally binding agreements to buy or sell specific assets at a predetermined price at a future date. Futures provide traders access to an array of financial markets. Whether it’s Forex, Crypto, or Commodities and Interest Rates, Futures trading is a rich and multifaceted marketplace.
Therefore, naturally, Futures’ prices may be susceptible to changes stemming from various factors depending on their underlying asset. Here’s what you need to know about what drives Futures prices:
How do Futures prices work?
Knowing how Futures prices work is just as important as understanding what drives them. Essentially, Futures are derivatives“,” meaning they derive their value from their underlying assets. In other words, Futures prices are affected mostly by the costs of the underlying assets and move along with them. Therefore, when the price of the underlying financial instruments rise, so will the prices of the Futures contracts and vice versa.
What Is the Expectation Hypothesis?
Following the same logic as above, many expect Futures prices to be identical to the prices of their underlying assets, which is what is called the “Expectation Hypothesis.” However, while in certain cases this hypothesis can hold true, it generally does not comply with reality. As a matter of fact, Futures prices may differ dramatically from spot prices depending on the asset’s class, storage or carry costs, and even exchange rates.
Factors that Drive Futures Prices
Supply and Demand
Supply and demand relate to the amount of goods sellers are willing to sell and buyers are willing to purchase for a particular price. In addition, as a rule of thumb, the law of supply and demand states that a good's price will adjust to balance supply and demand. As such, prices of goods rise when demand exceeds supply, and they fall when supply exceeds demand. For this reason, supply and demand can play a huge role in determining Futures prices. In other words, if traders expect demand to exceed supply between now and the expiration of a Futures contract, the price will rise. Conversely, if they expect supply to exceed demand the price will decrease.
One clear case in point is the volatility experienced in the energy commodities markets in 2022. Throughout 2022, the economy faced challenges caused by inflation and high-interest rates, as well as the ongoing war in Ukraine. As a result, Crude Oil rose to its highest price in over a decade due to market jitters arising from a possible fear of supply and demand issues. Because Russia is Europe's largest oil producer and because of the sanctions imposed on its energy sources following the war in Ukraine, many market watchers were concerned that there wouldn't be enough oil to meet the rising demand. In turn, Crude Oil hiked to near record highs , and Crude Oil Futures prices soared along with it.
Geopolitics and World Events
From the example above, it is clear that geopolitical tensions and escalations can also have a direct impact on Futures prices and not only on energy commodity Futures but also on Forex Futures among other types.
For instance, a country's economic or political crisis may cause investors to lose confidence in its currency, leading them to sell it, which decreases its value, and naturally lowers Forex Futures prices. On the flip side, if the political turbulence comes to a halt, investors and traders may be more optimistic and there might be more demand for the currency which, in turn, can increase Futures prices. To sum it up, if a currency pair's spot rate increases, its futures prices are more likely to rise, and if its spot rate decreases, its futures prices are more likely to fall.
Following the Brexit announcement in 2016, for example, when the United Kingdom voted to exit the European Union, geopolitics played a large part in determining Futures prices. Accordingly, as investors and traders responded to the uncertainty surrounding Brexit, both Forex Futures and Index Futures markets saw significant volatility as the British Pound fell and the FTSE 100 slumped.
Mother Nature is definitely a potent force in shaping the world around us including Futures trading. In this regard, some Futures contracts are more susceptible to price changes due to the weather, such as agricultural Futures. Droughts, floods, or frosts can damage crops and reduce yields which increases the price of the Futures contract by reducing the supply of the affected commodity. The price of Futures contracts can also decrease when unexpected weather conditions that are favorable for crop growth take place, such as above-average rainfall or mild temperatures. These conditions can lead to increased crop yields, thus causing an increase in supply.
In addition, weather can impact energy Futures prices, like Natural Gas Futures, as extreme temperatures increase demand for these commodities. Accordingly, traders and investors also use weather forecasts to predict future supply and demand for commodities, which affects the price of Futures contracts.
The importance of weather in affecting Futures prices could be clearly seen in 2021 as a wave of drought followed by frost hit one of the world's biggest coffee and corn producers, Brazil, causing coffee and corn prices to soar.
It might not come as a surprise to know that economic and macroeconomic factors can have a direct effect on Futures prices. One significant factor influencing Futures prices is interest rates. An interest rate is either the amount you earned from saving or the amount you owe a lender. Since interest rates are essentially the cost of borrowing money, higher rates affect commodity prices in that it makes the cost of borrowing higher, which may deter some investors and traders from trading Futures on certain commodities, hence causing Futures prices to lower. Along the same lines, lower interest rates may also affect currency prices as higher rates strengthen a country’s currency, which can decrease Futures prices. In addition, inflation, recession, GDP figures, and CPI releases may play a big role in driving Futures prices.
Other factors that may affect Futures prices are certain companies' earnings, market capitalization, and news updates. This is especially true when speaking about Equity Index Futures prices since market Indexes like the S&P 500 and the Nasdaq track the trajectory of a myriad of stocks. Accordingly, changes in stock prices may drive Futures prices too.
Market sentiment is also a driving force that may shift Futures prices. To put it simply, market sentiment can be defined as the overall attitude of traders and investors toward a particular financial asset. This means that if traders and investors are bullish, the price of a contract may increase, and if they are bearish, the price may drop.
How Are Futures Contracts Used?
In many cases, Futures contracts are often used by buyers and sellers to hedge against price changes while speculators often use them to potentially benefit from their anticipated price swings. However, since Future prices may change and are volatile, traders and investors should bear in mind that past performance does not guarantee future results.
There is a wide variety of financial markets that can be accessed through futures contracts. It should be noted that with this access and variety also comes the fact that the price of futures can be volatile and susceptible to change due to a variety of factors. As a way to better understand how the Futures market works, it is helpful to understand what the factors are that affect it. To view the pricing of various Futures contracts on Plus500’s Futures trading platform, you may click here.