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Convergence

The tendency of a futures price to meet the cash price of the underlying commodity as expiry approaches.

Convergence is enforced by arbitrage. If futures sit above cash near expiry, a trader can buy the physical, sell the future and deliver; if below, the reverse where possible. As time to expiry shrinks, cost-of-carry shrinks with it and the two prices must meet.

When convergence fails — as it did in US wheat around 2008 because of a broken delivery mechanism — hedgers lose confidence in the contract and exchanges change the rules.

Example: with two months left, corn futures at $4.60 against cash at $4.35 reflect 25 cents of carry. On the last trading day that gap should be near zero at the delivery location.

Related: basis, cost-of-carry, physical-delivery, cash-market

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Contango and backwardationTwo futures curves against contract expiry: one rising above spot, one falling below it.The same commodity, priced for delivery at different dates.78.0076.0074.0072.0070.00Futures pricespot+1m+2m+3m+4m+5m+6mMonths until the contract expiresspot price74.00CONTANGOlater contracts cost more than spotBACKWARDATIONlater contracts cost less than spot
Contango and backwardation. A futures curve shows what buyers will pay for delivery in one month, two months and so on. When later contracts cost more than the spot price the curve is in contango; when they cost less it is in backwardation.

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