In futures trading, “convergence” refers to the process by which the price of a futures contract and the price of the underlying asset come together as the expiration date of the futures contract approaches.
This is a fundamental principle of the futures market and ensures that futures prices are reliable predictors of future spot prices.
Futures contracts are agreements to buy or sell an asset at a future date for a specified price.
When the contract is first initiated, the futures price and the spot price (the current market price of the asset) can differ significantly based on the market’s expectations for future price movements, interest rates, storage costs, dividends, and other factors.
However, as the expiration date of the futures contract approaches, the futures price gradually adjusts to more closely align with the spot price.
This happens because, at expiration, the futures contract requires delivery of the asset (for physically delivered futures contracts), and thus the futures price must equal the spot price.
If there were a difference, it would create an opportunity for arbitrage — risk-free profit — which market participants would quickly exploit, thus eliminating the difference.
For example, if the futures price were higher than the spot price at expiration, traders could buy the asset at the spot price and simultaneously sell the futures contract, making a risk-free profit.
This action would increase demand for the asset in the spot market, raising its price, and increase supply in the futures market, lowering the futures price, until the two prices converge.
This principle of convergence helps ensure the efficiency of futures markets and gives traders confidence that the futures prices they see today are reasonable estimates of what the spot price will be in the future.