So in backwardation spot prices exceed forward prices and in contango its the opposite. Over time we expect the forward price to converge to the spot price (so in backwardation the forward price will go up and in contango the forward price will go down). Is this correct? Also, why does the forward price converge to the spot price and not the opposite? Thanks.

CFAIIICFAIII Wrote: ------------------------------------------------------- > So in backwardation spot prices exceed forward > prices and in contango its the opposite. Yes > Over > time we expect the forward price to converge to > the spot price Yes (so in backwardation the forward > price will go up and in contango the forward price > will go down). Not necessarily. > Also, why does the forward price converge to the > spot price and not the opposite? Either way works, as long as they converge. (I recently read an article about a certain liquid commodity where this convergence wasn’t happening – perhaps an agricultural product – but it’s quite an anomaly.)

The forward PRICE is just the spot price projected out at the borrowing (usually risk free) rate and adding/subtracting any costs/benefits to the holder of the underlying. As the time to maturity shortens, all of these adjustments get smaller, so the fair price of a new forward contract gets closer and closer to the spot price as you get closer and closer to expiration. Now, if you have a forward agreement already in place, that PRICE doesn’t change, but the VALUE does. The forward value is the PV of the difference between the price of the forward you have and the price of a new forward that you could negotiate at today’s rates. So forward prices converge to the spot price, but any forwards you already have negotiated won’t be converging, but their value will change to reflect any non-convergence. In futures, all of this is taken care of through changes to the margin account, so you’ll be accumulating the value over time.

I have a further question. In backwardation, one can profit by buy-and-hold a futures contract. The reason is that “the futures price must converge to the spot price of the commodity” (2nd paragaph under table, p.300, CFAI vol 4) I don’t understand this. Can these not happen? 1. spot price goes down to reach “my futures price” ---- I can make no profit 2. spot price goes below my “my futures price”, and so the futures price goes further down to reach the lower spot price — I make loss. Thanks! - sticky

Obviously you can’t make a riskless profit by buying a market in backwardation. If you could, you could make unlimited money in any number of commodity markets. There’s not even a clear case that you expect to make money by buying a market in backwardation.

forward prices depend on spot prices, not vice versa. Think of them as dependent and independent variables.

Except if a market is in backwardation, there’s a good case to be made that they are not especially dependent.

CFAAtlanta Wrote: ------------------------------------------------------- > forward prices depend on spot prices, not vice > versa. Think of them as dependent and independent > variables. Sorry but I still don’t understand this. You buy a july oil futures contract for $100/barrel but the spot is $120/barrel today. A backwardation, right? Now july comes and due to whatever reason, oil price becomes 80/barrel. I lose , right? So how come “one can profit from backwardation by buy-and-hold strategy”? May sound a stupid question but help much appreciated. - sticky

and to show that I don’t understand this topic :), I’ve got another question: If “under backwardation, one can profit through buy-and-hold strategy”, what should the strategy be under contango? - sticky

Sticky: Sorry but I still don’t understand this. You buy a july oil futures contract for $100/barrel but the spot is $120/barrel today. A backwardation, right? Right Now july comes and due to whatever reason, oil price becomes 80/barrel. I lose , right? So how come “one can profit from backwardation by buy-and-hold strategy”? This is an unexpected price shock. You’re correct in that you lose money, but this implies the curve has shifted and is now in contango. If “under backwardation, one can profit through buy-and-hold strategy”, what should the strategy be under contango? With contango, futures prices are higher than expected spot prices. Therefore you minght not want to purchase the futures, depending on your circumstances. When enough people decide they don’t want to purchase futures, the buyers must be paid a premium for entering into them - curve shifts to backwardation

thedarkhorse Wrote: ------------------------------------------------------- > Sticky: Sorry but I still don’t understand this. > You buy a july oil futures contract for > $100/barrel but the spot is $120/barrel today. A > backwardation, right? Right > > Now july comes and due to whatever reason, oil > price becomes 80/barrel. I lose , right? So how > come “one can profit from backwardation by > buy-and-hold strategy”? This is an unexpected > price shock. You’re correct in that you lose > money, but this implies the curve has shifted and > is now in contango. > No it doesn’t - it just means the spot price has dropped. August oil could be $10 (well, not really). You just lose money because you went long something went down. > If “under backwardation, one can profit through > buy-and-hold strategy”, what should the strategy > be under contango? With contango, futures prices > are higher than expected spot prices. Therefore > you minght not want to purchase the futures, > depending on your circumstances. When enough > people decide they don’t want to purchase futures, > the buyers must be paid a premium for entering > into them - curve shifts to backwardation Futures prics are almost always higher than E(S) because that’s the normal arbitrage relationship (Futures price = price to finance, store, and buy something now). Anyway, backwardation vs contango gives you almost no information about whether or not you should be long or short. It’s about the same as saying “the stock pays a good dividend do you want to be long or short?”

JoeyD, I’m also having a very difficult time grasping this concept. My question is, do convenience yields, the ability to lease, and storage costs play a role in backwardation and contango? For example, if there are storage costs, then the curve should be in contango (all else equal), right? If the asset can be leased out for a return or has a convenience yield, i think of this as a benefit to holding today, thus, the spot is greater than the futures and we have a downward curve and therefore backwardation. Am i thinking about this correctly or am i way off?

thedarkhorse Wrote: ------------------------------------------------------- > Now july comes and due to whatever reason, oil > price becomes 80/barrel. I lose , right? So how > come “one can profit from backwardation by > buy-and-hold strategy”? This is an unexpected > price shock. You’re correct in that you lose > money, but this implies the curve has shifted and > is now in contango. So we can’t really say “When the futures markets are in contango, a +ve return will be earned from a simple buy-and-hold strategy” (2nd paragraph under exhibit 16, p.300, CFAI vol 4), right? This sounds weird like “when the price of google has dropped 20%, a +ve return will be earned from a simple buy-and-hold strategy … because the price will pick up and go back to where it was”. To me, backwardation simply means that the market is pessimistic with the future prices of the commodity. It is NO indication that there is any higher chance of a profit made. Comments? Need help from you guys. - sticky

i believe these two are the most confusing derivatives concepts ever…

JoeyDVivre Wrote: > Futures prics are almost always higher than E(S) > because that’s the normal arbitrage relationship > (Futures price = price to finance, store, and buy > something now). Anyway, backwardation vs contango > gives you almost no information about whether or > not you should be long or short. It’s about the > same as saying “the stock pays a good dividend do > you want to be long or short?” (sorry miss this part) So why is the CFAI text saying “When the futures markets are in contango, a +ve return will be earned from a simple buy-and-hold strategy” (2nd paragraph under exhibit 16, p.300, CFAI vol 4)? An example from CFAI just adds to my confusion. Part 4, exhibit 18, p.304, CFAI vol 4. Question: (Given the backwardation situation in parts 1,2) Recommend a futures strategy that will provide a +ve return in this scenario. Answer: When futures markets are in backwardation, a +ve return will be earned from a simple buy-and-hold strategy. This occurs because as the futures contract gets closer to maturity, its price will rise to converge with the higher spot price. This increase in value produces a +ve roll return (as calculated in part 1). - sticky

My understanding is that backwardation provides +ve roll return - buy and hold should provide you a +ve return assuming all other things remained the same. So, I would assume contango needs to produce a -ve roll return.

CareerChange Wrote: ------------------------------------------------------- > My understanding is that backwardation provides > +ve roll return - buy and hold should provide you > a +ve return assuming all other things remained > the same. So, I would assume contango needs to > produce a -ve roll return. understand, but question is how probable can “other things remain the same”? eg. with futures price as the “expected/indicative” spot price at contract expiry, I would expect the spot price to be more likely to drop towards futures price instead. Buy-and-hold will be my lowest priority strategy, unless I expect futhrer “+ve news” that boost the spot price again. When there is backwardation, there MUST be some market reason for that. I won’t just say “hey, it happens to be backwardation, and since it will converge to this spot, let’s buy and hold”. Comments? - sticky

i think there is a supply and demand aspect as well in a backwardation market, there are more sellers than buyers (imagine 10 wheat farmers and 1 bakery), meaning that sellers are willing to provide a discount in order to guarantee the future delivery of their product (the baker will pay spot now, but he has no incentive to ‘lock in’ a future purchase. the farmer, on the other hand, wants to lock in the sale b/c there aren’t enough buyers out there. he’ll be willing to sell the futures at a lower price than spot). the positive roll return reflects the fact that buyers are at an advantage, and thus get a positive return for accepting future delivery of something that is in abundant supply. as time to maturity decreases, sellers are not as incented to accept the discount and thus the futures price will not be as deep a discount, which is why the futures converges to the spot, and not the other way around.

eklypse Wrote: ------------------------------------------------------- > i think there is a supply and demand aspect as > well > > in a backwardation market, there are more sellers > than buyers (imagine 10 wheat farmers and 1 > bakery), meaning that sellers are willing to > provide a discount in order to guarantee the > future delivery of their product (the baker will > pay spot now, but he has no incentive to ‘lock in’ > a future purchase. the farmer, on the other hand, > wants to lock in the sale b/c there aren’t enough > buyers out there. he’ll be willing to sell the > futures at a lower price than spot). fine. > the positive roll return reflects the fact that > buyers are at an advantage, and thus get a > positive return for accepting future delivery of > something that is in abundant supply. hmmmm… I don’t understand what you saying above. At this point I don’t think you can guarantee any +ve roll return here (see what-if below) > as time to maturity decreases, sellers are not as > incented to accept the discount and thus the > futures price will not be as deep a discount, > which is why the futures converges to the spot, > and not the other way around. What if this? As time to maturity decreases, there are more wheat farmers selling wheat and so the farmers can only accept more discount, eventually pushing the spot price down to somewhere below the futures price that was longed. The futures price, already further down, goes up just a bit to “converge to the spot” (I hate to say which merge to which because they simply will come together) Correct me if I am wrong, but I don’t think one should assume the spot price is stable sitting there waiting for the futures price to converge to it. If this is happening, arbitrage can be exploited and the gap will disappear immediately. Simple question: if futures price is below spot, will you long the futures contract without thinking? Yes, I understand what CFAI text is trying to say regarding +ve roll return on backwardation, but I am simply not convinced that this can happen that easily. Comments and feedback, please! - sticky

hey sticky, i think i see where your gripe is. i went back and read the CFA text on pg 300. It says: “when the futures markets are in backwardation, a positive return will be earned from a simple buy-and-hold strategy”. the confusing point is that the wording says “positive return”, when it should really say “positive ROLL return”. when you initially read it, the sentence implies that it is referring to the TOTAL futures return. the total futures return will be affected by other things, namely the underlying asset’s price. if the underlying asset falls in value, the total futures return in a buy-and-hold strategy could be zero, or even negative, as you had hypothesized previously. BUT it will exhibit a positive roll return (simply because, as defined, a market in backwardation has a downward sloping term structure… so as time to maturity decreases, the higher up the y-axis the futures contract will go). so yea, total return = spot return + roll return + etc etc… if spot return is -ve and roll return is not enough to counteract it, total return could definitely be -ve. Hope that makes sense.