I used to remeber the cantango has upward sloping (since future contract price > spot price), and roll return is -ve. Backwardation is vice versa.
However, I do understand why when the future price > spot price (for cantango), the roll return is not +ve, but instead -ve? Hope someone could clarify this silly question for me. Many thanks!
It’s because you are losing value having to roll over your futures as they expire when the market is in contango, therefore a negative roll yield
Thanks for the answering sdanalyst. Could you show me an easy example for the explanation as I still don’t get it.
You are holding the futures for a certain exposure to an underlying asset. Your futures contract at the current spot price will expire in a specified amount of time. When the market is in contango, the futures prices are higher than the spot price. When your futures expire, in order to maintain the exposure to the underlying asset you must roll over your futures (meaning buying new futures). When you are paying more for the same contract that you had before you are generating a negative roll return because it’s a cost to you
I believe contango and backwardation refers to futures prices only, not the relationship between futures and spot. Contango is when the futures curve is upward sloping, as in futures price in the future (no pun intended) is higher than futures price in the present. So when you roll your futures contract into another one, you would be expected to do it at a higher futures price, you end up with a negative roll yield.
lets think of the simple example of an airline that consumes a lot of jet fuel
the jet fuel term structure is in backwardation… meaning that the futures curve is downward sloping and as a result, the airline can buy its fuel at spot for lets say, $100/bbl, or instead, buy 3 months futures at $98, wait 3 months and take delivery of the fuel.
as long as jet fuel in the spot market remains at $100, the airline is going to earn $2 simply by being long the 3 month, $98 futures contract and waiting 3 months before taking delivery
this gain is called a positive roll yield. the reverse would happen if jet fuel was in contango…
if you are instead not an airline, and do not want to take physical delivery, like a hedge fund who wants exposure to jet fuel, the hedge fund could do the same thing in the futures market, buy the 3 month contract and roll it over every three months when it matures. the hedge fund can do this indefinietly, consistently earning a positive roll yield, as long as spot remains higher than 3 month futures
Thanks for you guys’s clarification and I get a clearer picture now.
but for the example shown by Carthurj, the positive roll yield is based on the assumption than the future spot remains or is higher than the contracted future price. What is worse is that after you purchase the future in backwardation and it changes to cantango, your loss with increase significantly. (In contango, the spot is future may drop to below $98/barrel)
So, the positive yeild from backwardation is not always true as you are betting the future spot price higher than the current future price. Otherwise, arbitrage opportunity exists and should bring the roll yield to zero? Is my understanding correct? Thanks.
arbitrage is just to ensure that futures are priced correctly and does nothing to roll yield…i tihnk