“In backwardation, the term structure will have a negative trend. Futures prices will be lower than the current spot price. An investor can profit from taking long positions in successive futures contracts and holding them until maturity”
Why would an investor profit buy holding a future until maturity if the forward price is lower than the spot price? The futures is LOWER, so why would it be assumed that they will profit by holding to maturity?
downward sloping curve for the price.
spot is > future (s0 > f0)
but at the time t (maturity) st = ft (due to convergence of the futures price to spot price).
if you hold the futures contract to maturity - you would sell the underlying at a higher price than you bought it. so you would get a profit.
say spot price now s0 = 100. since the futures price is lower - you agreed to buy the underlying in the future (one month later) at say 90.
one month later - (maturity) if the spot price = say 95 (higher than the futures price you signed up for) - you will be able to get it at 90 (due to your futures contract), turn it around sell it for 95.
ok got it, but it assumes that the spot price is always higher than the futures during a backwardation. Why is that? Can’t the spot price fall below at maturity, and hence a loss?
the spot price curve lies above the futures price curve -> that is the definition of Backwardation.
If the spot curve were below the futures price curve - that would be Contango - so there will be a loss then.
Backwardation is what you call it when the spot price is higher than the futures price. It’s not saying a market will always be in backwardation, but it must be in backward if current spot is higher than future prices.
In regards to the market staying in backwardation, think about the entire term structure moving at the same time, in the same direction. The future price might have risen 15%, but likely the spot has risen 15% + a little more… It is very rare to see a market aggressively change from backwardation to contango. If it has, there’s a major shock that has changed the entire dynamics of the market.