In case of backwardation, Future price < spot price. Spot price here refers to the current spot price or expected future spot price?
Please add some comments.
expected future spot price = future price…
not exactly summerside. Expected future spot price is not always same as Future’s price. But to answer his question, of course spot rate is today’s rate.
In fact, if Futures price > Expected future spot price you have a normal contango. Futures price differs due to cash flows and supply/demand, etc.
I’m going to break this down as best I can:
THERE ARE 4 SITUATIONS U BETTER KNOW COLD b/c the CFA Gods will never let anybody get their charter if they get these 4 concepts screwed up and it is very easy to get confused here. This is how we separate ourselves from people who don’t understand investing…lol
Perspective ***remember Demand drives the commodity market not supply b/c if you had huge pliles of dead branches, nobody will care… so you look at it from the who wants badly to do what with the commodity in question (they want to get rid of it badly (sell) or hoard tons of it (buy)). Hedgers are the demand side (they have a legit reason to want it for raw material or something) and Speculators will just take the opposite side of the Hedger trade as long as they get paid enough to do it.
1. Contango - [FP0 > S0] [thanks Dreary for suggestion] This is actually what I consider the “normal” state of the world. Where the future price of something is greater than the current spot price. B/c it costs money to inventory/hold and take future risks and you should get paid for it. Think when all is good, you dance and Tango my friends.
2. Backwardation - [FP0 < S0] Is when the world is “backwards” where the spot price is greater than the future price. Think about it, if you can buy something for less in the future it’s a little weird b/c inflation will normally drive most prices up. The reason this happens for any commodity is say there is a shortage of coconuts b/c of a massive storm and u need those damn coconuts to make VuQo vodka that is distilled from coconut nectars. You are going to pay more to get it now b/c of the shortage and b/c in the future, they can grow more so prices will go down.
>>>There is the current spot price now for situation 1-2 and then their is the Expected Spot Price for 3-4, where you wonder what the future spot price will be later and want to hedge against that now.
3. Normal Contango - [FP0 > E(S0)] In Normal Contango, the Hedgers are net buyers and want to BUY all of it in the near future for their business. They will pay more to not have to hold it from now b/c they r too lazy to do LIFO/FIFO inventory…lol until months later but they want to make sure they have when they need it. They bid up Future Contract Prices so they are higher than the Expected Spot Price.
4. Normal Backwardation - [FP0 < E(S0)] There is nothing “normal” about normal backwardation… all the Hedgers now want to sell their “junk” to you, the speculators, even at a loss. You don’t want it. So the only way they can get you to take it is if they sell it to you for less than what it is worth, meaning less than the Expected Spot Price. They sell it to you at a discount so you buy it thinking you will flip it later and collect your risk premium. So now the Future contract prices in this market environment is that they are LOWER than the Expected Spot Price for the goods.
If this topic comes up and you don’t nail it, I will be mad O_0
Excellent summary with good points…only if you added for each notations like F0 > S0, F0 < E(S0), etc., to make it easier to read.