I have trouble understanding the three return components of the commodities future. Spot return is little easy. Please help in putting in simple words…the underlying meaning and difference between each of the return component - spot return, collateral yield (commodity is the collateral…so where is the yield ? ) , and roll yield (backwardation cases… but how to digest it?)… thanks.
collateral yield - opportunity cost of capital - margin money could otherwise have been invested at the risk free rate. (this will always be a positive number - as a result).
Roll Return = Change in Futures Price - Change in Spot Price
– when in contango - futures price < Spot Price … so there is an upward sloping term structure. This makes the roll return negative. Remember that at expiration - futures price will meet up to the new spot price at expiration. If this happens - and the Spot prices are higher - your roll return would be negative.
– when backwardation occurs - Futures price > Spot Price. Usually happens when producers are willing to drag down the futures price so as to be guaranteed that the inventory would be sold. Creates a downward sloping term structure. Causes that you can get out of a contract and get into a new one at a lower price. And this creates a positive roll return.
Slight clarification on the collateral yield. As I understand it, the collateral yield is the interst you earn on the cash that is not required to fully fund a comodity contract position. For example, let’s say you wanted to invest $1 in gold and you are required to put up 10% as margin. The remaining $0.90 will be invested in short term fixed income investments (or in risk free assets) and earn you an additional yield (the collateral yield).
Obviously I hate to question CPK, so let me know if anyone disagrees with this.
Since the futures contract needs to be paid only at its maturity - you set aside the money today in anticipation of meeting the futures payout at expiration of the contract - and it earns the interest for that time period.
hate to quetion you, but isnt the above opposite?
contango = futures price > spot price
backwardation = spot price > futures
what am i missing from Lvl 2 lol
yes you are right. And thanks again… Losing my mind !