# Commodity forward?

Yes: in backwardation the forward price is lower than the spot price; in contango the forward price is higher than the spot price. Contango should be more common; backwardation will exist primarily when the benefits of holding an asset (lease rate plus convenience yield) exceed the cost of holding the asset (risk-free rate plus storage).

I’m not quite sure what you mean here.

No. Contango, for example, means that today’s forward price is higher than today’s spot price, but the original forward price could be higher or lower than today’s spot price, and higher or lower than today’s forward price. The difference you show is neither always positive nor always negative (it could be either when markets are in contango, and either when markets are in backwardation).

Yes, though for some reason they always do these calculations from the viewpoint of the long position.

Nope. See below.

No. That’s total return (ignoring collateral return for the moment.)

Spot return = new spot price – old spot price

Roll return = (new forward price – old forward price) – spot return

= (new forward price – old forward price) – (new spot price – old spot price)

Total return = spot return + collateral return + roll return

A better way to think of roll return uses a bit of algebra:

Roll return = (new forward price – old forward price) – (new spot price – old spot price)

= (new forward price – new spot price) – (old forward price – old spot price)

= (new cost/benefit of forward) – (old cost/benefit of forward)

So, if you don’t roll, then you drop the (new forward price - new spot price) and get:

total return =spot return + collateral return + roll return

= (new spot price – old spot price) + collateral return – (old forward price – old spot price)

= new spot price – old forward price + collateral return . . . as you would expect.

(Note that when you don’t roll, the roll return isn’t zero, it’s: –(old forward price – old spot price).)

“you compare the spot to the forward. If the forward price is cheaper (taking into account your storage costs, your lease income, and the time value of money), then you’ll sign the contract. If the spot (plus storage, minus lease income) is cheaper, then you’ll buy the oil today.”

• This is what my 2nd question is referring to - why is the spot adjusted for anything (above said, spot plus storage minus lease income)?

Last Question:

The inequality on page 62 shows the forward as greater than or equal to spot plus storage but the inequality for the no-arbitrage range shows the forward as less than or equal to spot plus storage (page 67) - what gives?

S2000, you’ve been a huge help and incredibly generous to address my questions. I’m not covinced that I know this topic perfectly but your help as solidified the general understanding that I think this reading is really trying to drive home. Thank YOU!

You adjust the spot for storage, lease income, and convenience yield for the same reason that you adjust it for the time value of money: they’re costs that you incur or benefits that you obtain by buying in the spot market that you don’t incur/obtain if you buy in the forward market. Think back to your Level II derivatives: why did we say that the forward price had to satisfy:

FT = S0 × (1 + rf)^T?

Because either:

1. You would have to borrow money to buy in the spot market today which you wouldn’t have to borrow to enter into a forward contract, so the spot market cost (to you) includes the cost of interest, or

2. You could buy in the forward market today and invest cash (in the amount of today’s spot price) and earn interest, or buy in the spot market and have no cash to invest and so earn no interest.

Either way, the forward price has to be higher than the spot price by the amount of interest. If it were anything else . . . arbitrage!

The same thing is happening here with storage cost, lease rate, and convenience yield. Storage cost is no different than interest: it’s a cost you incur if you buy in the spot market that you don’t incur if you buy in the forward market. Lease rate is the opposite: it’s a benefit you gain if you buy in the spot market that you don’t gain if you buy in the forward market. Convenience yield is the same as lease rate in that respect.

Promise?

I covered this about 47 pages ago. (Yes, I exaggerate: look at your post #8 and my post #9.)

That inequality specifies the condition under which a user of the commodity would rather buy in the spot market than in the forward market; it tells you that _ the forward price it too high _. I would not have written it that way, because it’s prone to cause confusion, as we have seen.

Once again, my pleasure.

The best way to thank me is to nail this stuff on the exam June 1, pass the stupid thing, and come back here in August to let me know that you passed.

No, really. Last one now - just to follow up your last answer about adjusting the spot price. If i were to look up the spot price today in the market, the market price should theoretically reflect these factors (storage, etc)?

" The best way to thank me is to nail this stuff on the exam June 1, pass the stupid thing, and come back here in August to let me know that you passed " - Thanks for the kind-hearted support!!!

No; no more than the price of a car at the dealership reflects the costs of storage, insurance, fuel, tires, maintenance, repairs, and so on. But a prudent buyer researches those costs and figures them into the equation when comparing one car to another.

So if markets are in backwardation, why would anyone buy now?

Obviously, if you need the commodity today then you can’t wait…but if you can wait 90 days, then why would you pay more for the same thing today, not to mention the time value of delaying.

And to think I almost believed you!

Maybe their convenience yield is higher than is priced into the forward, or maybe they can earn a higher lease rate than the forward price includes, or maybe they’re just stupid.

However, I think we’re getting a bit far afield. Leave the whys and wherefores until June 2; right now, concentrate on what you need to know to pass this exam.

(By the way, why are you listed as a Level II candidate?)

Because the future is uncertain .

If you need 200 barrels of oil to fly airplanes in your airline n two months , would you wait 2 months to place an order ?

its not just to lock in deliveries , but the spot might have risen much beyond what the futures prices two months ago said they would be.

So based on your futures prices for two months you tell your customers what their ticket prices are going to be and start booking tickets . And you hedge oil deliveries too using the same estimates . If you wait two months to know the price of oil and also not let customers book flights for two months, no one could plan their trips. If you wait two months , and you could be totally priced out of the airline market too if oil rises abnormally in two months and you don’t have a hedge on.

Business cost estimates should match your revenue estimates . Otherwise you would be soon out of business

I believe his proposed comparison was going long the forward vs. buying the spot today, rather than waiting two months and buying the spot then vs. buying the spot today.

Never updated following the pass last June. No good reason for not. Hoping the next time I change it is the last time I change it (fingers crossed).