Commodity Roll return confusion

CFA Level III
#1

I understand what the roll return is. It is the movement in the future price that is not explained by the movement in the spot price.

However, I do not understand why should the roll return be greater the closer the contract is to the maturity is. I you refer to exhibit 16 from CFAI Volume5 page 48, you can see from the table that the closer the contract is to the maturity, the greater the roll return becomes. Why is that?

Can anyone please explain? Thanks.

#2

if you are studying again for Level III - please note that this chapter has been removed and is no longer relevant from a CFA curriculum perspective.

#3

Oh damn…thanks cpk123 for the information. Do you know where should I look for the changes in the curriculum?

Thanks.

#4

Look here:

http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91325581

You’re welcome.

#5

I can still see this LOS " explain the three components of return for a commodity futures contract and the effect that an upward- or downward-sloping term structure of futures prices will have on roll yield" in 2014 syllabus.

So I guess roll return is not removed right?

#6

Nope: roll return’s still there. But all you have to do is explain what it is and how it is affected by markets in contango (it’s negative) or markets in backwardation (it’s positive).

#7

Thanks magician :slight_smile:

#8

It’s really quite simple. Draw a horizontal line. Then from the beginning point of that line draw an upward sloping line and a downward sloping line. Now the upward sloping line represents a futures market in “contango” and the downward sloping line represents a futures market in “backwardation”. The horizontal line represents the spot price through time. Now draw directional arrows showing the movement from each sloping line to the horizontal line.

Since futures prices must converge to the spot price , the movement from each sloping line to the horizontal middle line represents the roll return.

For cantango you drop down from the upward sloping line to the middle line (the futures contract price is above the expected future spot price) thus you have to go down, so the roll return is negative. For backwardation you go up to the middle line (the futures contract price is below the expected future spot price) thus u have to go up, so the roll return is positive.

Once you draw it out it’s quite simple.

#9

You’re welcome!

#10

Spranga5: That is an excellent explanation.

But why does the expected future spot price remain constant (the horizontal line) at every point of time?

#11

The horizontal line doesn’t mean the price remains the same, it just represents whatever the spot price is at contract maturity. In the diagram I draw, the horizontal line is just there to show that the contract price must converge to the spot price and to help me remember all the details of contango, backwardation, and whether roll return is positive or negative.

Sorry for the confusion about the spot price.