B is correct because positive “roll yield” occurs when the futures price is above the “full carry” price, referred to as backwardation, which may occur when prices are low and volatile and producers are concerned that they will fall further, to a level that is unprofitable. Producers will accept less that the “full carry” price in order to hedge price risk.
roll yield is positive when there is backwardation, i.e.,the futures price is *less* than the “full carry” price – is your statement above incorrect?
but anyway, if today you see a futures contract selling for less than what the future spot price is expected to be, you have backwardation and you will have a positive roll yield if you decide to roll your contract.
This is from the CFAI mock. Problem 25 on the AM exam.
this is bothering me too— contango/backwardation == normal/otherwise is confusing per CFAI
Dreary Wrote: ------------------------------------------------------- > roll yield is positive when there is > backwardation, i.e.,the futures price is *less* > than the “full carry” price – is your statement > above incorrect? His statement is correct.
futures > spot = contango (-'ve roll yield) futures < spot = backwardisation (+ve roll yield) Not sure on what full carry price is…something to do with storage, warehousing…?
Full carry is the expected spot…it’s the price today plus all associated costs to keep the asset till the expiration date of the contract. If you agree that when futures < spot, it means backwardisation, and also when futures < E(spot), it means natural backwardisation, and both result in positive yield, then the statement of the problem is not correct … it says “positive “roll yield” occurs when the futures price is above the “full carry” price”. Anyone else can explain it differently?
I think there is a similar sounding argument in the text… as well. Based on the Risk Free rate + any other form of convenience yields - the Full Carry Price is determined. Think of the following in the absence of a market available for derivative instruments like Futures. If the Full Carry price is determined by the Producer of the commodity to be too HIGH -> he would most like make sure that the Future price is lower than that Full Carry Price, and he would do this purely to protect his own business. A long only speculator could be found to take over this price risk from the producer. If that happened - Future Price < Future Spot -> Backwardation. In the case of a Long only speculator -> he buys the product now at a low price, sells it when he is ready to sell, at the market Spot price (which is higher) - so he earns a positive roll yield, because he agreed to a lower price from the Producer, in the beginning. I AM DEFINITELY NOT GOING TO BE ABLE TO DO ALL THIS THINKING IN THE EXAM. WHAT SH*** ARE THEY TESTING?
If you cannot think thru , the rest of us have very little chance ( think 3-sided coin toss).
I think this is an errata in the explanation. It uses 2 statements which are contradicting each other: “positive “roll yield” occurs when the futures price is *ABOVE* the “full carry” price” “Producers will accept *LESS* than the “full carry” price in order to hedge price risk.” My comments: 2nd Statement is Correct. While the 1st statement is not correct and is contradicting 2nd. 2nd statement says accurately that Futures Price is LESS than Full Carry price when producers are hedging their risks and this is correctly a case of Backwardation. Whereas, 1st statement is saying Futures Price to be ABOVE full carry price, which is NOT backwardation. ‘ABOVE’ needs to be replaced by ‘BELOW’. Roll Yield: Roll yield is from the perspective of long only investor in that commodity. This guy remains long in that commodity, by rolling over his futures contract each time it expires. If futures price falls for his next contract that he enters, he maintains the same right to buy the underlying in future, but at lower rates. This is called positive Roll Yield.
rus1 -> please check the text book too. It makes a similar sounding statement - but explains that same with saying “think that no derivatives transactions as are present today were available”. in that case - if a producer suspected (expected) future spot price to be lower than the full carry price - he would be willing (in order to protect his business) to sell the product to willing buyers at lower than future spot price. And he would definitely be able to find buyers (speculators) who will absorb that price risk. In that case - the future spot price is lower than the current spot - and a backwardation situation would arise. This situation would happen when volatility was high and prices were historically falling.
CP, what you are saying is perfectly correct. But, this is explaining a situation, why futures prices (or future spot prices, in assumption where there are no derivatives) are BELOW full carry value and not ABOVE full carry value. It is backwardation as you are saying correctly, when futures prices are BELOW full carry value. But, the CFAI explanation says ABOVE and that is what is not convincing me. Anyways, i need to go back to text on this …
rus1bus, I agree that’s what I mentioned above as well. It is clearly a mistake in the text, wherever this came from.