Backwardation is when Futures prices are higher than the spot price and eventually converge. Contango is the opposite. But what causes futures price to be above or below the spot in the first place ? Anyone ?
Backwardation is spot price higher than futures price. Contango is Futures price higher than Spot price. Risk free rate is cost of carrying the commodity( Buy the commodity now by borrowing and sell it on the futures expiration date, by borrowing money). If the commodity has a convenience yield higher than risk free rate, futures price will be less than spot price. Convinience yield is the business value of having that commodity as back up inventory or work in process inventory or some thing like that. Hope this helps.
you can also look at it from a supply demand standpoint If a market is dominated by suppliers looking to lock in sale prices from their commodities (for example farmers selling their harvests forward dominate the market (as opposed to users / consumers of the commodity), the farmers will push forward prices down as they are willing to accept lower prices to assure they sell their crop If the market is dominated by users (say the Chinese buying oil in anticipation of the needs resulting from the Olympics) then the forward curve can be higher than spot rates due to the demand…people are willing to pay more to assure commodity availability in future
that does help , thanks
can also look at oil futrures for a couple of months back. Market was in backwardation, where the spot was greater than futures, the market need oil so greatly, they’d would pay more for it now, rather than wait. That and what Getsgo said above.
I distictly remember the news outlets referring to the oil market being in contango… i.e the oil was being locked in at the higher futures rate, and being stored to sell it forward. The costs of carrying the oil to the futures date was less than what they would recieve selling it, i.e. argbitraging the extreme contango.