For example, corn futures will have storage and spoilage cost. I would use FP = S x (1+Rf)T + FV (NC) to price the future. Using the above formula would point to Future Price > Spot Price (contango). I thought commoditities with significant storage cost will be in backwardation? Please someone to the rescue!
But if you have to spend a fortune to keep it fresh, FV will be less than spot. You have to deduct these costs.
hmmm futures price = expected spot in the future - risk premium (P 99 of CFA book 6) with assets with high storage and spoilage, the trader will require compensation to bear risk. The actual asset holder will be ok with entering into the forward at a price that equals the expected spot LESS a risk premium. (P 100 of CFA book 6) SO i guess the future price has to come down to the point that it is lower than current spot and put things in backwardation… This has me stumped a bit though
storage costs and insurance costs are added net benefits - cash flows from the commodity, or convenience yield is subtracted I always get confused about this.
To price the contract, you add your costs and subtract the benefits. Who says all commodities have to be in backwardation if large storage costs are incurred?
Convenience yeilds/ benefits should be subtracted since they go to benefit who ever has the asset already so lower future price. Costs are added since the holder of the asset has to bear the cost making the future more expensive.
So: If storage costs exceed conviencnce yeild markets are in contango? If convein yield exceeds storage, markets in backwardation?
Still not very clear…Oh dear! June2009, you are referring to normal contango/ backwardation. This is different.
June is correct with contango and backwardation. Normal Backwardation and Normal Contango have to deal with Price risk. So if a lot of sellers are trying to lock in the price they can sell an item at there is to much supply not enough demand. Thus, sellers need to discounts future prices to encourage people to buy the future. Normal Contango is the opposite of above. too many speculators bidding the price up
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Yes, I mixed things up too! Blame it on ethics. If you have to spend a fortune to keep it fresh, you will want to be compensated for that. Backwardation occurs when a commodity is expected to be plenty in the future…say, that capacity expansion plans indicate a drop in prices next year. In that case, the future contract will be priced at lower than today’s spot. This has happened quite a lot with oil in the past.