Which of the following best defines contango? A contango is known as when the futures price lies: A) below the expected future spot price and the futures price falls over the life of the contract. B) below the expected future spot price and the futures price rises over the life of the contract. C) above the expected future spot price and the futures price falls over the life of the contract. D) above the expected future spot price and the futures price rises over the life of the contract. Your answer: C was correct! A pattern of falling futures prices is known as a contango. This situation occurs if hedgers are net long. ******************************************************* Can somebody explain this explanation to me (the hedgers part)
This one too. How is market backwardation related to an asset’s convenience yield? If the convenience yield is: A) positive, causing the futures price to be below the spot price and the market is in backwardation. B) negative, causing the futures price to be below the spot price and the market is in backwardation. C) larger than the borrowing rate, causing the futures price to be below the spot price and the market is in backwardation. D) lower than the risk free interest rate, causing the futures price to be below the spot price and the market is in backwardation. Your answer: A was incorrect. The correct answer was C) larger than the borrowing rate, causing the futures price to be below the spot price and the market is in backwardation. When the convenience yield is more than the borrowing rate, the no-arbitrage cost-of-carry model will not apply. It means that the value of the convenience of holding the asset it is worth more than the cost of funds to purchase it. This usually applies to non-financial futures contracts.
Here is what I feel. Hedgers are the ones who want to transfer the price risk of the assets from them to the purchaser of the contracts. Since they are net Long, meaning, there are many people who want to do this risk transfer. So there must be premium over the real futures contract for the buyers to take on that risk. So the present Futures contract price are greater than expected in the future, and so the contract prices diverges DOWNWARDS during te life of the contract.
. edited since I haven’t read the q properly
^^Correct, Dinesh
If the CY is greater than the BR then what it actually means is that the one who is holding the assets to be delivered in the future is bebefitting by the interim cash flows generated by those assets (DIV, INT, bla…). Thus there is no advantage of buying the futures contract, where the underlier asset is paying of cash which are not collected by the contract owner, rather everything goes to the asset owner. Thus the buyers of the contract need a discount to compensate for the loss of cashflows from that asset.
I was wondering the same the florinpop. I’ve gotten used to associating “expected” with “normal contango/backwardation” so they kind of threw me off.
You are right about expected and normal contango. Since all the answers were using expected I just went with it…
For the second q look at the formula. In backwardation the spot will be above the futures price. You subtract the convenience yield when calculating the future. If its greater than the borrowing rate the future price will be less than the spot, and you’ve got backwardation.
A pattern of falling futures prices is known as a contango. This situation occurs if hedgers are net long. ******************************************************* Can somebody explain this explanation to me (the hedgers part) The idea is that speculators will only be short in a contract if they get a premium for selling the asset in future. that means that future prices are higher than what is expected the spot price to be. if speculators are short it means that hedgers are long
convenience yield: non monstary benefits from holding financial assets Net cost: sotrage cost-convenience yield net benefit: yield of asset+convinience yield backwardation: future price lower than spot price because of net benefit contango: future price higher than spot price because of net cost
dinesh.sundrani Wrote: ------------------------------------------------------- > Here is what I feel. > > Hedgers are the ones who want to transfer the > price risk of the assets from them to the > purchaser of the contracts. Since they are net > Long, meaning, there are many people who want to > do this risk transfer. So there must be premium > over the real futures contract for the buyers to > take on that risk. So the present Futures contract > price are greater than expected in the future, and > so the contract prices diverges DOWNWARDS during > te life of the contract. there is no risk of holding the asset here since the hedgers are long it’s just the fact that speculators will not sell grain in future let’s say a year from now for 10$ if they are expecting the prices to be 10$ remember speculators dont have the asset and they would gain only from differences between the expected spot prices and the future prices - ie buy in future for 8 - expected- and sell for 10 futures price
C) larger than the borrowing rate, causing the futures price to be below the spot price and the market is in backwardation. you can think of this as a net convenience yield.the cost of borrowing money to purchase the asset is less than the convenience of owning it therefore future prices are below spot prices or expected - depends