How do you understand LOS 48.1 Explain why some commodity futures such as gold have limited “contango”? I am working with Schweset and don’t understand their explanaiton? Can anybody help me with that and explain? Thanks!!
Contango -> is the situation when Forward Price > Expected Future Spot Price. For items like gold - if the Forward price > expected future Spot price - there is a clear arbitrage opportunity available. Person would be able to sell a futures contract on Gold, borrow money today, invest in gold today at the spot price today. in the future - sell the gold, make a profit after paying off the risk free rate on the gold. As more and more investors start to see the profitability in this operation – this arbitrage opportunity will be used by more investors and cause the Forward price to be equal to the expected future spot price - so there is no more contango. hope this answers your question tgrycner…
cpk123 Wrote: ------------------------------------------------------- > Contango -> > is the situation when Forward Price > Expected > Future Spot Price. > > For items like gold - if the Forward price > > expected future Spot price - there is a clear > arbitrage opportunity available. Person would be > able to sell a futures contract on Gold, borrow > money today, invest in gold today at the spot > price today. > > in the future - sell the gold, make a profit after > paying off the risk free rate on the gold. As more > and more investors start to see the profitability > in this operation – this arbitrage opportunity > will be used by more investors and cause the > Forward price to be equal to the expected future > spot price - so there is no more contango. > > hope this answers your question tgrycner… Forward>expected spot: Normal contango Forward>spot: Contango
sorry… thanks bpdulog… got confused between the expected spot and the spot piece.
cpk123 Wrote: ------------------------------------------------------- > For items like gold - if the Forward price > > expected future Spot price - there is a clear > arbitrage opportunity available. cpk, that would not constitute an arbitrage opportunity because of it being “expected”. You can’t make a risk-free profit relying on some expected outcome. However, it can be an arbitrage opportunity at the expiration instant of the future.
Another reason for limited contango is that there is a real benefit of holding the PHYSICAL assets thus buying the spot NOW (compared to forward price which is equivalent of owning the PHYSICAL asset later), thus narrowing the contango spread. The benefits of holding the physical gold come because there are (at times) people who are willing to borrow (lease) your gold and pay real cash for this. The first group comes from short sellers of gold who must borrow the gold before they can short. The second group comes from manufacturers (of electronic goods) who would suffer if they run out of gold supply as input for their production thus suffer from stopped production. Note this lease rate varies depending on lease demand. The lease rate is widely reported in the industry. http://www.kitco.com/lease.chart.html
What exactly do you mean “limited”? Limited to what? The post above is absolutely correct, but this only acts to lower any contago spreads. Who is to say that there is some sort of limit on it? What about skyrocketing storage costs?
I take limited “contango” to mean the contango spread (if any) for gold is much more moderate than other commodities. The (contango) spread = interest cost- lease rate = interest cost + storage cost - convenience yield Gold is not known to have high storage cost (0.1% pa, not like say gas around 30% pa), so the spread is low. On the other hand, the convenience yield can be significant for gold at time, narrowing the contango spread, as you said. If the convenience yield was high enough (like the early 2000s), it can go into backwardation.
Just so we are clear, I am very well versed in the areas of futures. With that being said, my point is that you cannot claim there is a limit without expressing some sort of idea as to what that practical limit is. What point on the curve are you talking about? 3 months? 5 years? What are inflation expectations? What currency are you speaking about? Reasonable contagos are not consistent across different enviroments. I don’t disagree with you, but rather just don’t like the question.
Oh…and while I am on the subject, Dreary is correct above. There is no such thing as an clear arbitrage opportunity for physical commodities futures. At times, for known future yields and storage costs, upper limits on the futures price may be obtained. However, future yields are rarely known or constant throughout time. Therefore, there is no clear way to replicate the future, and no way to arbitrage it the way you can with financial futures.
Storage cost I quote is annual. As you saw in the chart, net lease rate for gold got to be 6-10% in 1999 for maturities 1-12m, which was higher than nominal risk free (if I recalled correctly). Inflation, as you know, is baked into the nominal risk free rate. USD rate. http://www.kitco.com/lease.chart.html Anyway, agree with you that the LOS is not clear, so I took it to be RELATIVE to other commodities (say gas or even worse electricities which have no storage).