Schweser, Book 4, page 432: “When prices are perceived as relatively low, commodity producers are exposed to larger risks and seek to sell futures. This excess supply drives futures prices lower (backwardation)”. But a Schweser QBank question says that “In normal backwardation, futures prices tend to rise over the life of the contract because speculators are net long and have to receive compensation for bearing risk. When hedgers are net short futures contracts, they must sell them at a discount to the expected future spot prices to get speculators to hold a net long position.” So in normal backwardation, are futures prices being driven lower or higher???
backwardation is when forward or futures price is below its spot price. When prices are low and volatile, producers hedge and the market enters backwardation.
Let me take a run. Future/Forward prices - The farmer (for simplicity) is not in the business of trading grain, but farming. Therefore he will enter into a future contract early in the season prior to harvest offering a discount (ie future
backwardation and normal backwardation are not the same thing. they are two different concepts… When the Futures price < Spot Price then this is called Backwardation. Futures price below the current spot price (FP < S0) Can occur if monetary and/or non-monetary benefits of holding assets are large enough and they swamp the interest rate in the cost of carry for the asset. F=S*(1+rf)^t - Net Benefits… Now Normal Backwardation and Normal Contango. =================================================== Where does the expected spot price fit into all this? Answer: It depends on the balance of hedgers and speculators Suppose all the hedgers are on the short? Can futures price = expected spot price? Probably not: Hedgers (shorts) are rejecting price risk (They want to sell their goods). Speculators (longs) will require compensation to accept risk – need a price inducement to buy the goods. Result: Futures price < expected spot price This is called normal backwardation If all the Hedgers are Long: They want to buy goods, again are rejecting Price Risk. Speculators (short) will need compensation to accept the price risk. (again price inducement in forms of higher prices). So Futures Price > Expected Spot Price. This is called Normal Contango.
So backwardation is when futures prices is less than spot price, and normal backwardation is when expected futures prices is less than expected spot price?
not expected future - but futures price is less than expected spot…
the way i think of it is that they both have the same result, you just get there different ways. since the net benefit rarely outweighs the interest rate, we don’t call it “normal.” so the “normal” way to get to backwardation is when hedger are net short.
CP, does this get covered both in derivatives and in alternative assets?
yes… a little less in alt inv. more in derivatives.
don’t forget, that when a market is backwardation the commodity will in theory get offered out of storage. The best example was the recent wild cantango in the crude market. The futures were so high the carry trade was effectively profitable (if you own a VLCC that is!). So you buy the crude, store it and sell the higher priced future against it. The main point here is to show that a cantango is bearish because of this effect. The points above are dead on, the motivations to buy/sell the futures by a speculator/hedger (producer).
I’m really confused. CPK says: “Suppose all the hedgers are on the short? Can futures price = expected spot price? Probably not: Hedgers (shorts) are rejecting price risk (They want to sell their goods). Speculators (longs) will require compensation to accept risk – need a price inducement to buy the goods. Result: Futures price < expected spot price This is called normal backwardation” So could you fill in the step for me please between the speculators (longs) requiring compensation to accept risk (needing a price inducement) and FP
if people need to be induced into buying something - what does that mean? Reduce the price for them… so that means that the expected spot price will not be equal to the futures price.
cpk123 Wrote: ------------------------------------------------------- > if people need to be induced into buying something > - what does that mean? Reduce the price for > them… so that means that the expected spot price > will not be equal to the futures price. CP is right. I would rephrase it a little differently to make it clearer (atleast it helped me). The speculators are in the market to make a profit. And future prices converge to spot at maturity. So if a speculator is long in future (for a profit,obviously), he expects future price to rise - which can happen if expected spot is higher than future price. So if hedgers are net short, they would need to induce the speculator (buyer in this case) with a “profit” motive which in this case is the expected spot > current future. This is normal backwardation. Note you could have a backwardation (spot > future) and normal backwardation (expected spot> future) at the same time. You could also have backwardation (S
Ah ok, so for normal backwardation, hedgers buy spot ,and sell the futures to the speculators at low prices (and the speculators are hoping the prices will go up), thus bolstering the expected spot price and depressing the futures price. Normal Contango: The opposite
Normal Backwardation and Backwardation are essentially the same thing. Normal Backwardation is just a real life form of Backwardation that incorporates the transfer of risk. From Schweser “Backwardation refers to a situation where the futures price is below the spot price” “…we would expect the futures price to be lower than the expected price in the future to compensate the future buyer for accepting asset price risk. This situation is called normal backwardation”
jdane416 Wrote: ------------------------------------------------------- > Normal Backwardation and Backwardation are > essentially the same thing. Normal Backwardation > is just a real life form of Backwardation that > incorporates the transfer of risk. > > From Schweser > > “Backwardation refers to a situation where the > futures price is below the spot price” > > “…we would expect the futures price to be lower > than the expected price in the future to > compensate the future buyer for accepting asset > price risk. This situation is called normal > backwardation” Not sure what you mean they are the same thing. 1) one could have a backwardation (spot > future) and normal backwardation (expected spot> future) at the same time. Spot =14; Future= 10 ; ES =11 2) have backwardation (S>F) and normal contango( ES
This crappy thread has confused me to death. I have reported this thread to the moderator. A simple concept is over-analysed and unnecessarily killed so many peoples’ confidence.
Apologize for adding to the confusion; just go with what cp wrote on this ; ignore rest; Cheers
No apologies bro. I really like your posts, to the level of detail you take them to and try to explain it in simple lucid language to be understood by us here. I simply got pised because I had to stay at home on a Fri night and study for this crappy exam.
Thadim, your explanation is really good. Could someone give a similiar example for when normal contango happens?