Charta is on Google Play: practise on the go. Get the app
Charta

Explain roll return and its link to how the futures curve is shaped

CFA® Level I · Alternative Investments · Natural Resources · AI.5.c

The idea

A commodity futures position held for continuing exposure must be rolled as contracts approach expiry, and the result depends on the curve. In contango the futures price exceeds the spot price and the position sells a cheap expiring contract to buy a more expensive further one, producing a negative roll return that erodes performance even if spot prices are flat. In backwardation the relationship reverses and rolling adds to return. Total return on a collateralised futures position is the sum of spot return, roll return and the collateral yield, and roll has dominated the difference between indexes over long periods.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does contango describe?

  1. A futures price below the spot priceWhy not: That is backwardation, the downward-sloping curve associated with tight current supply.
  2. A futures price above the spot price — correct
  3. Equal futures and spot pricesWhy not: A flat curve, which is neither contango nor backwardation.

An upward-sloping curve is contango, and rolling a long position along it means repeatedly buying higher, which costs return.

A harder one

What are the three components of return on a collateralised long commodity futures position?

  1. Spot return, roll return and collateral yield — correct
  2. Dividend yield, capital gain and roll returnWhy not: Commodities pay no dividend, and the collateral yield is missing.
  3. Coupon, spot return and convenience yieldWhy not: No coupon is paid, and the convenience yield is a determinant of the curve rather than a return component.

The collateral earns a money market return, the spot price moves, and the roll adds or subtracts depending on the curve. Ignoring roll is the most common error in forecasting commodity returns.

The hardest tier

Spot prices are unchanged over a year but the curve has been in steep contango throughout. What happened to the futures position's return?

  1. It matched the spot return of zeroWhy not: Ignores both the roll drag and the collateral yield, which move the result in opposite directions.
  2. It rose by the collateral yield aloneWhy not: Counts the collateral and leaves out the roll, which in steep contango is a substantial cost.
  3. It fell below the spot return of zero — correct

Each roll sold a cheaper expiring contract and bought a more expensive one. Roll return is realised regardless of what spot does, and persistent contango can cost several percentage points a year, which is why index construction rules around rolling matter so much.

In the app: 15 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

Take the free diagnostic →

More in Natural Resources