Analyse how spot and futures prices relate when markets are in contango and when they are in backwardation
The idea
A futures curve is in contango when deferred futures prices sit above spot or near-dated prices, and in backwardation when they sit below. Under the theory of storage, contango is normal for goods with ample inventory, because a deferred price must cover financing and storage costs; backwardation appears when stocks are scarce and holders value having the physical good now, its convenience yield. Whatever the shape, a futures price converges to spot at expiry. The trap is reading contango as a forecast that spot prices will rise: the slope mostly reflects carry costs and the balance of hedging demand, not expected price change, and a long investor rolling positions in contango earns a negative roll return each time.
In the app: 2 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 Introduction to Commodities and Commodity Derivatives
- Contrast the features of the different commodity sectors
- Contrast how commodity sectors move through their life cycle, from production to trading or consumption
- Explain how valuing commodities differs from valuing equities and bonds
- Set out the kinds of participant found in commodity futures markets
- Contrast theories explaining commodity futures returns
- Set out, work out and interpret each part of the total return on a fully collateralised commodity futures contract
- Contrast roll return when markets are in contango with roll return when they are in backwardation
- Explain how commodity swaps can be used to gain or adjust exposure to commodities
- Explain how the way a commodity index is built influences its returns