Subject 5. Backwardation and contango

The terms are used primarily in certain commodities and energies markets.

Backwardation is a market condition when the spot price exceeds the futures price, or when the nearby futures price exceeds the distant futures price. An asset has a convenience yield when traders are willing to pay a premium to hold the physical asset at a certain time. For example, natural gas prices tend to be high in the winter - just when people need heat. Likewise, soybean prices are high just before harvest - just when supplies are low and people still want to eat.

Contango is the opposite condition, where futures prices exceed spot prices.

A market can be in backwardation or contango. For example, in the oil market, the prevailing condition may reflect supply and demand. If crude oil is contango, it may indicate a glut of immediately available supply. Backwardation might indicate an immediate shortage.

Practice Question 1

Which of the following statements is (are) true with respect to the theories that explain the differing futures price patterns?

I. Normal backwardation generally occurs in a market that is more dominated by short hedgers.
II. Under the contango theory, the futures price is set below the spot price expected at the time the contract matures.
III. The net hedging hypothesis states that, futures prices rise and fall as they approach maturity.
IV. Under normal backwardation, the future price is seen to be moving over time from above the expected future spot price over the actual spot price upon expiration of the contract.

A. I and III
B. I, III, and IV
C. II, III, and IV
Correct Answer: A

II is incorrect because under the contango theory, the market is dominated by long hedgers. Thus, in order to induce speculators to take on the sell side of the contract, the futures price is set above the spot price expected at the time the contract matures. In other words, if the speculators sell the contract, they can deliver the underlying asset at a contract price that is widely believed to be above the spot price in the future.

IV is incorrect because under normal backwardation, the future price is seen to be moving over time from below the expected future spot price over the actual spot price upon expiration of contract.