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Subject 4. Prices at the commodity futures exchanges

Backwardation and Contango

Contango is the situation where the price of a commodity for future delivery is higher than the actual spot price. It is a term to describe an upward sloping forward curve.

Backwardation is the opposite of contango. In this state, near prices become higher than far (i.e., future) prices because consumers prefer to have the commodity sooner rather than later.

A market that is steeply backwardated often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.

The difference between gold and oil is the usage of each and their storage costs. Backwardation very seldom arises in money commodities like gold or silver. This is because it costs a large amount of money to store oil, whereas gold costs next to nothing to stash somewhere as a function of its value. Instead, every barrel of oil that is extracted is done so for the purpose of consumption. The cost of storing oil on speculation or on arbitrage is just too huge to make it a profitable activity unless there were an absolute huge positive premium between near and far month contracts.

Return Component

The return from a collateralized portfolio of commodity futures contracts comes from four main sources:

Total return = Spot return + Roll return + Collateral return + Rebalancing return

  • The spot return is simply the price appreciation in the spot price, which is based on immediate delivery, of the commodity.
  • As an investor in futures contracts has to roll contracts he has to deal with contango and backwardation. If the term structure is in backwardation the roll yield is positive whereas it is negative when the term structure is in contango.
  • Collateral return is the return accruing to any margin held against a futures position and which is normally the U.S. T-bill rate.
  • Rebalancing return is the incremental return earned by a rebalanced portfolio. The underlying source of the diversification is the rebalancing.

Practice Question 1

As the futures contract approaches maturity, a commodity will trade at higher and higher prices to finally meet the future spot price. This situation is called:

A. Contango.
B. Backwardation.

Correct Answer: A

On the other hand, backwardation is the situation where the future contract price is lower than the spot price for a commodity. It is characterized by a downward slopping futures curve, which is referred as 'backwardated'.

Practice Question 2

Based on the assumption of rational expectations, ______ should dominate in the commodity futures markets.

A. Backwardation.
B. Contango.
C. Neither backwardation nor contango.

Correct Answer: B

The futures price should lie above the spot price based on rational expectations hypothesis.

Practice Question 3

Which of the three distinct sources of return is close to the T-bill return?

A. Collateral yield.
B. Roll yield.
C. Spot price return.

Correct Answer: A

It is the return on cash used as margin to take long derivatives exposure. The roll yield is also called the convenience yield.

Practice Question 4

The theory of backwardation is confirmed by:

A. The storage hypothesis.
B. The convenience yield hypothesis.
C. The global supply and demand analysis.

Correct Answer: A

If the storage cost of a commodity is high, its futures market is likely to be in backwardation.

Practice Question 5

Which commodity yield can be either positive or negative to the long investor?

I. Collateral yield.
II. Roll yield.
III. Spot price return.

Correct Answer: II and III

The roll yield can be positive (negative) when the market is in backwardation (contango). The spot price return can be either positive or negative because the price can go up and down.

Practice Question 6

The primary argument for adding commodities to traditional portfolios is

A. Inflation shock and liability matching.
B. Commodities provide a reduction in portfolio risk.
C. Return-timing diversification.

Correct Answer: B

Practice Question 7

When the market is in backwardation, the roll yield will be ______ for a long investor.

A. negative.
B. positive.
C. zero.

Correct Answer: B

The long investor can buy the commodity below the current spot level from a hedger.

Practice Question 8

For the long investor, when the commodity market is in contango,

A. The roll yield is negative.
B. The spot yield if positive.
C. The collateral yield is negative.

Correct Answer: A

This is because the long investor is buying futures at a price higher than the spot price.

Practice Question 9

Currently commodity markets are in contango. This means the roll yield on commodity indices is:

A. positive.
B. negative.
C. zero.

Correct Answer: B

An investor would need to buy the commodity index above the current spot level when it's time to roll the contract.

Practice Question 10

When the market is in backwardation, the roll yield will be ______ for a hedger.

A. negative.
B. positive.
C. zero.

Correct Answer: A

The long investor can buy the commodity below the current spot level from a hedger when it's time to roll forward the maturity of the derivatives position.

Practice Question 11

The most difficult return component of commodity futures investments to forecast is the:

A. spot return.
B. roll return.
C. collateral return.

Correct Answer: A

The spot price is influenced by fundamental factors that are unpredictable.

Practice Question 12

If the commodity market is in contango, the roll return will be:

A. positive.
B. zero.
C. negative.

Correct Answer: C

The rolling from the maturing to the next shortest futures contract generates negative income.

Study notes from a previous year's CFA exam:

f. explain backwardation and contango in terms of spot and futures prices;

g. describe the components of return to a commodity futures and a portfolio of commodity futures;

h. explain how the sign of the roll return depends on the term structure of futures prices;