If you’re well versed with the fundamentals of future market, you may well have detected of the words Contango and backwardation. Ostensibly troublesome owing to the jargon, this is often truly an easy thought and can potentially be tested as theory queries in FRM and CFA.
Most people confuse normal and inverted future curves with Contango and Backwardation. Actually Contango and Backwardation are totally different from future curves.
If the contract costs of future contracts with longer terms to maturity area unit on top of those with shorter terms to maturity, itâ€™s known as a normal futures curve. If the contract costs of future contracts with longer terms to maturity are less than those with shorter terms to maturity, itâ€™s known as an inverted futures curve.
Remember that the normal and inverted futures curves are plotted for costs of future contracts each with a distinct maturity. Normal futures curve is typically observed as a result of 2 reasons mentioned below:
- If a physical plus is to be delivered sometime in future as against the current time, the vendor incurs a storage price and thence costs are higher for future delivery.
- The value to be paid in future ought to logically embrace the chance price of interest lost at the unhazardous rate.
Inverted futures curve may be a less probable factor however will be discovered if there’s a profitable convenience yield in case of commodity futures or if there are future dividends expected in case of stock futures driving the long run value up.
Now contemplate one futures contract. In futures basics, you have learnt that at maturity, the futures price ought to converge to identify spot price or the â€˜basisâ€™ that is the distinction between futures price and spot price, ought to return right down to zero.
Unlike normal and inverted markets wherever the curve is for future contracts with completely different maturities, Contango and Backwardation phenomena are observed within a future contract till the time maturity.
If the present futures value of a contract is above the expected price at maturity, it’s referred as Contango. And as per the basis convergence principle, the long run value ought to be downward sloping to equal the price at maturity.
If the futures value is below the expected price at maturity, it’s referred as Backwardation. And as per the idea convergence principle, the long run value ought to be upward sloping to equal the price at maturity.
The reasons for Contango and Backwardation are mostly supply and demand;
- If copper is currently abundant and has uninterrupted supply, it might follow Contango because the current spot price will be lesser due to high supply.
- If copper is currently scarce and little supply, it might follow backwardation because the current spot price will be higher due to less supply.
Proper understanding of Contango and Backwardation concept helps a hedger foresee liquidity issues due to margin requirements in a future contract.