Contango & Backwardation

Contango & Backwardation

INTRODUCTION

The forward curve is a plot of forward rates against time to maturity. Contango and backwardation are the terms used to define the structure of the forward curve. Where the forward rates increase along with time creating an upward sloping forward curve, the market is said to be in contango. The market situation is described as backwardation if the forward rates decrease with time creating a downward sloping forward curve.

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CONTANGO

Futures price being greater than the spot prices create an upward sloping forward curve. This market is in contango whereby the future contracts are trading at a premium to the spot price. Generally, financial instruments are in contango as the futures prices are higher than the spot price to factor the cost of carry (storage cost, operating cost, etc.). Contango can be considered as a normal market position. The chart explains the contango situation.

The primary reasons for a contango market situation are enumerated below:

• Market Expectation

If the market participants expect that the price of the underlying asset will increase in the future, the price of a futures contract of such commodity/instrument will reflect an upward trend.

• Low Convenience yield

Convenience yield is the benefit derived by owning the asset. Where the underlying asset has a low convenience yield, market participants will tend to defer the ownership of the asset which shall decrease the spot price as compared to the futures price.

• Other factors

The other factors that significantly affect the futures price, especially in the commodities market, are demand for the asset, its quality, seasonality, climatic conditions

Practical examples of a contango market situation:

*(prices rounded off to nearest integer)

Example based on the above prices:

A manufacturer of electrical wires requires copper in the month of June. Since the market is in contango, there is no benefit in holding the asset i.e. no convenience yield. Therefore, the manufacturer should enter into a futures contract to buy copper and not opt for the cash and carry model.

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BACKWARDATION

Where the future curve is downward sloping, the market is described to be in backwardation. It implies that the futures contract of a commodity/financial instrument is trading at discount as compared to the spot price. It is an infrequent situation and does not usually last for long. The chart explains the backwardation situation.

The primary reasons for a contango market situation are enumerated below:

• Market Expectation

If the market participants expect that the price of the underlying asset will decrease in the future, the price of a futures contract of such commodity/instrument will reflect a downward trend.

• High Convenience yield

Where the underlying asset has a high convenience yield, market participants will tend to opt for cash and carry model by increasing the stocks of the asset which shall increase the spot price as compared to the futures price.

• Other factors

The other factors that significantly affect the futures price, especially in the commodities market, are demand for the asset, its quality, seasonality, climatic conditions.

Practical examples of a backwardation market situation:

(prices rounded off to nearest integer)

Example based on the above prices:

A manufacturer of batteries requires Nickel in the month of June. Owing to the backwardation situation of Nickel prices, there is a significant benefit in holding the asset that offsets the cost of carry and the opportunity cost. Hence, the manufacturer should follow the cash and carry model and inventory the requirement for June at the spot price.

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RELATION WITH PRICING MODEL

Pricing of commodity and financial forward/futures contracts is based on the spot price of the underlying asset. In the case of a financial asset, the futures price is calculated as expected future spot price as reduced by the dividends received during the period. Similarly, the futures price of a commodity futures contract is calculated as the expected futures spot price as reduced by the cost of storage, leasing cost, and opportunity cost. Non-monetary factors such as quality, climate, etc. also affect the price of the futures contract. The price of a commodity futures contract is calculated as follows:

Where,

S₀ = current spot price

r = risk-free rate

d (delta) = lease rate i.e. income earned if the commodity is loaned out

Based on this commodity futures formula, if r > d then the forward price shall be greater than the spot price resulting in contango market. However, if r < d, then the forward price shall be less than the spot price.

Example:

The spot price for gold is Rs. 42,400. The risk-free rate is 7% and the lease rate is 4%. In this situation, the price of the 3 months gold futures contract shall be

= 42,400 * e^{(0.07-0.04)0.25}  = Rs. 42,719.20

This results in a contango situation.

However, in the same example, if the lease rate is 8%, then the price of a 3 months gold futures contract shall be

= 42,400 * e^{(0.07-0.08)0.25}  = Rs. 42,294.13

This results in a backwardation situation.

CASE STUDY

Metallgesellschaft (MG)

MG was a huge German conglomerate that decided to open an energy trading office in the US in the early 90s. The strategy implemented by MG was as follows:

• Sell refined products using long term forward contracts (5 to 10 years contract)
• Invest in production of refined products
• Buy short term futures contracts and implement the stack and roll hedge

The sales contracts were set at high forward rates making the short-term future contracts profitable. MG would roll its future contracts every month and intended to do so till the maturity of sales contracts. The strategy worked as the market was in a backwardation situation where the price of future contracts for each successive month was lower than the previous month.

However, in 1993, the prices fell and reversed the market from backwardation to contango. This resulted in the price of future contracts of each successive month being higher than the previous month. The positions taken in the futures market were marked to market on a daily basis which increased the losses multifold. The resultant loss totaled to approximately $1.5 billion. MG eventually negotiated a $1.9 billion bailout from its bankers. MG was later bought out by a competitor.

DIFFERENCE BETWEEN CONTANGO AND BACKWARDATION

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IMPACT ON THE CONCEPT OF CONVERGENCE

Convergence is the movement of prices of future contracts toward the spot price of the underlying asset as the delivery date approaches. Convergence happens because the market will not allow the same commodity to trade at two different prices at the same place at the same time. The term of the futures contract may reflect a contango or backwardation situation but the futures price and spot price will converge as the term matures. If significant price differences exist on the delivery date, an arbitrage opportunity exists.

CONCLUSION

Understanding the concept of contango and backwardation helps the investor to design their strategy correctly. It also helps to interpret the future demand trends of the underlying asset.

Author: Apoorv Mehta