CONTANGO AND BACKWARDATION:
- The current price of an asset (financial, commodity) at which it is bought and sold for immediate payment and delivery is called spot price. The price of an asset (financial, commodity) at which it is bought and sold in future is called the future price.
- The shape of the futures curve is important to commodity hedgers and speculators. Both care about whether commodity futures markets are contango markets or normal backwardation markets.
- In 1993, the German company Metallesellschaft famously lost more than $1 billion dollars – mostly because management deployed a hedging system that profited from normal backwardation markets but did not anticipate a shift to contango markets.
- A situation where the future price is greater than spot price of market is called contango.
- This usually happens when people pay premium for commodity in the future instead of paying the costs of storage and carry costs of buying the commodity today.
- Future Curve will be Upward Sloping.
- Backwardation is simply the opposite of contango.
- Backwardation can occur if the markets have oversupply of commodities.
- Backwardation refers to the market situation where the future prices are lower than the current spot prices for a particular commodity.
- Future curve will be downward sloping.
- Backwardation starts when the cost of carry –i.e., storage, financing and convenience fees, exceeds the difference between the forward and spot price.
Both Contango and Backwardation are important for rational pricing in futures markets, and sometimes present opportunities for investors to arbitrage price discrepancies.