In the course on commodity investments (CFAI) i read: “When the futures markets are in backwardation, a positive return will be earned from a single buy-and-hold strategy” Ok, so this one, i already don’t get… buy and hold what? Just a futures? How will it ensure return? And then it goes: “The positive return is earned because as the futures contract gets closer to maturity, its price must converge to that of the spot price of the commodity”. Ok here i get lost really. We just discussed in another post that the futures price is fixed. Or do they mean here the price of the futures contract, and not the futures price (of the underlying in the contract)? And even though, it makes no sense to me. Finally, third sentence in a row: “Because in backwardation the spot price is greater than the futures price, the futures price must decrease in value” They lost me… i don’t want to launch an endless discussion here so if you have a hint like “just go and read Schweser instead” or anywhere where they provide baby language, please don’t hesitate.
In backwardation, futures cost less that the spot price. So, if you buy a futures contract in backwardation, it’ll get more valuable as it gets closer to expiration. If you buy a one month forward commodity in backwardation at say $54 when the spot price is $60. If the spot price doesn’t move (which is a big if), at expiration you’ll buy the commodity for $54 and sell it for $60. $6 profit just by buying and holding.
Yes, exactly, I have a problem with this big if. If specialists assume that a buy and hold strategy pays good returns in backwardation, I understand it means that they don’t consider futures prices as a indication of expected future spot price. Why is it that obvious on commodity markets in backwardation that spot price will not move down to futures price? Thanks for your help
I think in this case with futures & commodities is:
- the price of the future actually able to rise/fall (without entering into an offsetting position) because of the mark-to-market feature of futures. typically futures are not used to deliver the underlining product.
In forwards, the “value” remains the same unless you enter into an offsetting position. I.e if you bought a forward of wheat @ 100 a bushell, you would deliver $100 and receive a bushel of wheat regardless of what the current spot rate is doing. That doesn’t mean the relative market value of your forward is worth more/less since you entered into the position.
- Storage costs make future @ t=1 less expensive than s=0 in cases of backwardation
Can we think about it from a roll yield perspective ? like when you roll for another futures contract ?
A buy and hold strategy in commodities does not guarantee a positive return. The spot price could move either way based on supply and demand. All else equal though, you can buy a commodity in backwardation and get positive roll yield if the spot price remains above the futures price you locked in until expiration.
It’s not the spot price that matters, it is the term structure of the future’s curve that matters. If the spot price moves down, then the futures @ t=2 (which becomes t=1 at the original future) also moves down which creates a profit when you roll over into the next future’s contract.
Ok thanks!!
I also want to add that this return i’ve been referencing is the roll-yield.
There are 3 components: spot return, roll-yield and collaterol yeild.
In backwardation the roll-yield will always exist but that does not ensure the spot price will not rise/fall. It’s possible that a product in backwardation would have a loss in the spot return.
Can you give me an example of roll over with some example dates?
I am having hard time understanding.
Is it like you have say one year futures. at the end of one year you enter into a new future contract for another year?
That’s exactly right.
Here’s a simple example, using each term period being a year in length.
Spot today is 40
Future for T=1 (today) is 35
Future for T=2 (today) is 30
1-year passes, Future @ T=1 is now T=0, time to roll. Assume no change in spot
Spot is 40
Future for T=0 (was T=1) is 40 (converged to spot - backwardation realized)
Future for T=1 (was T=2) is 35
Trader’s Action:
Sells Future for 40, buys T=1 future for 35. Roll-yield is 5/35 or 14%
Just to add, in backwardation the futures ‘curve’ goes further into ‘backwardation’ (although at less of a rate of change) the further along the curve you go.
Check out the futures curve of Cocoa:
got it…
the price 35 in calculating Roll-yield - is it the original price or price at the time of rolling over?
I am guessing its the price at the time of rolling over… can someone confirm?
Thanks.