Contango vs backwardation

CFA Level II Alternative Investments
#1

ok… so i think i have it down. LEt me know if anything im saying is incorrect.

Backwardation = Spot Price > Future Price = negative sloping. Roll yield is positive, since you save money roling into a lower price. Nonstorable commodities typically in backwardation and exhibit positive roll yields because you can’t store it and everyone wants it in the present time (spot rate) and not in the future.

Contango = Spot price < Future Price = positive sloping. Roll yield is negative, since you are rolling into higher prices. Storable commodities like gold are usually in contango and exhibit negative roll yields, because you can store it and consumers would want it in the future time.

Anything else BIG/important, that i am missing?

THANKS ALL

I plan on losing many brain cells this weekend for St. pattys day, so need to study up as much as i can tonight…

#2

I’ve not got to this point yet in my CFA L2 studies, but from what I remember from L1 that’s correct!

#3

There’s more to know… Better hold onto more of those brain cells :wink:

#4

That was pretty much it… a little stuff on convienence yield and thats it…

Commodities was a relatively easy chapter in schweser…

#5

You can also explain it using the storage theory, which considers the effect of convinience yeild: Non-storable commodities have low inventory levels -» high benefit of holding the commodity today as opposed to going long in the futures market -» high convinence yield -» low Futures price -» backwardation … For contango it’s the other way around … You can use the FP formula to link the convinience yield to FP: FP= S*e^(r + storage costs in percent - convinience yield)*T

#6

Another add on:

If the convenience yield is larger than the borrowing rate, causing the futures price to be below the spot price and he market is in backwardation. What you just said.

When the convenience yield is more than the borrowing rate, the no-arbitrage cost-of-carry model will not apply. It means that the value of the convenience of holding the asset it is worth more than the cost of funds to purchase it. This usually applies to non-financial futures contracts.

#7

IF RISK FREE IS LESS THAN DIVIDEND YIELD = BACKWARDATiON OCCURS

If dividend yield is greater than risk free = backwardation occurs.

If risk free rate is greater than dividend yield = Contango occurs.

If dividend yield is less than risk free rate = Contango occurs.

#8

Dividend yield? I’ve never heard of wheat distributing dividends to wheatholders.

#9

Groats.

#10

I still dont get roll yeild after reading this. In a long futures contract you are going to lock in a futures price, and current spot price is lower than futures price (contango) but isnt your profit depend on what the spot price is at expiration? so lets say at expiration of the futures contract the spot price is above the locked in futures price you make a profit?

I am not understanding the rolling part i guess?

#11

At Level III you’ll calculate roll yield as Δforward price – Δspot price.

What you’re trying to do is reconcile the difference between the forward price you pay and the (original) spot price you could have paid.