I don’t why I’m struggling with this. I think I am overthinking it but as I understand it, Insurance Theory states that producers will want to protect themselves against falling prices and will sell futures as insurance resulting in downward price pressure on futures. So if futures prices are falling, how does this translate into positive returns for the buyers of those contracts?
Insurance Theory simply explains backwardation. It doesnt say the buyers have to profit.
https://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91365542
From Schweser:
The Insurance Theory states that the futures prices will be less than current spot prices to provide a return to those buying futures from producers (i.e., speculators). In this view, the resulting positive return to the buyers of futures contracts is their return for providing insurance against price uncertainty to producers.
I thought about this some more and it makes sense to me if we assume SPOT and FWD prices remain unchanged. Let’s say producer P wants to insure his wheat prices and sells a 90 day forward. In this scenario, according to the insurance theory, FWD < SPOT as P will need to pay a “premium” to insure his price. Let’s say SPOT = 45 and FWD = 40. If prices remain unchanged after 90 days, Buyer B, who bought the wheat from P, pays 40 for the wheat and sells it in the market for 45 therefore making a net profit. Not sure if that’s the correct way to think about it.