please guys kindly help me out!! i understand collateral and spot/price return components of commodity returns. i however have difficulty catching the aspect of roll return where the curriculum says roll return should be positive in backwardation and negative in contango. why?what is the reasoning behind this please? thanks in advance guys…
Hi harryy02.
It might help to think about the shape of the curve. Contango means that if you were to chart futures prices (with time to maturity on the x axis and price on the y axis) you would get an upward sloping curve, projecting higher prices the further out you go. This is often deemed standard for certain commodities, particularly due to storage prices (and/or anticipation of higher future demand). What this implies is that if you need to maintain a 3-month forward position you need to regularly “roll” contracts and buy a new one as the previous one approaches maturity. The next one will be more expensive. You are buying higher and selling lower. There is a cost or negative roll yield associated with rolling down the curve, also sometimes referred to as cost of carry.
Reverse that reasoning for backwardation. If the slope is downward sloping because the market is expecting prices to go down, then you are “rolling up the curve” as your contract approaches maturity and increases in value. In this scenario spot price is higher than the 3-mth price which is higher than the 6-mth price etc. So you capture positive carry or positive roll yield by buying at a lower future price and letting it roll toward a higher spot price as it matures.
The above is of course simplifying, and the curve and the relationships it implies can get distorted if supply and/or demand suddenly change.
Hope this helps.
I was initially confused about this as well- thanks to reponders I’m clear now.
http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91326750
thank you very much Gottasay for the very clear explanations. i am ok with your scenario presented. However my only concern left has to do with whether this whole results will be negated when you are rather selling forward in the commodity futures contract unlike where i was actually long the contract? i.e if forward curve is in contango and i am short the futures contract, then it will mean that i will buy at low spot price and then sell at a relatively higher futures price right?. Does this therefore mean that i will make a positive roll return in contango when i am actually short the futures contract unlike the case where i was long the contract? thanks again
Yes. The above was from the perspective of a long position. If you are short you would simply reverse the logic, as with any other instrument.
Bottom line: assuming low transaction costs and assuming the shape of the curve doesn’t change on you, you stand to profit if you have long positions in contracts that are in steep backwardation, and short positions in contracts that are in steep contango.
thanx a lot gottasay… you’ve rlly been helpful… i have even appreciated it better after going through the new currency risk management reading- roll yield/carry trade section of it. i think you really have a good grasp of this roll yield thing. Are you in any way working in the commodity industry or something? …lol…