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Understanding the concept Contango, backwardation, convenience yield in Financial Derivatives

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Contango, Backwardation and Convenience yield are the important concept in FD. These concept indicates the relation between spot price and future price in commodity market.

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Understanding the concept Contango, backwardation, convenience yield in Financial Derivatives

  1. 1. CONCEPTS OF BACKWARDATION, CONTANGO AND CONVENIENCE YIELD Presented By: Geeta Saravate 1
  2. 2. INTRODUCTION Backwardation, Contango and convenience yield explain the relationship between the spot and futures prices in commodity markets.  Backwardation  Spot price > Futures price S(t) > F(t,T)  Contango  Spot price < Futures price S(t) < F(t,T)  Basis (temporal basis)  Futures price –spot price F(t,T) –S(t)  Backwardation  discount, Contango premium 2
  3. 3. CONTANGO  Contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. This fee was similar in character to the present meaning of Contango, i.e., future delivery costing more than immediate delivery, and the charge representing cost of carry to the holder.  Contango is a situation where the futures price (or forward price) of a commodity is higher than the expected spot price.  In a Contango situation hedgers are "willing to pay more for a commodity at some point in the future than the actual expected price of the commodity.  This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today. 3
  4. 4.  A contango is normal for a non-perishable commodity that has a cost of carry.  The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. The analysis of contango  The spread between futures and spot prices is related to the cost of holding commodities over time (carrying charges): F(t,T) –S(t) = CS(t,T) -F(t,T) : Futures price at t for delivery at T -S(t) : Spot price at t -C s(t,T): Storage costs between t and T 4
  5. 5. BACKWARDATION  The opposite market condition to Contango is known as normal backwardation.  A market is "in backwardation" when the futures price is below the expected future spot price for a particular commodity.  This is favourable for investors who have long positions since they want the futures price to rise.  In broad terms, backwardation reflects the majority market view that spot prices will move down, and Contango that they will move up.  Both situations allow speculators to earn a profit.  Normal backwardation, also sometimes called backwardation, is the market 5 condition wherein the price of a forward or futures contract is trading below the expected spot price at contract maturity.
  6. 6.  If there is a near-term shortage, the price comparison breaks down and Contango may be reduced or perhaps even reverse altogether into a state called backwardation. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later and because there are few holders who can make an arbitrage profit by selling the spot and buying back the future.  A market that is steeply Backwardated - i.e., one where there is a very steep premium for material available for immediate delivery—often indicates a perception of a current shortage in the underlying commodity.  By the same token, a market that is deeply in Contango may indicate a perception of a current supply surplus in the commodity.  In 2005 and 2006 a perception of impending supply shortage allowed traders to take advantages of the Contango in the crude oil market. 6
  7. 7. EXAMPLE  In 2005 and 2006 a perception of impending supply shortage allowed traders to take advantages of the Contango in the crude oil market. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses. It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this.  The Oil Storage Contango was introduced on the market in early 1990 by the Swedish based oil storage company Scandinavian Tank Storage AB and its founder Lars Jacobsson by using huge military storage installations to bring down the "calculation" cost on storage to create the Contango situation out of a "flat" market. 7
  8. 8. CONVENIENCE YIELD  Users of a Consumption asset may obtain a benefit from physically holding the asset (as inventory) prior to T (maturity) which is not obtained from holding the futures contract.  These benefits include the ability to profit from temporary shortages, and the ability to keep a production process running.  The convenience yield is inversely related to inventory levels.  Sometimes, due to irregular market movements such as an inverted market, the holding of an underlying good or security may become more profitable than owning the contract or derivative instrument, due to its relative scarcity versus high demand. 8
  9. 9.  Supply is an inelastic function of price -High fixed costs of production (mineral resources) -High fixed costs of transportation (gas facilities) -Seasonality (agricultural products) -Joint production processes (petroleum products) Uncertainty  Supply may abruptly change: -Weather conditions (agricultural products) -Failure in production / transportation / transformation capacities -New discovery (mineral resources) -New plants -Technological changes (energy products) 9

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