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What are the implications of contango and backwardation?

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What are the implications of contango and backwardation?

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"Contango" is the process whereby near-month futures are cheaper than those expiring further into the future, creating an upward sloping curve for futures prices over time (i.e. Futures Price > Spot Price at contract maturity). In a contango environment, an investor who is long futures may experience "negative roll yield" if the contract is rolled after the futures price moves downward to converge with the expected spot price. Even if the commodity appreciates, the investor holding long futures may experience a loss.


"Backwardation" is opposite of contango, when near-month futures are more expensive than those expiring further into the future (i.e. Future Price < Spot Price at contract maturity). In a backwardation environment, an investor who is long futures may experience "positive roll yield" if the contract is rolled after the futures price rises to converge with the expected spot price. Even if the commodity appreciates, the investor holding long futures may experience no loss.

WTI crude oil has at times in the past traded in contango due to material storage costs of oil, as well as high demand of crude oil. Because roll yields are considered in the calculation of the Index, the presence of contango in the commodity markets could result in negative "roll yields", which could adversely affect the level of the Index.  

Self Photos / Files - price_03_160303

Contango and/or backwardation are caused by many factors such as:

Carrying Costs
It consists of financial, storage, and insurance costs which are required to store the relevant commodity. Some commodities, such as natural gas and crude oil, are known for exhibiting steep contango over time as the carrying costs associated are relatively high.

Market supply and demand of the delivery month
E.G. For agricultural products, during September in the harvest season when shipment of the harvests takes place, the expected increase of supply influences the drop in price. If the expected supply is to increase, backwardation occurs where futures price is lower than the spot price.

Convenience yield
It refers to the non-monetary earnings from raw material inventory

Irregular market movements
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

 

Other You might be interested in:

When does the Sub-fund have roll-over trading? And how does it take place?

The Index includes provisions for the replacement (also referred to as "rolling") of the nearest contracts as they approach maturity. The rolling of a nearest contract occurs over a 5 day period every month, commencing on the 5th S&P GSCI Business Day of the month, and ending on the 9th S&P GSCI Business Day of the month.   For example, on 5 May 2016 (4th business day of the month), the Sub-Fund will hold 100% June 2016 contracts, which is the first nearby contract. For the avoidance of doubt, the last trading day of the first nearby contract is the 4th business day prior to the 25th calendar day each month. On 6 May 2016, which is the first day of roll-over being the 5th business day of the month, the Sub-Fund will hold 20% July 2016 contracts and 80% June 2016 contracts.  On 9 May 2016, the Sub-Fund will hold 40% July 2016 contracts and 60% June 2016 contracts. In the following two business days, the Sub-Fund will increase its holding of July 2016 contracts by 20% each business day while decreasing its holding of June 2016 contracts by the same amount until, at the end of 12 May 2016, which is the final day of the roll-over (9th business day of the month), the Sub-Fund will hold 100% July 2016 contract. 

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Any factors leading to contango or backwardation?

Contango and/or backwardation are caused by many factors such as:Carrying CostsCarrying costs consist of financial, storage, and insurance costs which are required to store the relevant commodity. Some commodities, such as natural gas and crude oil, are known for exhibiting steep contango over time as the carrying costs associated are relatively high compared with other commodities.Market supply and demand of the delivery monthFor agricultural products, during September in the harvest season when shipment of the harvests takes place, the expected increase of supply influences the drop in price. If the expected supply is to increase, backwardation occurs where futures price is lower than the spot price.Convenience yieldConvinience yield refers to a benefit or premium with  holding raw material inventory, rather than the contract or derivative product.  It stems from the availability of timely physical delivery.  In 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.

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