BROWSE

Backwardation

Definition

Normal backwardation, also sometimes called backwardation, is the market condition wherein the price of a commodities' forward or futures contract is trading below the expected spot price at contract maturity. The resulting futures or forward curve would typically be downward sloping, since contracts for further dates would typically trade at even lower prices. In practice, the expected future spot price is unknown, and the term "backwardation" may be used to refer to "positive basis", which occurs when the current spot price exceeds the price of the future.

What is 'Backwardation'

Backwardation is a theory developed in respect to the price of a futures contract and the contract's time to expire. As the contract approaches expiration, the futures contract trades at a higher price compared to when the contract was further away from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk-free rate.

Explaining 'Backwardation'

When backwardation occurs in a futures market, it has been suggested an individual in the short position benefits the most by delivering as late as possible. Backwardation in futures contracts was called "normal backwardation" by economist John Maynard Keynes. He believed a price movement like the one suggested by backwardation was not random but consistent with the prevailing market conditions.

Difference Between Backwardation and Contango

Backwardation is the opposite of contango. Contrary to backwardation, contango is the situation in which a commodity's or underlying security's futures price is above the expected future spot price. Consequently, contango indicates that futures prices are falling over time to converge to the future spot price. For example, if futures contracts on West Texas Intermediate (WTI) crude oil for delivery in six months are trading at $50 while the spot price on the commodity is trading at $40 per barrel, the market is said to be "in contango." Therefore, the WTI crude oil futures curve is upward sloping.

Benefits of Backwardation

The primary cause of backwardation in the commodities' futures market is a shortage of the commodity in the spot market. Since futures prices are below spot prices, investors who are net long the commodity benefit from the increase in futures prices over time as the futures price and spot price converge. Additionally, a futures market experiencing backwardation is beneficial to speculators and short-term traders who wish to gain from arbitrage. Consider the previous example in which futures contracts on WTI crude oil are experiencing backwardation. Assume a speculator who owns oil could sell barrels of WTI crude oil for $40 per barrel. Thereafter, the speculator could purchase the futures contract for $30 per barrel, locking in a "riskless" profit of $10 per barrel.


Further Reading


Normal backwardation is normal
onlinelibrary.wiley.com [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

Convenience yield without the convenience: a spatial–temporal interpretation of storage under backwardationConvenience yield without the convenience: a spatial–temporal interpretation of storage under backwardation
academic.oup.com [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

Is normal backwardation normal?Is normal backwardation normal?
search.proquest.com [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

Futures market backwardation under risk neutralityFutures market backwardation under risk neutrality
onlinelibrary.wiley.com [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

An application of arbitrage pricing theory to futures markets: Tests of normal backwardationAn application of arbitrage pricing theory to futures markets: Tests of normal backwardation
papers.ssrn.com [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

The Working curve and commodity storage under backwardationThe Working curve and commodity storage under backwardation
academic.oup.com [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

Reexamination of normal backwardation hypothesis in futures marketsReexamination of normal backwardation hypothesis in futures markets
search.proquest.com [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

Information and normal backwardation as determinants of trading performance: Evidence from the North Sea oil forward marketInformation and normal backwardation as determinants of trading performance: Evidence from the North Sea oil forward market
academic.oup.com [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

The impact of backwardation on hedgers' demand for currency futures contracts: theory versus empirical evidenceThe impact of backwardation on hedgers' demand for currency futures contracts: theory versus empirical evidence
tuprints.ulb.tu-darmstadt.de [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …

Efficient asset portfolios and the theory of normal backwardation: A commentEfficient asset portfolios and the theory of normal backwardation: A comment
www.journals.uchicago.edu [PDF]
… J. Miffre is a Lecturer in Finance at the ISMA Centre, the University of Reading, Reading, Berks., UK. Page 2 … 8The Kalman filter approach is used to generate white-noise unexpected components in the macro- economic and financial variables … Normal Backwardation 811 …



Q&A About Backwardation


What is backwardation?

Backwardation is a theory developed in respect to the price of a futures contract and the contract's time to expire.

How does backwardation differ from contango?

Contango indicates that futures prices are falling over time to converge to the future spot price.

Why does backwardation occur?

Backwardation occurs due to convenience yield being higher than prevailing risk-free rate.

What causes commodities' futures markets to be in contango or backwardation?

A shortage of commodities in the spot market causes commodities' futures markets to be in contango, while an abundance of commodities in the spot market causes them to be in backwardation.

Who benefits from backwardation?

Investors who are net long a commodity benefit from the increase in futures prices over time as the futures price and spot price converge.