Contago and Backwardation
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- When an asset does not involve any storage costs, cash flows, and/or convenience yield, then one could expect the price of a future contract to equal the spot multiplied by one plus the periodic risk free interest rate.
- However, if there are other cost/benefit variables associated with the underlying asset, then the futures price could equal, exceed, or be below the spot price of the underlying asset.
- Contango: Futures price exceeds current spot price (f0 > S0); interest and storage costs to finance asset purchase exceed physical ownership benefits.
- Backwardation: Futures price is below current spot price (f0 < S0); benefits of physical ownership exceed costs of storage and interest to finance asset purchase.
- "Normal" contango and backwardation describes the relationship between futures prices and the expected spot price.
- Normal Contango: The futures price exceeds the expected spot price (f0 > E(ST)); indicates that the futures price is biased high.
- Normal Backwardation: The futures price is below the expected spot price (f0 < E(ST)); indicates that the futures price is biased low.
- When thinking about contango and backwardation versus normal contango and normal backwardation, keep in mind that the futures price and the expected spot price reflect different degrees of risk. The futures price is based on risk free rate arbitrage pricing, while the movement from the current spot price to the expected future spot price is the price change on a risky asset.
- A futures price can be a biased estimate for the expected spot price and this bias is commonly low.
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