finance homework
Normal Backwardation and Contango in Futures Markets
Monzurul Hoque
A Case for no hedge, ab initio.
LONG ASSETS in place (Hedge Minus) <also true for short asset to be>
| Backwardation | T=0 | T=90 | +/- |
| Long Spot | 85 | 90 | +5 |
| Short Futures | 86 | 98 [St or E(St)] | -12 |
| Basis: (S-F) | -1 | -8 | Basis Weakening Significantly (NEGATIVE slope for basis) – Loss |
| Basis: (F-S) | 1 | 8 | Basis Widens Significantly, Loss |
Cash settle = S90+Profit to Short= 90+(-12)=78; Futures settle=F0+(S-F)= 86+(-8)=78 Backwardation (F0<St or E(St)) and Short hedgers dominate (which is the case here); Basis (S-F) weakening. Do not hedge, will get 90 instead of 78.
Short hedgers negative basis in backwardation market is bad.
If Basis is defined as in here (F-S), then Futures settle= S90-(F-S)= 86-8=78
LONG ASSETS in place (Hedge Plus) <also true for short asset to be>
| Backwardation | T=0 | T=90 | +/- |
| Long Spot | 85 | 90 | +5 |
| Short Futures | 86 | 90 | -4 |
| Basis: (S-F) | -1 | Basis Strengthens (marginally positive slope of basis) Marginally | |
| Basis: (F-S) | Basis Narrows/Weakens Marginally, Gain |
Cash settle = 90+(-4)=86 Futures settle=86+(0)=86 Backwardation (F0<St or E(St)) and Short hedgers dominate (which is the case here); Basis (S-F) strengthening. Do hedge, even though will get 86 instead of 90. But that is not a huge loss given the future uncertainty.
LONG ASSETS in place (Hedge Minus) <also true for short asset to be>
| Contango | T=0 | T=90 | +/- |
| Long Spot | 85 | 80 | -5 |
| Short Futures | 86 | 82 | +4 |
| Basis (S-F) | -1 | -2 | Basis weakens/narrows marginally negative slope of basis = Loss |
| Basis (F-S) | Basis Widens Marginally, Loss |
Cash settle = 80+(4)=84 Futures settle=86+(-2)=84 Contango (F0>St or E(St)) and Long hedgers dominate (which is the case here); Basis (S-F) weakening. Do hedge, will get 86 instead of 84. But that is not a huge loss given the future uncertainty.
LONG ASSETS in place (Hedge Plus) <also true for short asset to be>
| Contango | T=0 | T=90 | +/- |
| Long Spot | 85 | 80 | -5 |
| Short Futures | 86 | 79 | +7 |
| Basis: (S-F) | -1 | +1 | BASIS Widens/Strengthens, positive slope of basis |
| Basis: (F-S) | -1 | Basis Narrows/Weakens Significantly, Gain |
Cash settle= 80+7=87 Futures settle=86+1=87
Example from book:
SPOT UNKNOWN 0.7200
SHORT FUTURES 0.7800 0.7250
S-F -0.005 EFFECTIVE PRICE REC’D BY SELLER .7800 + (-.005)=.7750 BASIS (S-F) WEAKENING (negative slope of basis) IS BAD FOR SHORT HEDGERS (sellers)
SHORT ASSETS in place (Hedge Plus) <also true for long asset to be>
| Backwardation | T=0 | T=90 | +/- |
| Short Spot | 85 | 90 | -5 |
| Long Futures | 86 | 98 | +12 |
| Basis: (S-F) | -1 | -8 | Basis weakens/narrows significantly, Significant negative slope of basis, Gain |
| Basis (F-S) | Basis strengthens/widens Significantly, Gain |
SHORT ASSETS in place (Hedge Minus) <also true for long asset to be>
| Backwardation | T=0 | T=90 | +/- |
| Short Spot | 85 | 90 | -5 |
| Long Futures | 86 | 90 | +4 |
| Basis (S-F) | -1 | Basis widens marginally, marginally positive slope of basis, Loss | |
| Basis (F-S) | Basis Narrows Marginally, Loss |
SHORT ASSETS in place (Hedge Plus) <also true for long asset to be>
| Contango | T=0 | T=90 | +/- |
| Short Spot | 85 | 80 | +5 |
| Long Futures | 86 | 82 | -4 |
| Basis: (S-F) | -1 | -2 | Basis narrows marginally, marginally negative slope of basis |
| Basis: (F-S) | Basis Widens Marginally, Gain |
A Case for no hedge, ab initio.
SHORT ASSETS in place (Hedge Minus) <also true for long asset to be>
| Contango | T=0 | T=90 | +/- |
| Short Spot | 85 | 80 | +5 |
| Long Futures | 86 | 79 | -7 |
| Basis: (S-F) | -1 | +1 | Basis widens significantly, significant positive slope of basis, Loss |
| Basis: (F-S) | 1 | -1 | Basis Narrows Significantly, Loss |
SPOT UNKNOWN 70.00
LONG FUTURES 68 69.10
S-F 0.90
EFFECTIVE PRICE PAID BY BUYER 68 + (.90)=68.90 BASIS STRENGTHENING (POSITIVE) IS BAD FOR LONG HEDGERS
Cash Settle: 70 -1.10 = 68.90
EFFECTIVE PRICE PAID BY BUYER 68 + (70-69.10)=68.90 BASIS (S-F) WIDENING (positive slope of basis) IS BAD FOR LONG HEDGERS (buyers)
Changes in Basis impact profitability in a volatile market. So, to hedge against Backwardation volatility and Contango volatility when you use these concepts to invest; find out the basis slope. For Normal Backwardation, go long futures investment only when the downward sloping basis is steep. For Normal Contango, go for short futures investment only when upward sloping basis is steep.
Your HW: Integrated Investment Management with Cash and Futures only using online sources. Identify and interpret whether Soybean, Japanese Yen and S&P 500 Futures have Backwardation, Contango or Mix Market using online charts and news.
IDENTIFICATION of Normal Backwardation and Normal Contango
Normal Backwardation – 2 conditions: 1) short hedgers dominate and 2) F0 < E(ST)
Short hedgers information you get from Commitment of Traders. Go to CFTC.Gov
F0 < E(ST), this condition is from your fundamental analysis. Currently, you form your expectation [E(ST)]whether it will be higher than current F0.
Normal Contango – 2 conditions: 1) long hedgers dominate and 2) F0 > E(ST)
Short hedgers information you get from Commitment of Traders. Go to CFTC.Gov
F0 > E(ST), this condition is from your fundamental analysis. Currently, you form your expectation [E(ST)]whether it will be lower than current F0.
A note on Backwardation and Contango market used by traders.
Backwardation means that forward contracts are priced lower than nearer term contracts, or spot, and when it occurs it is a sign of price deflation to come. As an example, suppose you could buy gold today (March, 2015) for $1189/oz, and suppose the May 2015 contract were priced at $1180/oz. That means gold today is worth more than what the futures market says it is going to be worth in the future. This sort of condition typically happens due to momentary supply shortages in a spot market for “soft” commodities, especially natural gas or oil. Contango is exactly opposite.
Shape of curve: – Upwards sloping (contango) or – Downwards sloping (backwardation)
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