What is Backwardation and Contango in Futures Markets?

What is Backwardation and Contango in Futures Markets?

Hi my name is patrick boyle on the finance professor king’s college london and the queen mary university of london where i teach the financial derivatives class to masters and finance students welcome to my youtube channel where i trying to help beginners learn about finance and hopefully reach expert level so today’s video is on the topic of backwardation and

Contango in futures markets so let’s try to understand what these terms mean they can be a little confusing at first so a little background the economist john maynard keynes argued that in general the natural hedgers of a commodity are those who wish to sell the commodity in the future and so what he means by that is that producers of a commodity are the people

That are most likely to hedge in his opinion so he argued that if hedgers collectively hold a net short position in the forward futures market the other side of those contracts must then be held by speculators people who are trying to make a profit from from from their trading in in financial futures and so those people must thus hold a net long position hedgers

Are obviously interested in reducing risk and he argued that they will accept losing a little bit of money on their forward contracts in return for for reducing their risk and that equally that in order to attract speculators into the market that there should be a little bit of built-in profit there for them so kings argued that if speculators are holding a net

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Long position it must thus be the case that the expected future spot price is greater than the forward price this market situation where the futures price is less than the expected spot price is thus referred to as normal backwardation since the forward or futures prices converge with the spot price at maturity normal backwardation implies that futures prices

For a certain maturity are increasing over time the idea is that hedges of these commodities are essentially willing to pay speculators to take the risk of owning the commodity away from them so then contango contango is our other condition is a condition where the price of distant delivery prices for futures contracts exceeds spot prices and this is often due

To things like storage costs the cost of storing and ensuring the underlying commodity so contango implies the futures prices for a certain maturity are falling over time here’s a chart on your screen right now showing you what contango and backwardation look like versus the expected future spot price of the commodity there are lots of theories as to why certain

Products trade in contango or backwardation and no perfect answer exists it’s still a puzzle that academics are trying to explain today in fact there’s lots of papers that come out you know discussing this very topic some commodities have a way that they normally trade so they either normally trade in contango or normally in backwardation and then from time to

Time they might flip into the other condition driven by the pressures of supply and demand this obviously can materially affect a traders p&l these videos hopefully you are finding useful they’re all based on my book which is called trading and pricing financial derivatives it’s available on amazon and i’ve put a link below if you want to if you want to read

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It hopefully you found the video helpful if so i’d love if you could hit the like button below if you’d like to see more videos like this also hit the subscribe button please also feel free to comment below let me know what you think of these videos are they helpful how could i improve them and equally let me know if there are other financial topics that you’d

Like me to cover thanks very much for watching bye and see in the next video

Transcribed from video
What is Backwardation and Contango in Futures Markets? By Patrick Boyle

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