Question

In: Finance

Why do some commodity futures contracts trade at premiums to spot (contango) while others trade at...

Why do some commodity futures contracts trade at premiums to spot (contango) while others trade at discounts (backwardization)?

Solutions

Expert Solution

Contango is a situation where future price of a commodity is higher than its spot price while Backwardation is a situation where future price of a commodity is lower than its spot price.

The price difference between the futures and spot market may be due to several reasons that affect the cost of carry (for example, cost of carry for commodity goods may be cost of storage and insurance)

For example, a case of backwardation would be, say if there's a severe drought, the wheat prices may shoot up in the spot market, while the futures price may remain constant (assuming the weather department has predicted a good rainfall in the coming period).

Or
A case of contango would be, say if analysts expect the oil prices to increase in future due to geopolitical tensions in the major oil producing nations

However,  futures and spot prices are generally expected to converge with the spot price by the time futures expire.


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