Question

Question 1. Contango and backwardation.

1.       Go to the CME website, obtain a screenshot of the various futures contract prices for the following commodities, and determine whether each market is in contango, backwardation, or a mixture of contango and backwardation

(1)        Corn

(2)        Crude oil

(3)        Live cattle

2. Use the concepts of cost-of-carry and convenience yield we discussed in the class, explain why contango is the normal market behavior, while backwardation is often considered as an “abnormal” market.

3. Explain why when the market is in contango the inventory of the commodity tends to be high, and when the market is in backwardation, the inventory of the commodity tends to be low.

Answer 1

Answer 1

(a) Corn: Corn trades in Backwardation.

(b) Corn Oil: Corn Oil trades in Backwardation.

(c) Live Stock: trades in contango. This is because live stock has a finite life and have to be taken care of if they are supposed to live and serve the purpose. Hence the cost of maintaining a asset is more.

Answer 2

The general equation to depict the relationship between spot prices and futures prices we use the concept of cost of carry and convinience yield. Convinience yeild refers to the monetary and non monetary benefits derived from having the asset with the investor. So the equation is shown as below

So as the costs of holding an asset increases or the benefits decrease the futures prices tend ti increase and this phenomena is called the stage of Contango where the futures prices are higher than Spot Prices. Generally, the analysts are of the opinion that the resources are depleting etc whch figures out that ideally the prices going forward must be higher than the current prices.

On the other hand if the cost of holding an asset declines and the benefits increase then the futures prices tend toi decline and be less than the spot prices. This is referred to as the situation of Backwardation. This is against the primary thinking that the resources are being depleted and the growth in such resources are not possible.

Answer 3

In the times of contango people perceive that there is going to be a shortage of asset in the market. this is because the futures prices are expected to be higher than current prices. In light of the statement, people tend to accumulate the asset / buy the asset so that they don't havr to pay extra for the asset in the time of supposed shortage.

In times of Backwardation people perceive that since the prices are going to decline we can delay our consumption and buy the asset when the prices decline. Hence people tend to consume the asset in hand and hence the inventory levels decline during the phase of contango.