contango vs backwardation

Discussion in 'Commodity Futures' started by trade2live, Feb 8, 2011.

  1. It's well known that contango is limited by the full carry, still I believe it can exceed the full cost of carry on rare occurences.
    How often does that happen ?

    Now it's also well known that in backwardation there is no limit to the premium the front month can command over deferred months. I don't quite understand this, the premium can not be arbitraged away since the physical can't be borrowed and shorted against future purchase.

    But why hasn't finance come up with a way to do this, after all borrowing the physical to sell it then paying it back with a future delivery should be feasible ?
  2. rose


    firstly, the issue of contango and carry could open a can of worms here.

    Secondly, if a market is in steep backwardation it implies that the physical is very scarce. For instance, if there was a squeeze in live cattle how would you intend to borrow non-existent cattle? Insemination, gestation, maturation mean that natural methods will not deliver cattle to you soon enough. And no one will enter into any kind of synthetic cattle swap because they won't be able to hedge with the physical either.

    This more or less extends to all commodities - and explains backwardation. At some point the premium (say in chicago cattle) may becomes so large that it becomes economic to take australian or french cows, put them on an airbus, and deliver them into the short chicago market.
  3. An example of what can cause contango to significantly exceed full carry is an economic distortion that requires more of a certain good to be moved to storage beyond what is perhaps easy to store. The forward market creates an incentive to find new ways to store and arb the commodity. An example of this would be crude oil after the financial crash. The forward market was massively above cash for some time which created a profit opportunity to those able to create new storage (such as renting oil tankers). Something needed to happen so the price structure created the incentive.

    Backwardation: Perhaps you can invest a time machine that can transport goods back in time in order to alleviate a current shortage?

  4. local


  5. As a follow up to this thread, does anyone know how often commodity indexes are in backwardation and what determines the shape of their curve. I understand they are cashed settled, how do these indexes track the curve of their underlying ?