Contango and Backwardation

[arteja]

Hi David,

I think the way you explain these two terms is a little confusing. The Hull reading says that its contango when the future price of an asset today is more than the expected future spot of the asset, and its backwardation otherwise. So in Contango, traders long the contract lose money, and those short make money.

Is that right? I have difficulty understanding the terms "distant forward" that you use in the videos.

Thanks,
Ravi

 

[David Harper CFA FRM]

Hi Ravi,

Yes, I do differ with Hull in this respect; I have for years b/c i think he is imprecise (I am open to being wrong, of course). I am using terms from CFA and, specifically Don Chance (who i consider authoritative in this respect). Specifcally, when Hull says contango = futures price > expected [future spot] I think *that's* confusing. I have written extensively on this but basically, if we think about an observed forward curve

upward sloping = contango
e.g, note I happen to be in total agreement with wikipedia http://en.wikipedia.org/wiki/Contango
inverted = backwardation
note: these refer to relationship between Spot (S0) and current forward prices (F0)

then (for consistency, and I think, clarity), the use of the term "normal" refers to an unobserved dynamic: the relationship between the forward price and the "unobserved" expected future spot:
normal backwardation: F < E(St)
normal contango: F > E(St)

distand forward refers to the idea that a forward curve can variously have contango and backwardation segments (e.g., both corn and natural gas do), a contango segment is when: forward price (F0) of near term contract < forward price (F0) of distant contract

of course, i don't want to confuse with semantics. I think the key idea, and here of course Hull is profoundly good, to focus on the difference between:

1. The observed Forward price (F0) and
2. The expected future spot price; E(St)

....largely b/c as Hull shows, when the underlying has positive systemic risk, we should expect "normal backwardation" that is, we should expect F < E(St).

thanks, David

 

[David Harper CFA FRM]

...I just checked Hull's 7th Edition (page 121). I don't know when he introduced his caveat, but he now writes "sometimes these terms are used to refer tow whether the futures price is below or above the current spot price." So, Hull appears to at least acknowledge there are different definitions. (I assume he got f/back along the way about his terms). And, he only spends a few sentences on the terms per se, which I think, reinforces the idea that the terms are less important than the mechanics (or, at least I would say, the key theorectical idea is what everybody agrees is called "normal backwardation.") - David