Backwardation
Encyclopedia
Normal backwardation, also sometimes called backwardation, is the market condition wherein the price of a forward
or futures contract
is trading below the expected spot price
at contract maturity. The resulting futures or forward curve would typically be downward sloping (i.e. "inverted"), since contracts for farther dates would typically trade at even lower prices. (The curves in question plot market prices for various contracts at different maturities—cf. term structure of interest rates)
The opposite market condition to normal backwardation is known as contango
.
A backwardation starts when the difference between the forward price
and the spot price
is less than the cost of carry
, or when there can be no delivery arbitrage because the asset is not currently available for purchase.
Futures contract price includes compensation for the risk transferred from the asset holder. This makes actual price on expiry to be lower than futures contract price. Backwardation very seldom arises in money commodities like gold or silver. In the early 1980s, there was a one-day backwardation in silver while some metal was physically moved from COMEX
to CBOT
warehouses. Gold has historically been positive with exception for momentary backwardations (hours) since gold futures started trading on the Winnipeg Commodity Exchange in 1972.
The term is sometimes applied to forward prices other than those of futures contract
s, when analogous price patterns arise. For example, if it costs more to lease silver
for 30 days than for 60 days, it might be said that the silver lease rates are "in backwardation".
that is greater than the risk free rate.
It is argued that backwardation is abnormal, and suggests supply insufficiencies in the corresponding (physical) spot market. However, many commodities markets are frequently in backwardation, especially when the seasonal aspect is taken into consideration, e.g., perishable and/or soft commodities.
In Treatise on Money (1930, chapter 29), economist John Maynard Keynes
argued that in commodity markets, backwardation is not an abnormal market situation, but rather arises naturally as "normal backwardation" from the fact that producers of commodities are more prone to hedge their price risk than consumers. The academic dispute on the subject continues to this day.
, the term originated in mid-19th century England, originating from "backward".
In that era on the London Stock Exchange
, backwardation was a fee paid by a seller wishing to defer delivering stock they had sold. This fee was paid either to the buyer, or to a third party who lent stock to the seller.
The purpose was normally speculative, allowing short selling
. Settlement days were on a fixed schedule (such as fortnightly) and a short seller did not have to deliver stock until the following settlement day, and on that day could "carry over" their position to the next by paying a backwardation fee. This practice was common before 1930, but came to be used less and less, particularly since options were reintroduced in 1958.
The fee here did not indicate a near-term shortage of stock the way backwardation means today, it was more like a "lease rate", the cost of borrowing a stock or commodity for a period of time.
In more recent years, a backwardation in equities quoted on the London Stock Exchange has come to signify the unusual occurrence of an individual equities quote whereby the bid appears to be higher than the offer. This (of course) cannot occur for electronically traded stocks via SETS or SETS MM but only for quote-driven stocks (SEAQ)
market rules allow it to set a limit on backwardation in contracts traded there. At present times, all base metal contracts (excluding LME Minis) are subject to "lending guidance". Therefore, the exchange controls neither the absolute price level directly nor the trading positions held by exchange members. It rather limits the price differential between trades that go into delivery the next day ("tom position") and the day after ("cash position").
Calendar spreads are known in LME jargon as "carries". Buying a carry is referred to as "borrow" and selling a carry as "lending". Thus, if a metal is subject to lending guidance, dominant position holders may be required to lend tom-next, that is sell a tom-position and buy a cash-position, should the backwardation for that period exceed a certain exchange-set percentage. The price differential and number of contracts to be lent is determined by LME regulation.
The LME uses backwardation limits in emergency situations, such as in 2005 following Hurricane Katrina
when Zinc
warrants in New Orleans were suspended until the warehouses were checked, or to act against possible or suspected market manipulation, such tightness in particular prompts for Aluminium
in early 1999.
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
or futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
is trading below the expected spot price
Spot price
The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...
at contract maturity. The resulting futures or forward curve would typically be downward sloping (i.e. "inverted"), since contracts for farther dates would typically trade at even lower prices. (The curves in question plot market prices for various contracts at different maturities—cf. term structure of interest rates)
The opposite market condition to normal backwardation is known as contango
Contango
Contango is the market condition wherein the price of a forward or futures contract is trading above the expected spot price at contract maturity. The resulting futures or forward curve would typically be upward sloping , since contracts for further dates would typically trade at even higher prices...
.
A backwardation starts when the difference between the forward price
Forward price
The forward price is the agreed upon price of an asset in a forward contract. Using the rational pricing assumption, for a forward contract on an underlying asset that is tradeable, we can express the forward price in terms of the spot price and any dividends etc...
and the spot price
Spot price
The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...
is less than the cost of carry
Cost of carry
The cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or rather the opportunity cost; the cost of purchasing a particular security...
, or when there can be no delivery arbitrage because the asset is not currently available for purchase.
Futures contract price includes compensation for the risk transferred from the asset holder. This makes actual price on expiry to be lower than futures contract price. Backwardation very seldom arises in money commodities like gold or silver. In the early 1980s, there was a one-day backwardation in silver while some metal was physically moved from COMEX
Comex
Comex may refer to:*COMEX, a division of the New York Mercantile Exchange *COMEX , a French company in undersea engineering*COMEX, a gold trust owned by iShares...
to CBOT
Chicago Board of Trade
The Chicago Board of Trade , established in 1848, is the world's oldest futures and options exchange. More than 50 different options and futures contracts are traded by over 3,600 CBOT members through open outcry and eTrading. Volumes at the exchange in 2003 were a record breaking 454 million...
warehouses. Gold has historically been positive with exception for momentary backwardations (hours) since gold futures started trading on the Winnipeg Commodity Exchange in 1972.
The term is sometimes applied to forward prices other than those of futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s, when analogous price patterns arise. For example, if it costs more to lease silver
Silver
Silver is a metallic chemical element with the chemical symbol Ag and atomic number 47. A soft, white, lustrous transition metal, it has the highest electrical conductivity of any element and the highest thermal conductivity of any metal...
for 30 days than for 60 days, it might be said that the silver lease rates are "in backwardation".
Occurrence
This is the case of a convenience yieldConvenience yield
A convenience yield is an adjustment to the cost of carry in the non-arbitrage pricing formula for forward prices in markets with trading constraints....
that is greater than the risk free rate.
It is argued that backwardation is abnormal, and suggests supply insufficiencies in the corresponding (physical) spot market. However, many commodities markets are frequently in backwardation, especially when the seasonal aspect is taken into consideration, e.g., perishable and/or soft commodities.
In Treatise on Money (1930, chapter 29), economist John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
argued that in commodity markets, backwardation is not an abnormal market situation, but rather arises naturally as "normal backwardation" from the fact that producers of commodities are more prone to hedge their price risk than consumers. The academic dispute on the subject continues to this day.
Examples
Notable examples of backwardation include:- CopperCopperCopper is a chemical element with the symbol Cu and atomic number 29. It is a ductile metal with very high thermal and electrical conductivity. Pure copper is soft and malleable; an exposed surface has a reddish-orange tarnish...
circa 1990, apparently arising from market manipulationMarket manipulationMarket manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency...
by Yasuo HamanakaYasuo Hamanakais a man who formerly was the chief copper trader at Sumitomo Corporation, one of the largest trading companies in Japan, and was also known as "Mr. Copper" because of his aggressive trading style and "Mr...
of Sumitomo CorporationSumitomo CorporationSumitomo Corporation is one of the largest worldwide trading company , and is a diversified corporation. Sumitomo is headquartered in the Harumi Island Triton Square Office Tower Y in Chūō, Tokyo, Japan...
in what has come to be called the "Sumitomo copper affairSumitomo copper affairThe Sumitomo copper affair refers to a metal trading scandal in 1995 involving Yasuo Hamanaka, the chief copper trader of the Japanese trading house Sumitomo Corporation...
".
- SilverSilverSilver is a metallic chemical element with the chemical symbol Ag and atomic number 47. A soft, white, lustrous transition metal, it has the highest electrical conductivity of any element and the highest thermal conductivity of any metal...
: In 2009 has been in backwardation since late January. This is due to suspected long term price suppression as cited by Ted Butler.
Origin of term: London Stock Exchange
Like contangoContango
Contango is the market condition wherein the price of a forward or futures contract is trading above the expected spot price at contract maturity. The resulting futures or forward curve would typically be upward sloping , since contracts for further dates would typically trade at even higher prices...
, the term originated in mid-19th century England, originating from "backward".
In that era on the London Stock Exchange
London Stock Exchange
The London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...
, backwardation was a fee paid by a seller wishing to defer delivering stock they had sold. This fee was paid either to the buyer, or to a third party who lent stock to the seller.
The purpose was normally speculative, allowing short selling
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
. Settlement days were on a fixed schedule (such as fortnightly) and a short seller did not have to deliver stock until the following settlement day, and on that day could "carry over" their position to the next by paying a backwardation fee. This practice was common before 1930, but came to be used less and less, particularly since options were reintroduced in 1958.
The fee here did not indicate a near-term shortage of stock the way backwardation means today, it was more like a "lease rate", the cost of borrowing a stock or commodity for a period of time.
In more recent years, a backwardation in equities quoted on the London Stock Exchange has come to signify the unusual occurrence of an individual equities quote whereby the bid appears to be higher than the offer. This (of course) cannot occur for electronically traded stocks via SETS or SETS MM but only for quote-driven stocks (SEAQ)
London Metal Exchange
The London Metal ExchangeLondon Metal Exchange
The London Metal Exchange is the futures exchange with the world's largest market in options, and futures contracts on base and other metals. As the LME offers contracts with daily expiry dates of up to three months from trade date, along with longer-dated contracts up to 123 months, it also...
market rules allow it to set a limit on backwardation in contracts traded there. At present times, all base metal contracts (excluding LME Minis) are subject to "lending guidance". Therefore, the exchange controls neither the absolute price level directly nor the trading positions held by exchange members. It rather limits the price differential between trades that go into delivery the next day ("tom position") and the day after ("cash position").
Calendar spreads are known in LME jargon as "carries". Buying a carry is referred to as "borrow" and selling a carry as "lending". Thus, if a metal is subject to lending guidance, dominant position holders may be required to lend tom-next, that is sell a tom-position and buy a cash-position, should the backwardation for that period exceed a certain exchange-set percentage. The price differential and number of contracts to be lent is determined by LME regulation.
The LME uses backwardation limits in emergency situations, such as in 2005 following Hurricane Katrina
Hurricane Katrina
Hurricane Katrina of the 2005 Atlantic hurricane season was a powerful Atlantic hurricane. It is the costliest natural disaster, as well as one of the five deadliest hurricanes, in the history of the United States. Among recorded Atlantic hurricanes, it was the sixth strongest overall...
when Zinc
Zinc
Zinc , or spelter , is a metallic chemical element; it has the symbol Zn and atomic number 30. It is the first element in group 12 of the periodic table. Zinc is, in some respects, chemically similar to magnesium, because its ion is of similar size and its only common oxidation state is +2...
warrants in New Orleans were suspended until the warehouses were checked, or to act against possible or suspected market manipulation, such tightness in particular prompts for Aluminium
Aluminium
Aluminium or aluminum is a silvery white member of the boron group of chemical elements. It has the symbol Al, and its atomic number is 13. It is not soluble in water under normal circumstances....
in early 1999.