Notices

Backwardation

From Traderpedia

Definition:
Backwardation, sometimes incorrectly referred to as "backwardization," is the situation where futures contracts closer to expiration trade at higher prices than those that are far from expiration.


This is the case of a convenience yield that is greater than the risk free rate. Backwardation is an abnormal situation, and is suggestive of supply insufficiencies in the corresponding (physical) spot market. More generally, the term is sometimes applied to forward prices other than those of futures contracts, 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."

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 respective consumers. An academic dispute on the subject ensued that continues even today.

The opposite market condition to backwardation is known as contango.

Notable examples of backwardation include,

The Australian dollar, priced in Japanese yen terms (AUD/JPY), in 2006: the backwardation occurs simply because Australian dollar bonds pay so much more interest at every point in the yield curve than Japanese yen bonds do. Any high-yield foreign currency contract will show backwardation in its pricing.

[edit] See also