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Roll Returns in Markets in Contango and Backwardation

Roll Returns in Markets in Contango and Backwardation

Roll return is the amount of return generated in the futures market after an investor rolls a short-term contract into a longer-term contract and profits from merging the futures price toward a higher spot or cash price.

When a market is in backwardation, the future price of an asset is below the expected cash or spot price. In this case, an investor profits when the position is rolled to a contract with a later expiration date. The investor effectively pays less money, than expected by the spot market, for the underlying asset that the futures investment represents.

Negative roll return occurs when a market is in contango, which is the opposite of backwardation. When a market is in contango, an asset’s future price is above the expected future spot price, so the investor will lose money when rolling contracts.

Question

Which of the following is most likely accurate about a commodity futures market with pricing in backwardation?

  1. The roll return is usually negative.
  2. Rolling an expiring futures contract forward will require buying more contracts to maintain the same dollar position in the futures markets.
  3. Rolling an expiring futures contract forward will require buying fewer contracts to maintain the same dollar position in the futures markets.

Solution

The Correct Answer is B:

Commodity futures markets in backwardation exhibit price curves in which longer-dated futures prices are lower than near-dated contracts, and the nearest dated contract is priced less than the current spot price. With a lower futures price on the futures curve, rolling contracts forward in backwardation would require purchasing more contracts to maintain the same dollar position.

A is incorrect: The roll return is usually positive, not negative, in markets in backwardation.

C is incorrect: An investor would need to purchase more, not fewer, contracts in markets in backwardation to maintain his or her total dollar position.

Reading 37: Introduction to Commodities and Commodity Derivatives

LOS 37 (h) Contrast roll return in markets in contango and markets in backwardation.

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