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Finance and capital markets
Course: Finance and capital markets > Unit 9
Lesson 2: Forward and futures contracts- Forward contract introduction
- Futures introduction
- Motivation for the futures exchange
- Futures margin mechanics
- Verifying hedge with futures margin mechanics
- Futures and forward curves
- Contango from trader perspective
- Severe contango generally bearish
- Backwardation bullish or bearish
- Futures curves II
- Contango
- Backwardation
- Contango and backwardation review
- Upper bound on forward settlement price
- Lower bound on forward settlement price
- Arbitraging futures contract
- Arbitraging futures contracts II
- Futures fair value in the pre-market
- Interpreting futures fair value in the premarket
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Backwardation bullish or bearish
Thinking about why backwardation in commodities markets is bullish. Created by Sal Khan.
Want to join the conversation?
- So, buying/selling in backwardation market is similar to shorting?(6 votes)
- Is there any way to use futures curves (contango or inverted) to infer whether it makes more sense to hold oil now and sell at a later date or to sell it all now? I am searching for a way to measure Hotelling's principle (that a nonrenewable asset's price rises at the rate of interest) in practice. Thanks!(4 votes)
- Atcould short covering be a reason for desperation in the market? 2:10(4 votes)
- For commodities that are 'used'; like a smartphone or a car, the spot price is always higher than future price, not due to amortization but due to novelty. Do we assume that such actors are not 'rational' in this model? Or do we not take 'utility' into account?(1 vote)
- A commodity, by definition, is interchangeable with other units of the same thing. Smartphones and cars are not interchangeable. If one is used and one isn't, then they do not have the same value, not because actors are irrational, but because used goods will lose their utility.(4 votes)
- 'Future delivery dates of gold will not hold'. 2:16
But why? The exchange act as a guarantor so even if the seller cannot deliver the gold (goes the bankrupt) the exchange will pay you that amount anyway?(2 votes) - Would it be correct to say backwardation is bullish for buyers, but bearish for sellers? If rational, buyers believe prices will not go down (they are bullish) and therefore are willing to pay more than the expected future price. Sellers believe prices will go down (they are bearish) and therefore are more than happy to sell at the higher price.(2 votes)
- At, did Sal mean the market would be bullish in the short term, and bearish in the long term till the "later" day? 2:22(1 vote)
- Don't 10Y treasury futures also display backwardation because of coupon payments?? This isn't discussed(1 vote)
- Backwardation and contango are really terms to describe the cost of shipping, storing and transacting difficult to move physical commodities. Differences between the prices of financial futures that can be moved instantaneously at nearly no cost is just a representation of the cost of borrowing money. The differences insure that someone cannot borrow or lend at the risk free rate and earn a risk free profit and nothing else.(1 vote)
- But does not backwardation happen more because of oversupply? Like it is with oil and its futures right now?(1 vote)
- And what about indices futures? there´s is no shortage on them, so backwardation could mean that investors are selling at a lower price in the future in case the index fall further? Thanks!(0 votes)
- No, has nothing to do with index expectations.
An index future is 'valued' by looking at the spot price of the index. Then you need to add the opportunity cost of buying now (e.g. interest you're forgoing - what Sal refers to as opportunity cost of cash) and subtracting the value of the dividends over the life of the contract.
If interest is less than the dividends, the value is negative, and if interest is more than the dividend, value is positive.
So backwardation of index futures is very likely (at least at the time when I'm writing this), as we have a low interest rate environment, and dividends in the stock market surpass that.(1 vote)
Video transcript
If a commodities
trader tells you that a market is
in backwardation, they're essentially
saying that it costs more to buy
whatever commodity they're talking about now than
it would to buy it later, to go into a futures
contract to buy whatever that commodity might
be-- silver, gold, or oil-- to buy it later. So later is cheaper. So, the question you might
ask yourself, or really, any trader might ask
themselves, is this bullish or is this a bearish? Is this a bullish situation? And there's no obvious
rule of thumb here. But if someone says,
look, to get something now costs more than to
get it later, what does that tell you about
what's happening in the market? Well, it tells you that
people are desperate. Because if they
weren't desperate, the rational thing to
do would just be wait. Wait a little while and
get it cheaper for later. Or, if you don't need
that oil right now, if you don't need
that corn right now, or if you don't need
that gold right now, instead of paying
more for it right now, just say, look, I could
enter into a futures contract for delivery of
that gold or oil or corn or whatever it is at a later
date for a cheaper price. And I wouldn't even have to
store it between now and then. So, if some people were rational
and if they weren't desperate, this wouldn't happen. But because they're
willing to do this, they're willing to pay more
now than for a future delivery date, it shows you that there
might be some type of shortage. In the case of oil,
maybe the oil supply has been disrupted somehow. In the case of corn,
for whatever reason, some crops have been
destroyed, and people need to eat, and
all of the rest. For commodities that
aren't used, so to speak, like gold, if you see
backwardation there, I wouldn't say-- I mean, it's
definitely still desperation, but it's not out of a core need. If gold goes in
the backwardation, it's more because of some
type of irrational desire to have their hands
on the gold now than have their hands
on the gold later. Maybe they think society
is going to collapse, and the future
delivery dates of gold aren't going to
actually hold up. Who knows what they are? So in general, when people talk
about backwardation, because of this desperation
in the market, people tend to perceive
it as a bullish signal. Obviously if people
are desperate, there's demand for this thing. My argument is, you can't
just look at one tea leaf out of a bunch of tea leaves
and say whether it's bullish or bearish. But what you could
say is, look, there's something somewhat
abnormal going in the market due to
some type of desperation. It's a little less irrational
it it's due to a storage, but it could be very irrational
if it's a due to just wanting your hands on it. Because frankly, if you
wanted to buy gold just for the sake of
investing in gold-- you're not going to eat it
or use it to fuel your car or anything like that-- it
would make complete sense, or even better, if
you already held gold in this type of a market that's
undergoing backwardation. The rational thing
to do would be to sell your gold
now for more money, and then agree to buy it
back later for cheaper. And so once this later
date comes about, you'll still have
your gold, and you would have made some
risk free profits.