Forward and Futures Prices

and their relation with Spot

Prices

Part II
Readings:

Chapter 5: 5.8
 Futures (Forward) Curves
Curve is the relation between time-to-maturity (x –
axis) and futures price (y-axis)

Upward sloping (or, normal) The longer the maturity ,

the + the Px

Downward sloping (or, inverted)

In the industry (and financial press), slope of curve

often “confused” with contango/backwardation
 Contango and Backwardation (again)
All /Most

Normal Backwardation:1F below expected S.

Normal Contango: F above expected S

In the industry, the two concepts (‘Bw’ & ‘Cn’) define

the relation between F and current S. So:
• F<S (i.e., positive basis) ‘Backwardation’
• F>S ‘Contango’ Comparing Futures
Price
Price
with the observed spot

With the “industry” definition

• ‘Cn’ corresponds to an upward sloping (or, normal) futures
curve
• ‘Bw’ corresponds to a downward sloping (or, inverted) futures
curve
Normal Backwardation
'

Look at 3 month maturity if the 3 month Futures Price is below the

,

spot price expected in 3 months

Normal Contango

Looking at lyr Maturity ,

If the future price now
expiring in tyr is above

the expected spot price in lyr

 Contango and Backwardation (again)
Just terminology….
https://www.youtube.com/watch?v=o2X_XNdmWws

To summarize:
upward, sloping curve

• Contango: S0 < F0(T)

• Normal Contango: E(ST) < F0(T)
Downward sloping curve
to

• Backwardation: F0(T) < S0

• Normal Backwardation: F0(T)<E(ST)
 Contango and Backwardation
Commodities can be in contango (negative
basis), yet be in normal
observed
spot spot
expected
backwardation
observed Future

• EX: S0 = $30, E(ST) = 34, F0 = 32.

-

• Market is in “N.B.” but curve is upward sloping, i.e.,

basis is <0. FOLECST) So To<

Similarly, we can have a commodity in

backwardation (positive basis) and, at the same
time, in normal contango
Part of the reason for the industry shortcut (or,
for the confusion) is that E(ST) is unobservable
(not on traders’ screen)
Less confusing to use “basis” or “slope of curve”
for observed prices
 Contango and Backwardation
Once we are clear about the terminology, the
more substantial issues are:
1. What affects the slope of the curve (and,
hence, the basis)?
2. What may determine normal backwardation or
normal contango?
3. Do either the (slope of) the curve or ‘NBw’ vs
‘NCw’ contain relevant information for (i.e.,
predict) future prices (S and F)?
- i.e., are they useful to investors (hedgers
and/or speculators) ?
Slope of Curve and Future Returns
For investment assets slope of curve
simply reflects cost of carry y where -0

• if c>0 upward sloping * v.v

Slope does not necessarily predict

future prices or returns (spot or
futures). But…
An upward- or downward-sloping term
structure of futures prices does create
the possibility of the futures roll return
 Assets
Holds Investment to consumption
-

for

Slope of Curve and Roll Yield

EX:WTI Futures as of May 2004
FJuly 2004 =$40.95 FJuly 2005= $36.65 Forward curve is downward sloping
(inverted)

You could, in May 2004, go long the July 2005 contract

and hold the position for one year, then roll it over
'

close current position

→
( Go short)
long
( Futures ) open Another
-

curve

IF the term structure of oil remained unchanged with the same 14 months

between July ¥4 2004 and July

Clay 2005….
exp →

The roll return (“rolling down the curve”) would have 11.7%

been $40.95/$36.65 – 1= 11.7%

keep → u can
earning
annual return every year is term structure
I closeopen -0
unchanged is

Similar examples can be constructed for shorting

futures on normal curve → earn ⑦ return
In actuality, the curve may shift
Total Return on futures may differ from hypothetical
roll return
Beware of paper roll returns!(remember USO ETF, MG)
 -

May 2004 → Long July 2005 contract ,

hold to roll over

so ,
in May 2005 close out the lÑng position by going short to then

open another long position for the following 14 months too .

If the Futures curve

,
remain UNCHANGED b/w July
'
04 to
'
July 05 ,
what is ur return ?

Open#May @ ( 14 Month contract ) [ Fyuiy

{ closetMay
2004) $36.65 2005 ]
Buy Low
=
-

Sell High ,
20053 @ -40.9-5 12 -
month contract [Fouty zoos ]
As term structure stays the same
,
the price of 2 months Future contract

will be the in to
same May 2004 May 2005

Paper Roll Return [ continuation of set 2 Case study ]

Before After
When they start hedging Futures Curve .
Downward Sloping
hedging

After they started Hedging the curve move to upward sloping

¥
,

The Market situation (Future curves) hits them hard

change in
,
.

Because :

-
Not only they were losing on their Long Futures position ( Price 4) ,
they are

losing them at an
increasingly high rate because it
changes to upward sloping .

↳ When the curve is downward sloping → make ④ Roll Returns [Long Futures ]

to the futures upward sloping

long futures
But it fails if curve become
miserably ur ,
.

↳ Result in Bay High ,

sell low

↳
Every time a roll over ,
u incur loss

Yes slope of 12011 Returns but if the slope

'

- .

,
curve tells us we can make

changes ,
the ④ return will turn -0
 Slope of Curve and Future Returns
For consumption assets (and gold…), curve is
downward sloping

inverted if c<y (as seen earlier)

Theory of Storage posits that y declines as
inventory increases
Curve may have predictive power as it tells us
about conv. yield and, hence, about
probability of shortages through the inventory
channel If y CCY9 , probability of shortages
shows
↳ Price of good
✗ T

More generally, (slope of ) curve may tell us

about fundamentals (demand and supply)
Conv. yield and/or basis (slope of curve) are, basis + →
slope -

indeed, used as trading signals (see Barron’s basis -

→ slope -1

article) by some µ
there's no guarantee that you make money !

But remember: it’s like predicting stock returns!

 Slope of Curve and Future Returns
( slope of the curve)

Empirically either basis or y seems to have

rather limited and varying predictive power
↳ LOW

(low R^2) for subsequent futures returns for

[
most consumption assets
V. Low predictive power

But basis or y are better at predicting volatility

and correlation (and, hence, hedge ratios) of F
and S
• consistent with Theory of Storage (see next slide)
 Theory of Storage and Volatility

According to the Theory, if inventory ↓ and,

hence, y ↑ then
1. S will rise relatively to F (i.e, basis increases)
2. Supply conditions more constrained elasticity of
supply ↓ (harder to adjust supply in a situation of
scarcity)
For a given demand shock, prices are more
variable when supply is less elastic + volatility price in

basis or y should have positive relation with

volatility of S and F
 Spot Prices and Risk Premium
Why would one want to take a position in,
say, silver spot? How much would you
pay today for an ounce of silver?
Denote FI as foregone interest, I…, U…
cost
storage

We know that FI+U-I = C (cost of carry)

a

4-
Income

If investors don’t seek compensation for

risk (risk-neutral), market price is
S0= E(ST) - C
→ cost of carry

If investors want to be compensated for

risk (i.e., expect a Risk Premium)
S0= E(ST) - C - RP
 Futures Prices and Risk Premium
Rearrange E(ST) = S0 + C + RP (1)
We learnt that F0 = S0 + C – Y
S0 = F0 - C + Y (2)
Substitute S0 from (2) into (1)
E(ST) = F0 + Y + RP
Remember that E(ST) = E(FT)
E(ST) = E(FT) = F0 + Y + RP

For investment assets E(ST) = E(FT) = F0 + RP ,

where 4=0

For consumption assets, denote RP* = RP + Y (c.y

is extra premium for holding physical)
E(ST) = E(FT) = F0 + RP*
 Futures Prices and Risk Premium
E(ST) = E(FT) = F0 + RP*
Long (short) futures positions expect to gain if
RP*> (<) 0.
Notice, though, that RP does not come from
riskiness of futures: it comes from risk in spot
market ✗ To < Elsp)
If RP*>0 F0 < E(ST), i.e Normal Backwardation
(futures price is expected to rise)
If RP*<0 F0 > E(ST), i.e Normal Contango
(futures price is expected to drop)
Normal Contango or normal backwardation depend on
A sign and amount of spot asset risk premium !
For investors (speculators): if I can predict the RP
(especially, its sign!) I can take position accordingly
Normal Contango and Normal Backwardation
We can show the previous results with the RP in
terms of returns rather than in $
• Suppose k is the expected return required by
investors in an asset✗ outflow cash at t

• One can invest F0e–r T at the risk-free rate at

time 0 and enter into a long forward contract
• Strategy creates cash inflow of ST at
maturity Why G-
,
? Close out at T ,
hence receive

inflow
the asset

Outflow
to gonna
pay Fo

• NPV on investment is - F0e–r T + E(ST) e–kT

• If markets efficiently price investment to
have zero NPV F0 = E(ST) e (r-k)T
• It follows……(see next slide)
 Relation between Futures Prices &
Expected Spot Prices where :

K expected return

No Systematic Risk F0 = E(ST)

=

k=r r =
risk free rate

Positive Systematic k>r F0 < E(ST)

Risk ( B is-10 ) Normal
Backw.
Negative Systematic k<r F0 > E(ST)
Risk Normal
Contango
Positive systematic risk: stock indices (positive correlation with
overall “market”)
Negative systematic risk: gold (at least for certain periods)
No Systematic Risk: underlying asset uncorrelated with mkt portfolio

Careful about using futures price as forecast of

future spot price justified only if the underlying asset carries
,
is

no systematic risk .
Note Who earn
: ④ return ? Speculators
↳ Lecture

Risk Premium in Futures Markets: Theories

What may determine positive or negative RP*?
Early economic modelling (‘Hedging pressure
hypothesis’) point to hedgers’ net positions
• Naturally Long Net Short on futures willing to
lose on futures (insurance) Normal Backw
• Naturally Short Net Long on futures willing to
lose on futures (insurance) Normal Contango.
Subsequent modelling (‘Theory of storage’) focus on
the role of inventories
• c.y. is seen as RP linked to inventory levels
In more “modern” finance, CAPM and other factor
pricing (i.e., systematic risk) models.
• beta of spot asset w.r.t market determines sign and size of
RP
 Risk Premium in Futures Mkts:
What do the data tell us?
1. CAPM and other factor models do pretty poor
job
2. Commodity futures in which hedgers are net
short (net long) have positive (negative)
excess returns on average
risk premium
• consistent with hedging pressure hypothesis
3. Open interest has predictive ability for future
excess returns
• consistent with gross hedging demand story
(next slide)
it correlation b/w today interest to future excess return
open
 Open Interest and Futures Returns
Open interest is a measure of gross (i.e., on both sides
of the market), as opposed to net, hedging demand
Gross hedging demand is pro-cyclical. Ex: oil ( naturally Long)
producers anticipate higher demand could go short
oil futures; utilities anticipate higher demand from (naturally short)
manufacturing firms could go long oil futures
Anticipation of higher economic activity leads to higher
hedging demand (again, on both sides of the market)
open interest ↑
Thus, growth (decline) in open interest is a signal that,
e.g., oil prices will be going up (down) in response to
the higher (lower) demand.
I.e., changes in open interest predict futures excess
returns (with positive sign)
Forward vs. Futures Prices
Thus far we have looked at the pricing of
forward contract by no arbitrage and
ignored daily settlements
At first glance, futures prices ought to
differ from forward prices as the cash flow
stream differs between the two
More specifically, with futures gains earn
interest and losses need to be financed
However, it turns out that forward and
futures price may not differ by any
appreciable amount
Relation between Forwards &
Futures Prices
Specifically, when interest rates are constant, or
change in a deterministic way, or are
uncorrelated with spot / forward / futures prices
forward and futures prices are the same
It can be shown mathematically, assuming (quite
realistically…) that on a daily basis futures prices
are unpredictable (random walk)
At the intuitive level, accrued interest (on gains)
and financing costs (on losses) tend to offset
each other the more they offset each other,
the more a futures looks like a forward
As interest rates change over time in an
unpredictable (random, stochastic) way, there
may be a divergence between forward and
futures prices
 Relation between Forwards &
Futures Prices
If the underlying asset price is positively correlated
with interest rates, futures prices tend to be higher
than forward prices (long position is ‘better off’ with
futures).
If the underlying asset price is negatively correlated
with interest rates, futures prices tend to be lower
than forward prices (long position is better off with
forwards).
If the underlying asset price is uncorrelated with
interest rates (like, e.g., when interest rates are
constant) futures and forward prices tend to be very
close
If the maturity is only a few months, the difference
between the two prices is very small even if interest
rates are correlated with spot prices.
 Relation between Forwards &
Futures Prices
Other factors such as taxes,
transaction costs and default risk
may create a divergence between
forward and futures prices.
In general, we will continue to
assume that forward and futures
prices are, in most situations, equal
or almost so.