The term contango refers to a case where the futures price exceeds the expected future spot price of the underlying commodity. Futures prices are the prices of futures contracts for the commodity. Expected future spot prices are the prices of the commodity in the spot market that are expected to prevail in the future. Consequently, the futures price will fall to the spot price before the contract maturity date. This scenario is established under the expectation hypothesis, which suggests that futures prices are determined by market expectations. The opposite pattern, called backwardation, occurs when the futures price falls short of the expected future spot price. In this instance, the future rises toward the expected future spot price.
The relationship between the futures price and the expected future spot price depends on the net hedging position. Traders in the futures market can be classified into hedgers and speculators. Hedgers have a preexisting risk associated with a commodity and enter the market to reduce that risk, while speculators trade in the hope of profit. Hedgers, taken as a group, may be either long (i.e., they buy more than they sell) or short (i.e., they sell more than they buy). If hedgers are net short, speculators must be net long so that the market reaches equilibrium. To entice speculators, the futures price must be less than the expected future spot price and rise over time; hence the futures market exhibits backwardation. Conversely, if hedgers are net long, speculators must be net short. The futures price must lie above expected future spot price and fall over time to compensate the speculators, leading to contango.
An alternative definition relies upon the cost-of-carry arbitrage argument. Specifically, contango is referred to the case where the futures price exceeds the spot price. Moreover, the price of the futures contract with a distant maturity exceeds that with a nearby maturity. Conversely, backwardation refers to the situation in which futures price is less than the spot price; and the further away the contract maturity is, the smaller the futures price is.
In an efficient, frictionless market, to preclude arbitrage profits futures price must equal the spot price compounded at the risk-free rate, plus the cost of carry, which is future value of the storage costs minus the benefits (also called convenience yield ) over the life of the contract. Because the cost of carry can be either positive or negative (depending upon the magnitude of the benefits), the futures price can be greater or less than the spot price. In reality, the principles of the cost-of-carry place at best a no-arbitrage bound on the futures prices. Within the bound, expectations are critical in establishing futures prices.
Generally, buyers prefer to receive the commodities right away, whereas sellers need time to produce. Consequently, the spot price tends to be larger than the futures price and backwardation is normally expected. Empirical investigations suggest that backwardation prevails in agricultural commodity and energy markets and contango occurs in currency markets. Nonetheless, the market may revert from backwardation to contango and vice versa from time to time. The financial loss of Metallgesellschaft Refining and Marketing (MGRM), Inc. in 1993 was partially due to contango that prevailed in unleaded gasoline and heating oil futures markets.
SEE ALSO Hedging
Kolb, Robert W. 2000. Futures, Options, and Swaps. Malden, MA: Blackwell Publishers.
Smithson, Charles W. 1998. Managing Financial Risk. New York: McGraw-Hill.
Recorded from the mid 19th century, the word is probably an arbitrary formation on the pattern of Latin verb forms ending in -o in the first person singular, perhaps with the idea ‘I make contingent’.