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Backwardation and Contango

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Malachi posted on Sun, Oct 28 2012 6:17 PM
Can someone give a concise explanation of their significance in austrian terms?
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Prime replied on Sun, Oct 28 2012 6:58 PM

Do you just want to know exactly what they are? I don't think Austrians have anything unique to say about them per se...

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I've never heard of those before.
 
 
Backwardation
A market condition in which futures prices are lower in the distant delivery months than in the nearest delivery month. This may occur when the costs of storing the product until eventual delivery are effectively subtracted from the price today. The opposite of contango.
 
contango
In futures or options trading, a market in which longer-term contracts carry a higher price than near-term contracts. The premium accorded to longer maturities is a normal condition of the market and reflects the cost of carrying the commodity for future delivery. Compare inverted market.
 
That seems to make some sort of sense. Is there something wrong with it from an Austrian perspective?
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Austrians have unique things to say about interest rates and time preferences and I understand that theres a relationship between all of these. Interest rates in commodities loans are derived from futures markets. I want to know if anyone has analyzed these relationships praxeologically. I can do it myself but I find it hard to believe that no one else has an opinion, probably one thats more insightful than mine. I see it as a measure of uncertainty when people are willing to pay a premium for precious metals now over precious metals in the future. I also believe theres more to it than that, but its a little more than I can parcel out myself.
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@Groucho

theres nothing wrong with it, there should be a praxeological explanation of its significance. Sort of like how real estate prices (and the price of capital goods) are a function of rents. And the pure time-preference theory of interest. Futures markets can be computed in terms of interest rates. So what does a negative interest rate mean?

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Prime replied on Sun, Oct 28 2012 7:22 PM

These 2 terms have only to do with storage fees. Things such as natural gas are costly to store, so the further out the futeres contract, the higher the price. It has nothing to do with the spot price nor preferance. I'm not sure what exactly you are asking here? I assume this makes sense.

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Ok those terms have to do with the relation between prices. Storage fees are one part of that, yes. So is tne interest rate, such as in precious metals. If gold and silver are in backwardation for an extended period of time, is this a measure of risk? Banks and other warehouse facilities should expand their facility to make money in storage fees, if storage fees are driving the interest rate below zero. This is how a market reacts. I assume this also makes sense.
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Prime replied on Sun, Oct 28 2012 7:40 PM

I think backwardation is due to risk. From Investopedia :

"Sometimes, due to irregular market movements such as an inverted market, the holding of an underlying good or security may become more profitable than owning the contract or derivative instrument, due to its relative scarcity versus high demand.

An example would be purchasing physical bales of wheat rather than future contracts. Should their be a sudden drought and the demand for wheat increases, the difference between the first purchase price of the wheat versus the price after the shock would be the convenience yield.

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I tend to agree
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Bumper cars
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B.U.M.P. In the night
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Malachi:
Ok those terms have to do with the relation between prices. Storage fees are one part of that, yes. So is tne interest rate, such as in precious metals. If gold and silver are in backwardation for an extended period of time, is this a measure of risk? Banks and other warehouse facilities should expand their facility to make money in storage fees, if storage fees are driving the interest rate below zero. This is how a market reacts. I assume this also makes sense.

Banks already have a multitude of fees.  I once had BofA teller inform me the reason they assessed a $5 fee for cashing a check was because they didn't want people using banks as a check-cashing place! I nearly fell over. "Hey Mr. Drysdale, where do you suggest we cash checks? A pizza parlor?" They want people to deposit money and not withdraw anything other than electronically.

And of course banks have the hidden fees that come in the form of reducing the interest they pay for deposits.

But if banks were to actually claim a fee for storing money they would be unable to avoid fraud charges for fractional reserve banking.

An idealist is one who, on noticing that roses smell better than a cabbage, concludes that it will also make better soup. -H.L. Mencken
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http://mises.org/document/1667/Negative-Interest-Rate-Toward-a-Taxonomic-Critique

So heres the deal. We are going to informally cover interest rates, lease rates, futures as an expression of interest rates, normal backwardation and contango, and spot backwardation. I may come back and make some corrections, and I encourage you guys to make corrections if you see anything.

interest rates are prices of money, they are an expression of time preference. Real interest rates, as in a pure loan of savings to a debtor who will pay it back later, should always be positive. This is praxeologically true, because having something now and later is better than having nothing now and less later. Negative interest rates are an indicator of some irregularity in the market. For example, in a warehoused savings account, a negative interest rate might be the fee for the account. This is an expression of the risk differential, if you keep your money in the bank you believe that the account is so much less risky than your wallet that you are willing to pay a percentage to keep money in the account. The interest and the loan together could be a gift. In the url above, Block covers all of this. He does not cover the case of negative lease rates, where precious metal and currency are exchanged and agreed to be returned at a future date. These are primarily instruments of convenience for financial institutions, and negative lease rates reflect an imbalance of not enough leasees against too many leasors. One reference said that the leasor wants the collateral for short term needs.

In a futures contract, the buyer pays up front and the seller makes delivery at a future date. Normally these are in contango, as goods carry a storage cost. This means the price is more expensive than the expected spot price at maturity. Per wikipedia. Normal backwardation is when its less expensive than its "expected to be" whatever that means. I'll have to go back and look. Spot backwardation is when the physical good costs more than the futures, it reveals a shortage of physical. This happens seasonally in perishable goods like wheat.

So when backwardation occurs in durable goods, its a sign of risk/distrust in paper, or a genuine shortage. Because, in backwardation, if you believe a futures contract will be fulfilled, you can make a profit by selling physical and buying paper. This is a positive interest rate. So can it be said that futures markets in contango suggest an opinion that commercial producers can fulfill demand, and futures markets in backwardation reflect an opinion that commercial producers may not be able to fulfill demand?

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But in summary, contango/backwardation refer to the observed shape of the forward curve while "Normal" c/b refers to an instantaneously unobserved phenonemon because it relates to the expected future spot price.

* Contango = futures price greater than spot price.

* Backwardation (i.e., inverted curve) = futures price less than spot price.

* Normal contango = futures price greater than expected future spot price.

* Normal backwardation = futures price less than expected future spot price

http://www.bionicturtle.com/forum/threads/backwardation.444/
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We define the basis as the Future (bid) – Spot (ask) and the cobasis is, as mentioned above, Spot (bid) – Future (offer).  In a normal world, the basis is positive and it is basically given by the rate of interest.  The cobasis should be negative unless there is a shortage.  A shortage of gold or silver is meaningless as people have accumulated enormous inventories of the stuff over thousands of years.

But in the “new normal”, post 2008, the expiring gold or silver future often flirts with or even slips into backwardation for a period before expiry.  This is anything but normal.  It’s not a sign of imminent financial Armageddon, but it is a sign that beneath the surface there is a growing rot in the core of the system.  Why?

As a reminder, to profit from contango, one must buy physical and sell a future against it to end with the same net position plus a small profit.  To profit from contango, one carries the metal.  Think of carrying as like warehousing it for a small fee.  The only prerequisite is that one needs cash (or more typically credit). Carrying will push up the ask in physical and push down the bid in the future, thus reducing the basis.
http://etfdailynews.com/2012/03/22/the-arbitrageur-temporary-backwardation-the-path-forward-from-2008-gld-slv-iau-agq-zsl-sgol/
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