Backwardation
Also written Backwardation market · Inverted market
A market in which the futures price sits below the spot price — the cost of carry says futures should be dearer, and something is overriding it.
In plain language
Carrying a commodity costs money, so futures should normally trade above spot. When they trade below spot instead, the market is in backwardation, and the question to ask is what is strong enough to beat the cost of carry.
The workbook gives two answers. In agricultural commodities it is usually seasonality: supply is about to arrive. In non-agricultural commodities it is usually expected weakness — a demand glut or a gloomy economic outlook that the spot market has not adjusted to yet.
A third answer runs through the whole commodity chapter: convenience yield. Holding the physical good is worth something to a processor, and that benefit is subtracted from the futures price.
How it works
Follow the sowing season. At sowing, spot supplies are tight and spot prices are high. Everybody knows the harvest lands in roughly three to four months, and that supply will then be abundant.
A three-month future settles against the post-harvest market, so it is priced for abundance while spot is priced for scarcity. The three-month futures price is therefore lower than today's spot price, despite three months of carry sitting in between. That is a backwardation market, and it is seasonal rather than a mistake.
The currency channel runs the other way from contango: an expected appreciation of the rupee pulls down the futures price of imported or globally traded commodities, with spot following when the currency actually moves.
Convergence still applies. Backwardation, like contango, is a gap that closes to zero on the delivery date — a backwardated curve rises into expiry rather than falling into it.
The formula
Backwardation: Futures price < Spot price
F = S + C - Y C = cost of carry, Y = convenience yield
When Y is larger than C, the futures price drops below spot and the market is backwardated on that arithmetic alone.
A worked example
Work the workbook's guar seed numbers as a curve rather than as a storage decision.
| Rs per quintal | |
|---|---|
| Spot price of guar seed today | 6,000 |
| Storage cost and risk over six months | 200 |
| Convenience yield over the same six months | 300 |
Cost of carry alone would put the six-month future at Rs 6,000 + 200 = Rs 6,200 — a contango of Rs 200.
Subtract the convenience yield:
F = S + C - Y
F = 6,000 + 200 - 300 = Rs 5,900
The six-month contract now trades Rs 100 below spot. Nothing about storage changed; the benefit of actually having guar seed in the shed beat the cost of keeping it there.
A processor with a 1 MT (10 quintal) requirement sees this as a Rs 1,000 per tonne signal not to lock in forward, and the farmer holding stock sees it as a market telling him the incentive to store has already been paid to him in the spot price.
Why NISM asks about it
Chapter 3 (Commodity Futures), section 3.4 on convergence, and section 3.6 on convenience yield, which supplies the F = S + C - Y extension. Chapter 2 notes that abnormal backwardation in a single constituent need not drag the whole commodity index future into backwardation, because the index is diversified. Questions are usually the direct pair with contango, or a reasoning question on why an agricultural future can trade below spot despite the cost of carry.
Common exam traps
- Backwardation is the abnormal case, contango the normal one — for a storable commodity carry is always positive, so something has to override it.
- It is not the same as "the market is bearish." A backwardated curve often sits in a market where spot is high, not low.
- The most examinable cause in agriculture is seasonality — harvest supply arriving inside the contract's life — not speculation.
- Convenience yield is subtracted, never added. Writing
F = S + C + Yinverts the whole section. - Backwardation still converges at expiry. Futures rise to meet spot rather than the other way round.
- Do not read a single backwardated month as a backwardated curve. Seasonal commodities can be in backwardation for one expiry and in contango for the next.
Check yourself
1.If the futures price is higher than the spot price of an underlying asset, it is called:
- a)Convergence
- b)Divergence
- c)Contango
- d)Backwardation
Show the answer
Answer: (c) Contango
(This is a sample question from the NISM workbook.)
If the futures price is higher than the spot price of an underlying asset, market participants may expect the spot price to go up in the near future. This expectedly rising market is called the "Contango market".
Option (a) convergence is the near-miss worth understanding. Convergence is the process by which the gap closes as expiry approaches — and it happens in contango and backwardation alike. It is not a statement about which price is higher.
Option (d) backwardation is the exact opposite: if futures price is lower than spot price of an asset, market participants may expect the spot price to come down in future.
A useful memory hook: in contango, the futures market is asking you to pay extra for waiting — which is normal, because someone must fund and store the goods until then. Backwardation is the abnormal case, and it happens in spite of cost-of-carry because the market expects supply to improve.
2.With each passing day, the cost of carry of a futures contract:
- a)Decreases
- b)Increases
- c)Increases initially and then decreases
- d)Decreases initially and then increases
Show the answer
Answer: (a) Decreases
(This is a sample question from the NISM workbook.)
The cost of carry diminishes with each passing day and the differential must narrow — and on the date of delivery, the cost of carry reduces to zero and the spot and futures price converge. This is known as convergence.
The reason is almost tautological once you see it. Cost of carry pays for holding the commodity from today until expiry. Every day that passes shortens that window by one day. On expiry day the window is zero days long, so the cost is zero, and nothing remains to separate spot from futures.
Options (c) and (d) are the trap for anyone who half-remembers a curved diagram. This is a one-way decline — it never turns.
And note that convergence works from both directions: a contango market converges downward to spot, a backwardation market converges upward to spot. Both diagrams in the workbook end at the same point.
3.Which of the following is NOT a purpose of the spot prices that exchanges collect and disseminate through polling?
- a)Helping participants anchor their future price expectations
- b)Determining the Final Settlement Price (FSP)
- c)Letting players understand the extent of contango or backwardation built into futures prices
- d)Fixing the premium that option writers must charge on each strike
Show the answer
Answer: (d) Fixing the premium that option writers must charge on each strike
The workbook lists these uses of polled spot prices:
- "These prices are disseminated by the exchanges TO HELP THE PARTICIPANTS ANCHOR THEIR FUTURE PRICE EXPECTATIONS" — (a)
- "and are also used TO DETERMINE THE FINAL SETTLEMENT PRICE (FSP)" — (b)
- "Spot price dissemination helps the players regularly UNDERSTAND THE EXTENT OF CONTANGO OR BACKWARDATION built in future prices" — (c)
- "The collected spot prices also help the exchange/clearing corporation to have an EFFECTIVE SURVEILLANCE over the activities of the participants."
Option (d) is wrong. Option premiums are never fixed by anyone. As chapter 4 puts it, "Prices are never fixed by exchanges, SEBI, or anybody else." They are discovered by the market.
Definition to carry: "Polling is the process of compiling price information from a CROSS-SECTION OF MARKET PLAYERS FROM DIFFERENT CENTERS across the country to arrive at the spot prices." The panel consists of traders and users of the commodity.
Where this is taught
Free preparation for NISM Series XVIRelated terms
- ConvergenceThe certainty that a futures price and the spot price of its underlying meet at expiry — because on the last trading day the contract settles at the cash market price, leaving no room for a difference.
- BasisThe difference between the spot price and the futures price of an asset — positive when spot exceeds futures, negative when futures exceeds spot, and zero at expiry.
- Cost of carryThe cost of holding an asset until a future date — financing interest plus storage, less any income it pays. It links spot to futures: fair futures price = spot + cost of carry − inflows.
- ContangoA market in which the futures price sits above the spot price, normally because the futures buyer is paying for the cost of carrying the commodity through to delivery.
- Convenience yieldThe rupee benefit of physically holding a commodity rather than holding a futures contract on it — the term that lets a futures price fall below spot plus carry.
- Seasonality effectThe recurring swing in agricultural commodity prices between the sowing season, when spot supply is tight, and the harvest, when it becomes abundant — the main cause of backwardation in agri commodities.
- Expectancy modelThe view that a futures price is simply the market's expected spot price at expiry, so futures can trade at a premium or discount to spot and signal the expected direction of prices.
- Lean period marginAn additional margin on agricultural commodity futures during the pre-harvest lean period, when uncertainty about crop size makes spot prices volatile; the periods and rates are set by exchange circular.
- Weakening basisA change in basis (spot minus futures) towards a less positive or more negative number — futures rising relative to spot — which benefits a long hedger.
- Intra-commodity spreadA long futures position in one contract month and a short position in another month (or a different lot size) of the same commodity, taken to profit from a change in the gap between them.
- Buying a spreadAn intra-commodity spread trade — buying the near-month futures contract and simultaneously selling the far-month contract — taken when the near month looks underpriced or the far month overpriced relative to fair value.
- Roll yieldThe gain or loss from rolling an expiring futures position into the next contract month, over and above the pure cost of carry.
- Futures bear spreadAn intra-commodity futures spread taken when the actual gap between two calendar months is narrower than the fundamental average difference — sell the near month, buy the far month, and wait for the gap to widen.
- Law of averagesThe averaging effect that makes a commodity index less volatile than its constituents — useful diversification for a hedger, and the workbook's main explanation for why index derivatives stay illiquid in India.