Contango
Also written Contango market · Carrying-charge market
A 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.
In plain language
Buy a tonne of a commodity today and you tie up money, pay to store it, and insure it. Buy a futures contract on the same tonne instead and you do none of those things until delivery.
The futures price therefore starts out higher than the spot price, by roughly what the carry would have cost. A market shaped that way is in contango, and it is the normal state of a storable commodity.
As expiry approaches there is less carry left to pay for, so the gap shrinks. On the delivery date it is zero and the two prices meet. That meeting is convergence.
How it works
The workbook builds the idea from a single decision. Spot in June is Rs 8,000; September futures quote Rs 8,340. A buyer who needs the commodity in September can either go long the September future at Rs 8,340, or buy at Rs 8,000 today and store it for three months.
The spot buyer gives up three months of interest on Rs 8,000 and pays three months of storage. The futures buyer keeps his money earning interest and pays nothing to store. The Rs 340 difference is the cost of carry — finance cost, storage and insurance — and it is what makes the market contango.
Contango is not a forecast that prices will rise. It is mostly arithmetic. The workbook does add a genuine expectations channel, though: a depreciating rupee raises the expected price of imported or globally traded commodities, so futures rise first and spot follows when the currency actually moves.
The formula
Contango: Futures price > Spot price
Backwardation: Futures price < Spot price
F = S + C where C = finance cost + storage + insurance
The carry C shrinks every day the contract lives, and is zero at expiry.
A worked example
Take the workbook's Bullion Index Futures roll, which is contango doing real damage to a long-only index position.
| Rs | |
|---|---|
| Near-month Bullion Index Futures | 16,000 |
| Next-month Bullion Index Futures | 16,100 |
| One month's carry cost on the underlying | 50 |
An index fund holding 100 contracts must roll before the near month expires. It sells 100 at Rs 16,000 and buys 100 at Rs 16,100.
Roll cost = Rs 100 per contract x 100 contracts = Rs 10,000
It paid Rs 100 a contract to stay in a position that costs only Rs 50 a contract to carry. If contango persists and the new near month drifts from Rs 16,100 to Rs 16,150, the position gains Rs 50 x 100 = Rs 5,000 — but the roll itself cost Rs 10,000.
Roll into a costlier contract month after month and the drag compounds, which is exactly why a commodity index can fall behind the spot prices it tracks even when those spot prices are flat.
Why NISM asks about it
Chapter 3 (Commodity Futures), sections 3.3 to 3.5 — cost of carry, convergence and fair value are taught as one chain, and the chapter's own sample question asks directly: "If futures price is higher than spot price of an underlying asset, it is called ____" with contango as the answer. Chapter 2 (Commodity Indices) then reuses contango for roll yield on index futures. Expect a definition question, a direction question ("with each passing day the cost of carry ____" — decreases), and an index roll-over calculation.
Common exam traps
- Contango is not "the market expects prices to rise." For a storable commodity it is mostly the cost of carry. Read the gap against the carry before reading it as a forecast.
- Contango and backwardation describe the futures-versus-spot gap, not the direction prices actually move. A contango market can fall all month.
- Do not confuse contango with a widening basis. Basis is spot minus futures on one contract; contango is the shape of the whole curve.
- A long index position loses from contango on every roll, because it repeatedly sells the cheaper near month and buys the dearer far month. That is negative roll yield.
- The gap must collapse to zero at expiry. Any answer where futures and spot fail to converge on the delivery date is wrong.
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.
- Fair valueThe theoretical futures price — spot plus the cost of carrying the commodity to expiry — at which a buyer is indifferent between buying today and buying forward.
- 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.
- BackwardationA 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.
- 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.
- Roll yieldThe gain or loss from rolling an expiring futures position into the next contract month, over and above the pure cost of carry.
- 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.
- Contango and backwardationThe two shapes a commodity futures curve can take — contango when the futures price is above spot, backwardation when it is below.
- Strengthening basisA change in basis (spot minus futures) towards a more positive or less negative number — spot rising relative to futures — which benefits a short 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.
- Barter systemThe direct exchange of one good for another, with no money involved — the starting point the workbook uses to trace how commodity trading evolved into spot markets, forward contracts and finally futures.
- Currency effect on commodity pricesSince most commodities are priced globally in US dollars, a weaker rupee raises their rupee price even if the dollar price is unchanged, and a stronger rupee lowers it.
- 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.
- UnderlyingThe asset a derivative contract derives its value from — the index, stock, bond or currency whose spot price drives the contract. The derivative has no value of its own without it.
- 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.
- Futures bull spreadAn intra-commodity futures spread taken when the actual gap between two calendar months is wider than the fundamental average difference — buy the near month, sell the far month, and wait for the gap to narrow.
- Futures carry effectThe reason a call on futures carries more intrinsic value than a call on goods, while a put on goods carries more than a put on futures — because before expiry the futures price sits above the spot price.