Contango

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.

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.

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.

Take the workbook's Bullion Index Futures roll, which is contango doing real damage to a long-only index position.

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.

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.

• 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.