Forwardation
What Is Forwardation?
Forwardation is a term utilized in pricing futures contracts by which the futures price of a commodity or currency is trading higher than the spot (cash) price of the commodity for immediate delivery. The term forwardation is all the more normally known as contango.
Forwardation/contango can be diverged from backwardation.
Grasping Forwardation
A futures contract is a legal agreement to buy or sell a specific commodity or asset at a predetermined price at a predefined time from here on out. Futures contracts are normalized for quality and amount to work with trading on a futures exchange.
Forwardation means that the prices of a commodity are lower today than the prices of contracts that mature from now on. All in all, forwardation means there's a vertical slanting forward curve. The higher price for a futures contract versus the present spot price might happen due to high costs of delivery, insurance, and storage of the commodity.
On the other hand, assuming prices were higher today (spot price) versus prices of futures contracts, the forward curve would be inverted, which is called backwardation.
Special Considerations
After some time, the market constantly receives new data, which causes vacillations in the spot prices of commodities as well as adjustments to the expected future spot price — the most rational future price — of a futures contract.
More data will regularly push down or bringing down, the futures price. A market in forwardation considers these factors to determine the futures price; nonetheless, the real spot price will frequently veer off from the expected price.
Illustration of Forwardation
A plastics manufacturing company involves oil in making their products and requirements to buy oil for the next 12 months. The manufacturer should utilize futures contracts to lock in a price to purchase the oil. The manufacturer will receive the oil when the futures contract terminates in 12 months' time.
With the futures contract, the manufacturer knows in advance the price they will pay for the oil (the futures contract price), and they realize they will be taking delivery of the oil once the contract terminates.
For instance, the manufacturer needs 1,000,000 barrels of oil over the course of the next year, which will be ready for delivery in 12 months. The manufacturer could hang tight and pay for the oil one year from today. Be that as it may, they don't have any idea what the price of oil will be in 12 months. Given the volatility of oil prices, the market price around then could be totally different than the current price.
Expect the current price is $75 per barrel and the futures contract is at $85 for a one-year settlement. The vertical slanting price of oil would be an illustration of forwardation.
In the event that the manufacturer figures the price of oil will be lower one year from now, they might opt not to lock in a price now. On the off chance that the manufacturer figures oil will be higher than $85 one year from now, they could lock in a guaranteed purchase price by going into a futures contract.
Forwardation and Market Prices
Futures contracts can be utilized to hedge against volatility in a commodity or a currency. In any case, just on the grounds that a futures contract has a higher price than the present spot price doesn't mean that the spot price of the commodity will rise in the future to match the present futures contract price. All in all, the current price of a one-year futures contract isn't really a predictor of where prices will be in 12 months.
Of course, retail traders and portfolio managers are not keen on conveying or getting the underlying asset. A retail trader has little need to receive 1,000 barrels of oil, however they might be keen on catching a profit on the price moves of oil. Endless supply of the futures contract, a retail trader could offset the contract or unwind the position for a gain or loss.
Highlights
- Forwardation is the point at which the current price of a commodity or currency is lower than the futures price.
- Forwardation is justified and an assessment of the extra costs of delivery, insurance, and storage of the commodity.
- Since forwardation means the futures prices are higher than the present prices, a vertical inclining forward curve happens.
- Traders can endeavor to profit from forwardation by buying the spot at the current price and selling the futures at the higher price.
