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Two different definitions for Contango market?

sleepybird

Active Member
The first one is contango.

The second one refers to NORMAL contango.

Note the difference between spot S(0) and futures spot E(St). One is comparing to the current spot, the other one compares to the EXPECTED future spot.
 
Yes , i got it.So 'normal" is related with expected spot price at contract maturity.

So,shouldnt David Sir change the definition of contago posted on the investopedia site.?Sir ,Please do it if you mean normal contago on investopedia site.It gets very confusing for readers.

But , wikipedia also says that contago is futures>expected spot price.Now why is there such discrepancy?
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Hi Ankit,

I wrote the investopedia article many many years ago. My best view is exactly what sleepybird says; which (to my knowledge, when I last investigated this) follows Don Chance, who seems to have authority on the question (http://www.bus.lsu.edu/academics/finance/faculty/dchance/)

... it seems that authors vary

But I like the parallelism of using "normal" to refer to a relationship with the unobserved E[S(t)] and allowing "contango" (F2>F1>S0) and "backwardation" (i.e., without normal) to refer to an OBSERVED forward curve.

But I don't perceive the semantic of "normal contango" to be settled (or worrisome). I suspect the reason is that:
  • Normal backwardation comports with a risk premium theory; i.e., that the short forward pays compensation (an expected loss, F(t) - E[S(t)] as payment for the ability to transfer price risk) to the long position, who earns an expected gain = E[S(t)] - F(t)
  • But "normal contango" may not have quite the theory support. In other words, the risk premium theory holds that normal backwardation may be more normal than normal contango.
I hope that helps, thanks!
 
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