Underlying causes for market backwardation

Discussion in 'P1.T3. Financial Markets & Products (30%)' started by Liming, Nov 1, 2009.

  1. Liming

    Liming New Member

    Dear David,

    I have read from FRM handbook (5th) page 241 that high current demand leads to high convenience yields, thus causing backwardation in in commodity future market; and I have also seen one FRM practice question about whether a foreseeable lack of supply or high demand leads to backwardation. I'm a bit confused here because the answer seems to only recognize the effect of high demand but I think although high demand will definitely causes backwardation, short supply should causes it too. I base this thought on a very simple 'demand and supply' economic model where either high demand or short supply will move the commodity price upward.
    The second question I'd like to ask is whether "current" or "foreseeable/expected in the near future" would make a difference in the interpretation? For example, some practice questions I've done before mention phrases like "anticipatory", "front month" etc.... sorry, due to my lack of background, I'm not familiar with all these terms used in commodity futures market.

    Thank you for your enlightenment!

    Cheers
    Liming
    01/11/2009
  2. syaiful

    syaiful Member

    Dear Liming,

    IMO this backwardation issue probably due to Storage Cost Variable.
    (Conditions : Constant Supply, Seasonal Demand)

    just my tought :lol:
  3. Hi Liming,

    I do agree with you: all other things being equal, we can regard short supply as equivalent to high demand as the both would tend to create backwardation (inverted forward curve). Culp basically explains some historical oil backwardation with the idea of a "supply shock" caused by OPEC restrictions (on supply). I *think* a superficial equivalence is justified (i.e., either high demand or low supply implies higher spot price which, assuming there is some temporary aspect---that particpants expect some mean reversion--tends to put pressure toward a backwardation)...but please note it is maybe easier to regard this as a "temporary shock"
    ...it also seems to me, on the other hand, that Jorion (the FRM handbook) is smartly specific about demand rather than supply. Because our cost of carry model is:
    forward = rate + storage - income - convenience
    ...so the demand implies convenience, and the convenience lowers the forward curve (backwardation). So, it just *seems* to me the higher demand impacting convenience is more direct

    regarding anticipation, the forward curve results from complex interactions...in our assignments (culp, hull), the one example regards the oil backwardation. Culp says oil has typically been in backwardation because participants expect in the future that supply will meet demand. So, this is an example of the *expectation* of a future increase in supply lowering (or stabalizing) the future spot price. So, Culp certainly allows for, and it seems absolutely true that, the *expected* future spot price factors into the forward curve. But, for practical purposes, frankly, I would not be distracted by that. Our focus is rather on the concrete cost of carry model

    David

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