The Difference Between a Contango Market and a Backwardation Market

677 Words Jan 15th, 2018 3 Pages
In this type of situation, individuals are ready to pay a price greater than the actual price of a commodity considering the future profit. A backwardation market is the opposite of Contango market where the price of a commodity in the future is lower than the futures price (Gorton & Rouwenhorst, 2006). This type of transaction is beneficial to investors who speculate market condition will change to increase the futures price of a commodity (Gorton & Rouwenhorst, 2006).
The differences between Contango and backwardation market can be captured in the following example. Assuming that the current spot price of oil is $30 where, market participants expect the future spot price to be $34 and speculators and hedgers agree to set the futures price at $32, offering a $2 risk premium to speculators for assuming price risk. The market is in normal backwardation (futures price is below expected spot price) in the second situation. In the first situation, the market is in Contango situation because the futures price is above the current spot (Gorton & Rouwenhorst, 2006).
Derivatives are financial instruments based on other products, whether physical or financial. The other products may themselves be derivative. Three main forms of derivative exist futures, options and…