General Theory - Inverted Markets

Inverted Markets
There's nothing wrong with a market not being at full carry. In the case of precious metals or currencies – items that do not tend to spoil – there is the expectation that they will be near full carry, yet a lot of commodities simply do not work like that. Even the most efficient markets, though, are rarely at precise full carry.

There are six reasons why generally efficient markets need not be at full carry:

  1. Transition costs. Everyone who trades any kind of financial securities recognizes that there's a charge for every trade and figures that into the profit-and-loss calculations. The larger, more frequent traders have lower per-trade costs than smaller, occasional traders. If the number of individual traders in a market is unusually large, then the higher average transaction cost acts as a phantom carrying charge, making the market appear to be above full carry. Also, individual traders generally cannot borrow at the repo rate, so the added interest burden brings the market further above full carry.
  2. Ability to sell short. Although shorting benefits the market by making it more liquid, exchanges place limits on it. There is no short selling allowed on some physical goods, and even in the most rarified markets an investor taking a short position may have access to only half the proceeds of her transaction. The lack of short positions has the tendency to push markets below full carry.
  3. Supply and demand. The closer a commodity's production is to its consumption, the closer to full carry its futures market will be. Tight supply moves a market above full carry; overabundance moves it below full carry.
  4. Production seasonality. Most grain products are highly seasonal, so their prices rise over the months preceding the harvest, then decline after the harvest. Livestock can follow similar seasonal patterns.
  5. Consumption seasonality. You can depend on heating oil prices to go up in the autumn and down in the spring. Similarly, gasoline prices tend to rise at the onset of the summer vacation season, when all of America's minivans take to the Interstate.
  6. Storability. The harder it is to store a commodity – perishable fruits, for example – the harder it is to link its future price to a factor of its current spot price. When nature and the market clash, nature usually wins. There once was a futures market for fresh eggs, but it has long since passed into history because of the difficulty in setting a price for December eggs in June.

All these elements determine how desirable it is to hold a position in a commodity. But the question remains, why would anyone trade in a market that is not typically somewhere in the ballpark of full carry? It seems unnecessarily risky.

Simply put, full carry doesn't apply in a lot of cases. Instead, many commodities have a convenience yield, or return on holding the physical asset.

In a normal-yielding market at full carry, the current spot price for a commodity is lower than the price for delivery a month from now, which is lower than the price for delivery two months from now. If the market is persistently below full carry, these three prices begin to converge. This phenomenon is referred to as contango.

At some point, the relationship inverts: the spot price is higher than the price for delivery next month, which is higher than the price for delivery in two months. This inversion is called backwardation and suggests that the asset has a convenience yield, which in turn suggests that traders are willing to pay a premium to hold the physical asset at a particular point in time.

SEE:
Contango Vs. Normal Backwardation

Hedging
Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  2. Chart Advisor

    Traders Step Back to Assess Commodities Damage

    Traders are turning to these exchange-traded notes and exchange-traded funds to analyze key commodities and determine what could be coming next.
  3. Credit & Loans

    Four Ways to Improve Education In America

    U.S. students place 27th in math and 20th in science out of 34 countries. The United States must reform its education system or harm future economic productivity and global trade competitiveness.
  4. Investing News

    Oil or Gold: Which Will Recover First?

    Not sure where oil and gold are headed? The answer is complex.
  5. Investing Basics

    Explaining Forward Rate Agreements

    Forward rate agreement (FRA) refers to an interest rate or foreign exchange hedging strategy.
  6. Investing

    Using Fibonacci to Analyze Gold

    Use Fibonacci studies to analyze gold by picking out hidden harmonic levels that can provide major support or resistance.
  7. Options & Futures

    An Introduction To Value at Risk (VAR)

    Volatility is not the only way to measure risk. Learn about the "new science of risk management".
  8. Mutual Funds & ETFs

    ETF Analysis: United States Natural Gas Fund LP

    Find out more about the United States Natural Gas exchange-traded fund, the characteristics of the ETF and the suitability and recommendations of it.
  9. Mutual Funds & ETFs

    ETF Analysis: United States Oil Fund

    Find out more about the United States Oil Fund, the characteristics of USO, and the suitability and recommendations of the ETF for investors.
  10. Investing

    Why High Yield Still Has A Role To Play

    An asset class of this bull market has been high yield debt, as many searching for income in a low-rate world have turned to these higher-yielding bonds.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Series 6

    A securities license entitling the holder to register as a limited ...
  3. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  4. Best To Deliver

    The security that is delivered by the short position holder in ...
  5. Exchange Traded Derivative

    A financial instrument whose value is based on the value of another ...
  6. Advanced Diploma In Insurance

    A qualification earned by insurance professionals and conferred ...
RELATED FAQS
  1. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  2. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>
  3. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  4. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
  5. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  6. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!