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


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