Hedging - Effects On Commodity Delivered Or Purchased

Effects On Commodity Delivered Or Purchased

Futures prices are typically higher than cash prices, a status known as "contango," because:

  • The investor holding the contract is earning interest on the full price of the contract, minus the small margin deposit; and
  • The investor is spared the storage costs.

Contango occurs in typical markets, but not all markets. If inclement weather ruined last year's crop but good weather this year leads to predictions of a fulsome harvest, futures prices may be below cash prices, resulting in a positive basis. This is called "backwardation."

LOOK OUT!
When discussing agricultural commodities, the authors use the term "cash" rather than "spot" to describe the market counter to futures trading. The reason is that grain and livestock are seasonal businesses and it is not always possible to deliver in the off-season. The cash market for these commodities, rather, is a forward market which pays up-front for later delivery. This is distinct from the futures market in which delivery and payment occur at a later date.


Implications For Financial Markets


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