What is a Roll Yield
Roll yield is the amount of return generated when the futures market is in backwardation after rolling a short-term contract into a longer-term contract and profiting from the convergence toward a higher spot price. Backwardation occurs when a futures contract will trade at a higher price as it approaches expiration, compared to when the contract is further away from expiration.
BREAKING DOWN Roll Yield
Roll yield is a profit that can be generated when investing in the futures market due to the price difference between futures contracts with different expiration dates. When investors purchase futures, they have both the right and the obligation to buy the asset underlying the futures investment at a specified date in the future, unless they sell their investment ahead of the delivery date. Most futures investors do not actually want to take delivery of the physical asset that the futures investment represents, so they roll their near-term expiring futures investments into other futures contracts with expiration dates further in the future. By doing this, they maintain their investments in the assets without having to take physical delivery. The alternative is to sell the assets.
Roll Yield With Markets in Backwardation
When the market is in backwardation, the future price of an asset is below the expected future spot price. In this case, an investor profits when he rolls his position to the contract with a later expiration date, because he is effectively paying less money than expected by the spot market for the underlying asset that the futures investment represents. For example, imagine that an investor holds 100 oil contracts and wants to buy 100 again for expiration at a later date. If the contract's future price is below the spot price, the investor is actually rolling into the same quantity of an asset for a lower price.
Negative Roll Yield
Negative roll yield occurs when a market is in contango, the opposite of backwardation. When a market is in contango, the future price of the asset is above the expected future spot price. When a market is in contango, an investor will lose money when rolling contracts. Returning to the example of an investor with 100 oil contracts, if the investor wants to roll into 100 oil contracts with a later expiration date as its front-month holding nears expiration, the investor will actually be paying more money for the oil contracts compared to the spot market. He would therefore would have to pay more money to maintain the same number of contracts. Such an occurrence has led to major losses by hedge funds in the past.