Impact of roll return in contango/backwardation and basis strengthening or weakening.

[Anir]

Hi David,
Trust you are doing great.
I am confused in regard to the impact of roll return in contango / backwardation and basis strengthening or weakening in case of short or long hedge.
Please correct me as I think I am missing something here.
In case of unexpected strengthening of basis- cash price > futures price which is also “long the basis” this is favourable for a hedger with a short position and will yield profit. Similarly for a hedger with long position unexpected strengthening of basis will generate loss. This also means backwardation. But in backwardation roll-return generates profits for party with long position and losses for the short position.

The two situations above seem to contradict each other and hence I am getting confused.

Request to elaborate on this.

Regards
Anir.

 

[S666]

Remember a market in backwardation can experience both a strengthening or weakening of the basis, as can a market in contango.

The terms backwardation and contango refer to the whether the cash price is above or below the futures price on an absolute basis, whereas the strengthening or weakening of the basis refers to how the cash price changes in relation to the futures price on a relative basis.

 

[Arka Bose]

Hi Amir,
As S666 said, a market in backwardation or contango can experience both weakening as well as strengthening of basis. It would be better understood if you do not mix up basis with contango/ backwardation.
Also, you said, strengthening of basis means cash price> future price.

This is actually not true, strengthening of basis means the rise in the spot price is greater than rise in futures or fall in spot is lower than fall in futures. It obviously has effect on the roll yield, but the contradictory feeling you have is perhaps because you are thinking strengthening of basis means cash price> future price.

 

[David Harper CFA FRM]

I agree fully with @S666 and @arkabose. You may want to focus on the definitions and, to start, I would not worry too much about the consequence of "unexpected" basis weakening and strengthening. It is hard to grok Hull's point about unexpected impacts until you are solid on the definition. Here is an example to help sort the definition:

• Say today's (static) situation is: Spot = $10.00 the and 2-month futures price, F(2) = $12.00. As @S666 explained, this is contango because on an absolute basis the futures price is greater than the spot price. I think of contango or backwardation as observable and static: you can look at the forward curve and see it upward or downward-sloping.
  
  • And the at this point in time (today) is 10 - 12 = -$2.00
• Let's say we go "long the basis," which is long cash and short futures. As B = +S - F, you can see how long B is long spot (C) and short futures (F).
  
  • As we are long the basis, we profit from an increase in the basis, which can be an increase in the spot (+S) and/or a decrease in the futures price (-F) as either strengthen the basis; i.e., if we are long the basis, we profit from a strengthening of the basis
  • Let's go forward in time (leaving static today) to next month and assume the spot price does not change; so, spot price stays at $10.00. We expect the futures price, which shortens from two month maturity to one month, to converge toward the spot price. In this case of contango, maybe it drops from $12.00 to $11.00. This is a strengthening of the basis from -2.00 to -1.00; as expected, this profits us due to our short position in the futures contract. You can hopefully see why @arkabose says you are incorrect to associate backwardation with strengthening of the basis.
    
  • Further, the roll return is the gain we experience due to the short position when the futures price drops from 12.00 to 11.00; i.e., if we closed the futures contract, we'd profit +$1.00. Contango, which is static and implies F > S, contains the expectation that the roll return will be profitable for the short futures position (and losing for the long futures position) because it embeds the expectation that the basis will strengthen (from negative to zero). I hope this helps!

 

[Anir]

S666, arkabose and David,

Thank you so much for the explanation.

Regards
Anir.