Commodities, contango and collateral | Financial News

Investors in commodities futures need to understand the concepts of backwardation and contango. When commodities futures are in backwardation, the futures price is lower than the spot price. Investors in commodities futures (and total return commodities indices) sell down their position immediately before actual delivery and buy a further-dated futures contract. Although they are long the commodity, they never receive delivery. They roll forward their futures position. When a commodity is in backwardation, an investor can sell his or her near-dated future for a premium to the cost of the further-dated contract. This results in a positive roll yield. The reverse position, in which futures prices are higher than spot prices, is known as contango. In this case, rolling forward the futures position creates a loss for the investor or index, a negative roll yield.

Buying futures represents a leveraged position, as only a margin payment needs to be made upfront. The rest of the investment can be deposited as collateral, and earn the investor a return from interest rates or active management.

The total return on a commodities index or futures position therefore has of three elements: the change of the underlying price of the commodity futures (spot); the yield from selling near-dated and buying further-dated contracts (roll yield); and the return from the collateral backing the futures investment.

The historical return a year for each component in the GSCI over 35 years to March 2005 was: 3.89% for spot; 1.79% for roll yield; and 6.42% for collateral yield.

Excerpt from the November Supplement of Financial News