What are Backwardation and Contango?
In interest rates management, backwardation and contango are two critical phenomena that identify the direction of interest rates.
Normal backwardation is defined as the process when the expected spot rate will exceed the Forward rate. That means future returns will be more than the risk-free rate.
Contango is precisely the opposite of normal backwardation. In contango, the forward rate will exceed the expected spot rates. In other words, the risk-free rate will be more than the future returns.
Normal backwardation (contango) could also refer to a situation where future prices are lower (higher) than the current spot price.
Example of Backwardation and Contango:
Backwardation means that the futures price is below the spot price. Let’s take ABC stock which is currently trading at USD 100/ share. The share is expected to go up to USD 110/ share in a week. In this case, it would be beneficial for the investor to hold the asset. If the price is expected to go down, that would be referred to as contango, and the investor should be selling the asset.
Why are Backwardation and Contango important?
The right expectation of future prices would assist the investor in making the right investment strategies and taking more profitable decisions for the institution.