Backwardation

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Backwardation, sometimes incorrectly referred to as "backwardization," is the situation where futures contracts closer to expiration trade at higher prices than those that are far from expiration. This is the case of a convenience yield that is greater than the risk free rate. Backwardation is an abnormal situation, and is suggestive of supply insufficiencies in the corresponding (physical) spot market. More generally, the term is sometimes applied to forward prices other than those of futures contracts, when analogous price patterns arise. For example, if it costs more to lease silver for 30 days than for 60 days, it might be said that the silver lease rates are "in backwardation."

In Treatise on Money (1930, chapter 29), economist John Maynard Keynes argued that in commodity markets, backwardation is not an abnormal market situation, but rather arises naturally as "normal backwardation" from the fact that producers of commodities are more prone to hedge their price risk than respective consumers. An academic dispute on the subject ensued that continues even today.

The opposite market condition to backwardation is known as contango.

Notable examples of backwardation include,

Copper circa 1990, apparently arising from market manipulation by Yasuo Hamanaka of Sumitomo Corporation.

The Australian dollar, priced in Japanese yen terms (AUD/JPY), in 2006: the backwardation occurs simply because Australian dollar bonds pay so much more interest at every point in the yield curve than Japanese yen bonds do. Any high-yield foreign currency contract will show backwardation in its pricing.

[edit] London Metal Exchange

The London Metal Exchange market rules allow it to set a limit on backwardation in contracts traded there. When a limit is set, sellers may pay a fee (per tonne per day) on settlement day to defer if they're unable to deliver or to borrow for less. This choice for sellers is not a direct price control, but acts as a limit because an arbitrage opportunity is created if a backwardation greater than the fee exists.

The LME uses backwardation limits in emergency situations, such as in 2005 following Hurricane Katrina when Zinc warrants in New Orleans were suspended until the warehouses were checked, or to act against possible or suspected market manipulation, such tightness in particular prompts for Aluminium in early 1999.

[edit] London Stock Exchange

In the past on the London Stock Exchange, backwardation was a fee paid by a seller wishing to defer delivering stock they had sold. This fee was paid either to the buyer, or to a third party who lent stock to the seller.

The purpose was normally speculative, allowing short selling. Settlement days were on a fixed schedule (such as fortnightly) and a short seller did not have to deliver stock until the following settlement day, and on that day could "carry over" their position to the next by paying a backwardation fee. This practice was common before 1930, but came to be used less and less, particularly since options were reintroduced in 1958.

The fee here did not indicate a near-term shortage of stock the way backwardation means today, it was more like a "lease rate", the cost of borrowing a stock or commodity for a period of time.