Backwardation

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Backwardation, sometimes incorrectly referred to as "backwardization," is the situation where futures contracts for delivery further out trade at lower prices than those that are for closer delivery and than the spot price. 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. At present times, all base metal contracts (excluding LME Minis) are subject to "lending guidance". The exchange does therefore control neither the absolute price level directly nor the trading positions held by exchange members. It rather limits the price differential between trades that go into delivery the next day ("tom position") and the day after ("cash position"). Calendar spreads are known in LME jargon as "carries". Buying a carry is referred to as "borrow" and selling a carry as "lending". Thus, if a metal is subject to lending guidance, dominant position holders may be required to lend tom-next, that is sell a tom-position and buy a cash-position, should the backwardation for that period exceed a certain exchange-set percentage. The price differential and number of contracts to be lent is determined by LME regulation.

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.

In more recent years, a backwardation in equities quoted on the London Stock Exchange, has come to signify the unusual occurrence of an individual equities quote whereby the bid appears to be higher than the offer. This (of course) can not occur for electronically traded stocks via SETS or SETS MM but only for quote driven stocks ( SEAQ)