Backwardation Definition

See Also:
Contango
Interest Rate
Efficient Market Theory
Market Dynamics
Arbitrage

Backwardation Definition

Backwardation is a term used to describe a commodities market when the spot rates are higher than the future price of that certain commodity. In other words there is a downward sloping forward curve relative to the spot rate set for maturity of the commodity. This is the opposite of a market that is in Contango.

Backwardation Explained

Backwardation has been seen in commodities like corn, wheat, or oil. A backwardation market usually occurs because farmers and other commodity producers would like to lock in a price so that they do not have to accept the risk of the fluctuations in the market. Many of these farmers will accept a current rate to mark a guaranteed price. The investors on the other hand will need to expect that the spot rate is actually higher so that they can lock in the current future price and make a profit.

Backwardation Example

Hal, a corn farmer in Nebraska, has been observing prices as of late to decide what he should do about his crop that is about to mature. Hal calculates that the future price of corn is around $6 per bushel. The spot rate at maturity is $8. However, Hal knows that this is never for sure. The market has been known to fluctuate the same amount the other way to $4 per bushel. Hal talks to some of his customers and locks in the future price of $6 to be sold when the crop matures. Because the customers believe the future spot rate to be correct they are happy to accept the $6 price. This way when they go to sell in the market they expect to make a profit of $2 per bushel.

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