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Contango Definition

See Also:
Future Value
Discount Rate
Exchange Traded Funds
Backwardation
Interest Rate Swaps
Arbitrage

Contango Definition

Contango is a term used to describe the forward yield curve when it is upward sloping and the price of a future commodity is above that of the spot rate. This is the opposite of backwardation.

Contango Meaning

Contango usually occurs when there is a belief that the commodity is in overabundance or surplus in the market. It’s usually a non-perishable item, like gold and oil. The large supply on hand will cause current prices to drop, while future rates remain higher. Often times there is room for arbitrage in a contangoed commodity market depending on which way the interest rates are moving.

In a contangoed market, an investor or trader would buy the short term interest rates if it were expected to fall. They would do this while simultaneously selling a future. In contrast, a trader would be expected to sell in the short term while simultaneously buying future rates assuming that the short term interest rates were expected to rise. Many investors will also lock in a long position even if the price is higher. So they are able to protect themselves from even higher future prices.

Contango Example

Bob is a trader for Chevaco Inc., a company that specializes in the oil and gas industry. Bob has been observing prices of oil for some time now. Then he realizes that the market is in contango where the price of a future in oil is listed at $80/barrel. The future spot rate of oil is listed around $72/barrel and, current prices of oil are around $60/barrel. Due to the circumstances involved Bob has decided to buy the spot rate at $72/barrel. Even though this price is much higher than the current price of $60, Bob believes it is best to reduce the risk and lock in a price. If the price of oil does rise to $80 he will have saved the company a lot of money.

contango definition

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Arbitrage

See Also:
Arbitrage Pricing Theory
Market Positioning
Capitalization
Inventory to Working Capital Analysis
Mining the Balance Sheet for Working Capital

Arbitrage Definition

Arbitrage is the practice of profiting from the mispricing of an asset that trades in multiple markets. For arbitrage to be possible, an asset must trade in at least two different markets. If the same asset is trading in two different markets with two different prices, there is an arbitrage opportunity. The idea is to buy the asset where it is cheaper, sell it where it is more expensive, and pocket the difference.

Arbitrage Examples

For example, imagine you can buy an apple at the supermarket for fifty cents and sell it to tourists on the sidewalk for one dollar. This is an arbitrage opportunity. You would buy apples at the supermarket and sell them to the tourists. For each apple, you would profit 50 cents.

Similarly, if one US dollar is worth .5000 British pounds in London, and one US dollar is worth .5001 British pounds in New York, the arbitrageur might want to purchase dollars with pounds in London and then sell the dollars for pounds in New York. Depending on the volume and the transaction costs, this could be a profitable arbitrage opportunity.

Arbitrage and Market Efficiency

Due to market efficiency, arbitrage opportunities are hard to find. When they do exist, they are typically small and fleeting. Profiting significantly from arbitrage often requires timely action and large sums of money. And because of market efficiency, the very act of engaging in arbitrage serves to eliminate the arbitrage opportunity.

arbitrage definition

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