Editing Normal backwardation

{{Short description|Situation when futures prices are below the expected spot price at maturity}}
{{Use dmy dates|date=March 2020}}
[[File:Contangobackwardation.png|thumb|right|300px|The graph depicts how the price of a single forward contract will behave through time in relation to the expected future price. A contract in backwardation will increase in value until it equals the spot price of the underlying at maturity. Note that this graph does not show the [[forward curve]] (which plots against maturities on the horizontal).]]

'''Normal backwardation''', also sometimes called '''backwardation''', is the market condition where the price of a commodity's [[forward contract|forward]] or [[futures contract]] is trading below the ''expected'' [[spot price]] at contract maturity.<ref>[http://www.investopedia.com/articles/07/contango_backwardation.asp Contango Vs. Normal Backwardation] {{Webarchive|url=https://web.archive.org/web/20140726183442/http://www.investopedia.com/articles/07/contango_backwardation.asp |date=26 July 2014 }}, ''Investopedia''</ref> The resulting futures or [[forward curve]] would ''typically'' be downward sloping (i.e. "inverted"), since contracts for further dates would typically trade at even lower prices.<ref>The curves in question plot market prices for various contracts at different maturities—cf. [[yield curve]]</ref> In practice, the expected future spot price is unknown, and the term "backwardation" may refer to "positive basis", which occurs when the current spot price exceeds the price of the future.<ref name=Facts&Fantasies>{{cite journal |last1=Gorton |first1=Gary |first2=K. Geert |last2=Rouwenhorst |title=Facts and Fantasies about Commodity Futures |journal=Financial Analysts Journal |year=2006 |volume=62 |issue=2 |pages=47–68 |doi=10.2469/faj.v62.n2.4083 |s2cid=14880480 |url=http://www.nber.org/papers/w10595.pdf }}</ref>{{rp|22}}

The opposite market condition to normal backwardation is known as [[contango]]. Contango refers to "negative basis" where the future price is trading above the expected spot price.<ref name=Facts&Fantasies/>

Note: In industry parlance backwardation may refer to the situation that futures prices are below the ''current'' spot price.<ref>{{cite web|url=https://www.investopedia.com/terms/b/backwardation.asp| publisher=[[Investopedia]]|title=Backwardation|access-date=21 June 2020}}</ref>

Backwardation occurs when the difference between the [[forward price]] and the [[spot price]] is less than the [[cost of carry]] (when the forward price is less than the spot plus carry), or when there can be no delivery arbitrage because the asset is not currently available for purchase.

In a state of backwardation, futures contract prices include compensation for the risk transferred from the underlying asset holder to the purchaser of the futures contract. This means the expected spot price on expiry is higher than the price of the futures contract. Backwardation seldom arises in money commodities like gold or silver. In the early 1980s, there was a one-day backwardation in silver while some metal was physically moved from [[Commodity Exchange|COMEX]] to [[Chicago Board of Trade|CBOT]] warehouses.{{Citation needed|date=May 2008}} Gold has historically been positive with exception for momentary backwardations (hours) since gold futures started trading on the Winnipeg Commodity Exchange in 1972.<ref>{{cite web | author = Antal E. Fekete|  title = RED ALERT: GOLD BACKWARDATION!!!(page 3)| date = 2 December 2008| url = http://www.professorfekete.com/articles%5CAEFRedAlert.pdf| access-date = 20 December 2008}}</ref>

The term is sometimes applied to forward prices other than those of [[futures contract]]s, 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". Negative lease rates for silver may indicate bullion banks require a risk premium for selling silver futures into the market.

== Occurrence ==
This is the case of a [[convenience yield]] that is greater than the risk free rate and the carrying costs.

It is argued that backwardation is abnormal,{{Who|date=July 2010}} and suggests supply insufficiencies in the corresponding (physical) spot market. However, multiple commodities markets are frequently in backwardation, especially when the seasonal aspect is taken into consideration, e.g., perishable and/or soft commodities.

In ''Treatise on Money'' (1930, chapter 29), economist [[John Maynard Keynes]] argued that in [[commodity market]]s, 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 consumers. The academic dispute on the subject continues to this day.<ref>Zvi Bodie & Victor Rosansky, "Risk and Return in Commodity Futures", FINANCIAL ANALYSTS' JOURNAL (May/June 1980)</ref>

== Examples ==
Notable examples of backwardation include:

* [[Copper]] circa 1990, apparently arising from [[market manipulation]] by [[Yasuo Hamanaka]] of [[Sumitomo Corporation]] in what has come to be called the "[[Sumitomo copper affair]]".{{Citation needed|date=November 2010}}<!--  Added the newest article where he mentions this, but probably the earliest would be better.  Anyone have time to look? -->
* In 2013, the wholesale commercial gas market entered backwardation during the month of March. The 2-year contract prices fell below the price of 1-year contracts.<ref>{{Cite web | url=http://www.apolloenergy.co.uk/wholesale-gas-market-an-important-update/ | title=Wholesale gas market – an important update| date=2013-03-14}}</ref>

==Origin of term: London Stock Exchange==
Like [[contango]], the term originated in mid-19th century England, originating from "backward".

In that era 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 [[Option (finance)|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.
<!-- Don't know what happened to interest earned on the money the buyer would have given.  In a short sale today eg. with a [[contract for difference]], the short seller earns that interest, meaning there's net income for having a short position, not a fee to be paid.  -->

==Normal backwardation vs. backwardation==
The term ''backwardation'', when used without the qualifier "normal", can be somewhat ambiguous.  Although sometimes used as a synonym for normal backwardation (where a futures contract price is lower than the expected spot price at contract maturity), it may also refer to the situation where a futures contract price is merely lower than the ''current'' spot price.

==References==
{{Wikisource1911Enc|Backwardation}}
{{Wiktionary|backwardation}}
{{Reflist}}

* ''[[Encyclopædia Britannica]]'', [[1911 Encyclopædia Britannica|eleventh edition (1911)]], articles ''Backwardation'', ''Contango'' and ''Stock Exchange'', and fifteenth edition (1974), articles ''Contango and Backwardation'' and ''Stock Market''.
*''[https://archive.today/20130221223353/http://www.materialsmanagement.net/modern_mkt_manipulation.htm Modern Market Manipulation]'', Mike Riess, 2003, paper at the International Precious Metals Institute 27th Annual Conference
*''[http://www.alunet.net/shownews.asp?ID=252&type=1 LME launches and investigation in primary aluminium trading]'', [[London Metal Exchange]] advice to members 15 January 1999, reproduced at aluNET International
* ''[http://www.lme.co.uk/4292.asp  New Orleans – Temporary Suspension of Warrants]'', [[London Metal Exchange]] press release 6 September 2005.
* ''[http://www.investopedia.com/terms/b/backwardation.asp investopedia Website]'', Articles on Contango and Backwardation'' and ''Stock Market''.

{{Derivatives market}}

{{DEFAULTSORT:Normal Backwardation}}
[[Category:Arbitrage]]
[[Category:Derivatives (finance)]]