Definition
The financial investing term backwardation refers to a market condition where the current price of a futures contract is lower than the anticipated spot price at maturity. Backwardation is considered an unusual market condition; the normal form of this relationship is known as contango.
Explanation
As a futures contract moves closer to the expiry date, the price of the contract will converge to the spot price. If this did not happen, the futures price would be different than the spot price and arbitrage would be possible. Under normal market conditions, the price of a futures contract will decrease over time, and this downward sloping plot is referred to as contango.
Backwardation exists when the price of a futures contract increases as it approaches its expiration date. Investors that hold the contract to maturity (are long in their position) will see the value of their contract increase over time as the future's contract converges to the spot price.
As the illustration below demonstrates, this upward sloping curve indicates a futures contract with a positive basis, and the price of that contract converges to the spot price over time. While the slope and positive basis are not considered "normal," this market condition can exist when the carrying cost of the asset and "convenience yield" are higher than the risk free rate.
Backwardation versus Normal Yield Curve
Backwardation is sometimes confused with a normal yield curve; since both exhibit the same upward sloping line plot. A yield curve is a plot of interest rates for debt of various maturities at a single point in time, while backwardation plots the price of a single futures contract over time.
Example
The following illustration demonstrates a futures contract "in backwardation."
Related Terms
- The financial investing term yield curve refers to a line plot showing the term, or maturity, on the x-axis and the corresponding rate of interest, or yield, on the y-axis. Yield curves are oftentimes used to compare interest rates on bonds such as debt securities issued by the U.S. Treasury Department, which have maturities that range from one month to thirty years.
Moneyzine EditorNovember 6th, 2024 - The financial investing term normal yield curve refers to an upward sloping line plot used to illustrate the interest rate differences between short and long-term debt instruments. Debt securities issued by the U.S. Treasury Department typically exhibit a normal yield curve, whereby the interest rates paid on securities with shorter maturities is lower than rates paid on debt with longer maturities.Moneyzine EditorSeptember 20th, 2023
The financial investing term inverted yield curve refers to a downward sloping line plot used to illustrate the interest rate differences between short and long-term debt instruments. An inverted yield curve is a rare event, since it indicates short-term rates are higher than longer-term rates. When debt securities issued by the U.S. Treasury Department result in an inverted curve, it's deemed a signal the economy is about to enter a recession.Moneyzine EditorNovember 6th, 2024- The financial investing term steep yield curve refers to a rapidly upward sloping line plot used to illustrate the difference between short and long-term debt instruments at various maturities. A steep yield curve is a variation of the normal yield curve, possessing the same basic properties; whereby the interest rates paid on securities with shorter maturities is lower than rates paid on debt with longer maturities.Moneyzine EditorSeptember 21st, 2023
The financial investing term flattened yield curve refers to a line plot that runs parallel to the x-axis, indicating rates that do not vary with maturity. A flattened yield curve is a very rare event; since it indicates both short and long-term debt provide the investor with the same return. A flattened curve for debt securities, such as those issued by the U.S. Treasury Department, can occur as yields shift between normal and inverted.Moneyzine EditorNovember 6th, 2024
The financial investing term humped yield curve refers to a bell-shaped curve, indicating mid-term rates that exceed both long and short term rates. When debt of similar credit quality, such as that issued by the U.S. Treasury Department, result in a humped yield curve it's typically interpreted as a slowing of the economy.Moneyzine EditorSeptember 20th, 2023
The financial investing term contango refers to a market condition where the current price of a futures contract is higher than the anticipated spot price at maturity. Contango is considered a normal market condition, while an unusual form of this relationship is known as backwardation.Moneyzine EditorNovember 6th, 2024
