Contango

The theoretical futures price is the spot price compounded forward at the financing rate, increased by the storage and insurance costs of holding the physical asset, and reduced by the convenience yield: the non-monetary benefit of having inventory on hand. When financing plus storage outweighs the convenience yield, net carry is positive and each successive delivery month prices above the last, producing contango.

The upper bound is enforced by cash-and-carry arbitrage: if a deferred contract trades far enough above spot plus carry, a trader buys the physical, funds and stores it, sells the future, and locks a riskless spread. The lower bound is weaker, because reverse cash-and-carry requires borrowing or short-selling the physical commodity, which is often impractical. That asymmetry explains why curves can move deeper into contango than pure carry economics would suggest when inventories are being forced into scarce storage.

A futures position has a finite life, so maintaining continuous exposure means selling the expiring contract and buying a later-dated one. In contango that later contract costs more, so the same capital buys a smaller notional position, or the same notional requires additional capital. The drag is the roll return, and it is negative whenever the curve slopes upward at the point where the roll occurs.

Total return on a fully collateralised long futures position is conventionally split into three parts: the spot price return, the roll return, and the collateral return earned on cash posted as margin. Only the second component is determined by curve shape. Candidates should note that magnitude matters as much as sign: a curve one percent upward-sloping per month is a fundamentally different investment proposition from one that is flat, even though both are technically in contango.

Storable commodities with cheap warehousing, such as gold and industrial metals, sit in mild contango almost permanently, because carry is dominated by financing costs and convenience yield is minimal. Energy and agricultural curves alternate: contango when inventories are ample, backwardation when supply is tight and immediate delivery commands a premium.

The same logic extends beyond commodities. Equity index futures price above spot whenever the financing rate exceeds the dividend yield; currency forwards trade at a premium when the domestic rate exceeds the foreign rate under covered interest parity. VIX futures typically slope upward in calm markets, which is why long volatility products bleed value over time. Broad commodity index funds address the problem through calendar spreading, optimised roll schedules, or holding contracts further out where the curve is flatter.

Given a table of spot and futures quotations, you should be able to classify the curve, infer the sign of net carry, and state the direction of roll return for both long and short positions. You should also be able to reason in the other direction: from a stated storage cost, financing rate and convenience yield, determine whether the no-arbitrage curve slopes up or down, and identify the arbitrage trade if a quoted price violates it.

Equally important is separating carry from expectations. Contango is a statement about the relationship between cash and futures prices today, not a forecast. Keynes's normal backwardation and the insurance theory of hedging pressure describe a risk-premium channel that can push futures below expected spot, and that channel operates independently of storage economics. Distinguishing the two arguments cleanly is what most curve questions are testing.