Futures Term Structure

The term structure of futures refers to the relationship between the prices of futures contracts and the differing maturity dates for these contracts. Essentially, it is the curve created when plotting the prices of futures contracts against their respective expiration dates. This concept is particularly important in understanding the cost of carry, market expectations, and the overall market sentiment.

Key Components

Futures Contracts

A futures contract is a standardized legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. Futures are traded on exchanges and are used for both hedging and speculative purposes.

Contango and Backwardation

The term structure of futures can be in one of two main states: contango or backwardation.

Contango

Contango is a situation where the futures prices are higher than the spot prices. In other words, futures contracts with later maturity dates are priced higher than those with earlier maturity dates. This condition occurs due to the cost of carry, which includes storage costs, insurance, and the interest foregone on invested funds.

Backwardation

Backwardation is the opposite of contango, where futures prices are lower than the spot prices. It occurs when the benefit of holding the physical asset (such as dividends or convenience yield) outweighs the costs.

Influencing Factors

Several factors influence the futures term structure, including:

Spot Prices

The current price at which an asset is bought or sold is the spot price, and this price is a primary input in determining the futures price.

Interest Rates

Interest rates affect the cost of carry, as the cost of funding the purchase of the underlying asset is dependent on prevailing interest rates.

Storage Costs

For physical commodities, storage costs—including warehousing, insurance, and deterioration—can influence the term structure.

Dividends and Coupon Payments

For financial instruments like bonds and stocks, the income received from these investments (i.e., dividends or coupon payments) can impact the futures prices.

Market Sentiment and Expectations

Trader sentiment and market expectations about future price changes, supply and demand, and macroeconomic factors also play a role.

Theoretical Models

Several theoretical models help explain the term structure of futures:

Cost-of-Carry Model

The cost-of-carry model posits that the futures price equals the spot price plus the cost of carry. This model applies primarily to commodities and financial instruments with negligible income.

Expectations Theory

The expectations theory suggests that the futures price is determined by the market’s expectation of the future spot price. According to this theory, the current futures price reflects the collective market prediction of where the spot price will be at contract maturity.

Normal Backwardation and Contango Theory

Developed by Keynes, the theory proposes that futures prices are biased predictors of future spot prices because hedgers are willing to pay a premium to avoid risk, leading to normal backwardation. Conversely, if speculators dominate the market, prices may exhibit normal contango.

Practical Implications

Arbitrage Opportunities

If the futures prices deviate significantly from what the theoretical pricing models suggest, arbitragers will step in to exploit these differences, thereby bringing prices back towards equilibrium.

Hedging Strategies

Understanding the term structure is crucial for hedgers who use futures contracts to mitigate risk. For example, oil producers may use a futures contract in contango to lock in higher future prices, thereby stabilizing revenue.

Investment Strategies

Investors may develop strategies based on the term structure. For instance, a trader might buy short-dated futures and sell long-dated futures when the market is in backwardation, expecting the prices to converge.

Market Examples

Commodity Markets

In commodity markets, the term structure can often signal future supply and demand conditions. For example, an oil futures market in contango might imply an oversupply in the market, whereas backwardation may indicate a current supply shortage.

Interest Rate Markets

In the context of interest rate futures (e.g., Treasury futures), the term structure can reflect market expectations about future interest rates. A steepening yield curve indicating contango might suggest expectations of higher future interest rates.

Equity Index Futures

Equity index futures illustrate the term structure in relation to expected equity market performance. Factors like dividend expectations and anticipated market volatility can influence the futures prices.

Real-World Companies Involved

CME Group

CME Group is a global markets company that owns large derivatives, options, and futures exchanges such as the Chicago Mercantile Exchange. They offer a wide range of futures products and are a key player in the analysis and application of futures term structures.

ICE (Intercontinental Exchange)

ICE operates numerous global exchanges and clearinghouses, and it is another pivotal player in the futures markets. They provide futures contracts on a variety of assets, from commodities to financial instruments, allowing for comprehensive term structure analysis.

Conclusion

Understanding the futures term structure is fundamental for participants in the futures markets, from hedgers to speculators and arbitragers. It allows for informed decision-making, optimal hedging and investment strategies, and the identification of potential arbitrage opportunities. Both theoretical and practical knowledge of the term structure can significantly impact trading outcomes and financial planning.