Thursday, January 27, 2011
Selling the family cow for a few magic beans
The swap rate is the difference between the forward price and spot price. The inverse of the swap rate is sometimes called basis. Spot price is sometimes called the cash price. When the swap rate is less than the cost of carry, then a market may turn from contango to backwardation. Cost of carry is basically the cost of holding a position. A market may begin to experience backwardation when no arbitrage can be made from delivery due to supply shortages or risk of a delivery failure. Contango occurs when the forward price is higher than the spot price, i.e., when the forward price is at a premium. Backwardation occurs when the forward price is lower than the spot price, i.e., when the forward price is at a discount. When there is a supply shortage, delivery arbitrage disappears because no supply is available.