Contango and Backwardation are a very old trading terms that arose when there was little storage of products and sail-powered trading ships took about 3 months to arrive in Europe from the ports where the trading items (eg. spices) were purchased. The prices in European markets were quoted "spot" for immediate purchases and "3 months" for goods that were paid for now and contracted to arrive in 3 months time.
If the 3 months price was above the spot prices, the market was described as being "in contango". This usually only occurred for seasonal and/or market shortage reasons.
If the 3 months price was below the spot price, the market was described as being "in backwardation". Markets usually were in backwardation due to the interest costs and risks on money over the 3 months the buyer had to wait for the goods to arrive.
Because gold is a form of money that can usually be sold forward at prices higher than today's spot price, gold markets are usually in Contango. (Oil and Silver are generally in backwardation!) This contango for gold is effectively:
Contango = Current cash interest rate - Gold lease rate
Because there is a huge tonnage of gold
in Reserve Banks available for lending and because the lending is only
done with highly reputable banks, the gold lease rate is usually lower
than the prevailing cash interest rates.
Assumed Gold Lease Rate is often used in a line of credit
contract. Most reserve banks will only lend gold for 12 months or less
- possibly because national budgets are done annually and national
economic conditions can change. But most gold miners hedge over several
years (even up to 10 years in some cases) to maximise the gold contango
effect which compounds over time and can increase the forward gold
price by over $100 per ounce. For this reason, the counterparty
dealer-banks have established a gold lease rate market that trades gold
lease rates for up to 5 years.
Gold lease rates can be fixed on a daily basis, monthly basis, annual basis or several year basis. The short-term lease rates are usually below 2% (say averaging 1.5% over a long period) because they roughly reflect the actual low rates between the conterparty banks and the reserve banks. Beyond 12 months, the gold lease rates can climb to above 3.5% because the counterparty banks are bearing all the risk.
The equilibrium futures price is that point where the market clears between longs and shorts. Arbitrage, however, forces the futures price to track the forward price (and vice-versa). Similarly, arbitrage between the futures market and the spot market on the final day of trading forces the futures price to converge to the spot price. On the final trading day at the SIMEX, where no gold can actually be delivered on a futures contract, the settlement price is set as the loco London price of the A.M. London price fix. This forces convergent of the futures price to the price in the London spot market. At the COMEX and CBOT, the open longs take delivery of spot gold, which accomplishes the same thing.
(On January 9, 1998, the SIMEX removed trading of its gold futures contract from the floor of the exchange. The contract is still available on the SIMEX Automated Trading System.)
Delivery at the COMEX and the CBOT is one 100-oz bar (plus or minus 5 percent) or three 1-kilogram gold bars, assaying not less than .995 fineness. (Note that 3 kilo bars is about 96 ounces of gold. The dollar amount actually paid at delivery depends, of course, on the specific amount of gold delivered, which must be within 5 percent of the hypothetical 100 ozs per contract.) Delivery at the CBOT takes place by a vault receipt drawn on gold deposits made in CBOT-approved vaults in Chicago or New York. Gold delivered against futures contracts at the COMEX must bear a serial number and identifying stamp of a refiner approved by the COMEX, and made from a depository located in the Borough of Manhattan, City of New York, and licensed by the COMEX. As noted previously, there is no delivery at the SIMEX. The futures contract is purely cash- settled, with the final settlement price determined by the London A.M. gold fix.
In part 3, we saw the U.S. dollar forward price of gold would be related to the U.S. dollar spot price of gold by the relationship
F(T) = S [1 + r (T/360)] / [1 + r* (T/360)].
where the spot price is S, the forward (or futures) price is F(T) for a time-horizon of T days, the eurodollar rate is r, and the gold lease rate is r*. If the eurodollar rate r is higher than the gold lease rate r*, then the forward (futures) gold price will be higher than the spot gold price. Historically gold lease rates have always been lower than eurodollar rates, so forward gold (or a gold futures contract) always trades at a higher price than spot gold. The same is not true, for example, in the silver market. During the year 1998, silver lease rates have frequently exceeded eurodollar rates, so forward silver has traded at a cheaper price than spot silver.
Different terms are used to refer to the relationship between forward or futures prices and spot prices. If forward gold (or a gold future) has a higher price than spot gold, the forward gold or gold future is said to be at a premium, or (in the London market) in contango. If forward gold has a lower price than spot gold, the forward gold or gold future is at a discount, or (in the London market) in backwardation.
As we noted before, forward gold has in recent history always been in contango, or at a premium, because dollar interest rates have always been above gold lease rates. We saw in part 3 that the difference between the forward price and the spot price, F(T)-S, is the swap rate. Since the forward price of gold has always been at a premium in recent years (since 1980, in particular), the swap rate has always been positive. A related term that is used in the U.S. futures markets is basis. Basis is the spot price minus the futures price, or S-F(T), which is just the swap rate with the sign reversed. The gold basis has always been negative in recent years. The Federal Reserve Bank of Cleveland, for example, publishes monthly charts of the gold basis. Reverse the sign on their chart, and you are looking at the swap rate.
While forward gold is traded in the form of swaps, which combines a spot trade (buy or sell) with the reverse forward trade (sell or buy), gold futures can be traded in the form of EFPs (exchange for physicals), which combine a futures trade with the reverse spot trade. EFPs are traded for the same months as gold futures. The EFP price represents the difference between the futures price and the spot price for the combined trade.
For example, a marketmaker may quote the August EFP at the COMEX as $1.10-$1.30 in 100 lots. This means the marketmaker's prices are good for a standard trade involving 100 futures contracts (10,000 ozs of gold). The marketmaker will "buy" the EFP at $1.10/oz, or "sell" the EFP for $1.30/oz.
This quotation implies that for $1.10/oz. the marketmaker offers to buy from you 100 gold futures contracts, while simultaneously selling to you 10,000 ozs of spot gold. For $1.30/oz. the marketmaker will sell to you 100 gold futures contracts, while simultaneously purchasing 10,000 ozs of spot gold. To summarize: the marketmaker's bid price is the price he will buy futures versus selling spot, while the marketmaker's asked price is the price he will sell futures versus buying spot. The EFP price is thus simply a different way of looking at the basis or the swap rate.
On June 24, 1998, the mid-market price (average of bid and asked prices) of the EFP associated with the August 1998 COMEX gold contract was a positive $1.25, while the mid-market price associated with the Dec 1998 COMEX gold contract was a positive $5.60. By contrast, the EFP associate with the July 1998 COMEX silver contract was a negative $2.00. This reflected the fact that gold lease rates were below eurodollar rates, while silver lease rates were above.