Normal backwardation

Formally, backwardation means a downward sloping forward curve (as in an inverted yield curve). A backwardation starts when the difference between the forward price and the spot price is less than the cost of carry, or when there can be no delivery arbitrage because the asset is not currently available for purchase.

The opposite market condition to backwardation is known as contango, in which the spot price is lower than the forward price.

Backwardation very seldom arises in money commodities like gold or silver. In the early 1980s, there was a one-day backwardation in silver while some metal was physically moved from COMEX to CBOT warehouses.^{[citation needed]} Gold has historically been positive with exception for momentary backwardations (hours) since gold futures started trading on the Winnipeg Commodity Exchange in 1972.^[1]

The term is sometimes applied to forward prices other than those of futures contracts, when analogous price patterns arise. For example, if it costs more to lease silver for 30 days than for 60 days, it might be said that the silver lease rates are "in backwardation."

Occurrence

This is the case of a convenience yield that is greater than the risk free rate.

It is argued that backwardation is abnormal, and suggests supply insufficiencies in the corresponding (physical) spot market. However, many commodities markets are frequently in backwardation, especially when the seasonal aspect is taken into consideration, e.g., perishable and/or soft commodities.

In Treatise on Money (1930, chapter 29), economist John Maynard Keynes argued that in commodity markets, backwardation is not an abnormal market situation, but rather arises naturally as "normal backwardation" from the fact that producers of commodities are more prone to hedge their price risk than consumers. The academic dispute on the subject continues to this day.^{[citation needed]}

Examples

Notable examples of backwardation include:

• Copper circa 1990, apparently arising from market manipulation by Yasuo Hamanaka of Sumitomo Corporation in what has come to be called the "Sumitomo copper affair".

• FX: The Australian dollar, priced in Japanese yen terms (AUD/JPY), in 2006: the backwardation occurs simply because Australian dollar bonds pay so much more interest at every point in the yield curve than Japanese yen bonds do. Any high-yield foreign currency contract will show backwardation in its pricing.^{[citation needed]}

• Silver: In 2009 has been in backwardation since late January. This is due to suspected long term price suppression as cited by Ted Butler.^[2]

Origin of term: London Stock Exchange

Like contango, the term originated in mid-19th century England, originating from "backward".

In that era on the London Stock Exchange, backwardation was a fee paid by a seller wishing to defer delivering stock they had sold. This fee was paid either to the buyer, or to a third party who lent stock to the seller.

The purpose was normally speculative, allowing short selling. Settlement days were on a fixed schedule (such as fortnightly) and a short seller did not have to deliver stock until the following settlement day, and on that day could "carry over" their position to the next by paying a backwardation fee. This practice was common before 1930, but came to be used less and less, particularly since options were reintroduced in 1958.

The fee here did not indicate a near-term shortage of stock the way backwardation means today, it was more like a "lease rate", the cost of borrowing a stock or commodity for a period of time.

In more recent years, a backwardation in equities quoted on the London Stock Exchange has come to signify the unusual occurrence of an individual equities quote whereby the bid appears to be higher than the offer. This (of course) cannot occur for electronically traded stocks via SETS or SETS MM but only for quote-driven stocks (SEAQ)

London Metal Exchange

The London Metal Exchange market rules allow it to set a limit on backwardation in contracts traded there. At present times, all base metal contracts (excluding LME Minis) are subject to "lending guidance". Therefore, the exchange controls neither the absolute price level directly nor the trading positions held by exchange members. It rather limits the price differential between trades that go into delivery the next day ("tom position") and the day after ("cash position").

Calendar spreads are known in LME jargon as "carries". Buying a carry is referred to as "borrow" and selling a carry as "lending". Thus, if a metal is subject to lending guidance, dominant position holders may be required to lend tom-next, that is sell a tom-position and buy a cash-position, should the backwardation for that period exceed a certain exchange-set percentage. The price differential and number of contracts to be lent is determined by LME regulation.

The LME uses backwardation limits in emergency situations, such as in 2005 following Hurricane Katrina when Zinc warrants in New Orleans were suspended until the warehouses were checked, or to act against possible or suspected market manipulation, such tightness in particular prompts for Aluminium in early 1999.

Normal backwardation vs Backwardation

The term, Backwardation, can also mean a situation when the futures curve is inverted. That is, when futures prices for all future maturities are higher than the spot price.^[3]

References

Wikisource has the text of the 1911 Encyclopædia Britannica article Backwardation.

• Encyclopædia Britannica, eleventh edition (1911), articles Backwardation, Contango and Stock Exchange, and fifteenth edition (1974), articles Contango and Backwardation and Stock Market.
• Modern Market Manipulation, Mike Riess, 2003, paper at the International Precious Metals Institute 27th Annual Conference
• LME launches and investigation in primary aluminium trading, London Metal Exchange advice to members 15 January 1999, reproduced at aluNET International
• New Orleans - Temporary Suspension of Warrants, London Metal Exchange press release 6 September 2005.
• investopedia Website, Articles on Contango and Backwardation and Stock Market.