Trade off theory of capital structure investopedia forex

The graph depicts how the price of a single forward contract will typically behave through time in relation to the expected future price at any point in time. A futures contract in contango will trade off theory of capital structure investopedia forex decrease in value until it equals the spot price of the underlying at maturity.

The opposite market condition to contango is known as backwardation. A market is ‘in backwardation’ when the futures price is below the spot price for a particular commodity. The Commission of the European Communities, in a report on agricultural commodity speculation, defined backwardation and contango in relation to spot prices: “The futures price may be either higher or lower than the spot price. When the spot price is higher than the futures price, the market is said to be in backwardation. The curves in question plot market prices for various contracts at different maturities — cf. A contango is normal for a non-perishable commodity that has a cost of carry.

A normal forward curve depicting the prices of multiple contracts, all for the same good, but of different maturities, slopes upward. Sellers like to “sell forward” because it locks in an income stream. Farmers are the classic example: by selling their crop forward when it is still in the ground they can lock in a price, and therefore an income, which helps them qualify, in the present, for credit. The contango contract for future delivery, selling today, is at a price premium relative to buying the commodity today and taking delivery.

The backwardation contract selling today is lower than the spot price, and its trajectory will take it upward to the spot price when the contract closes. The Oil Storage Contango was introduced on the market in early 1990 by the Swedish-based oil storage company Scandinavian Tank Storage AB and its founder Lars Jacobsson by using huge military storage installations to bring down the “calculation” cost on storage to create the Contango situation out of a “flat” market. Contango is a potential trap for unwary investors. Between 2005 and 2010 the number of futures-based commodity ETFs rose from two to ninety-five, and the total assets rose from 3. 9 to nearly 98 billion USD in the same period. The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one.

If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation. In 2005 and 2006 a perception of impending supply shortage allowed traders to take advantages of the contango in the crude oil market. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses. But by the summer, that price curve had flattened considerably. If short-term interest rates were expected to fall in a contango market, this would narrow the spread between a futures contract and an underlying asset in good supply.