What Does Forwarding Mean?
When a commodity or currency’s futures price is higher than the spot (cash) price for immediate delivery in futures contracts, this is known as forwardation. Contango is the more common name for forwardation.
Backwardation is in contrast to forwardation/contango.
Key Takeaways
- Forwardation occurs when a commodity or currency’s current price is lower than its futures price.
An upward-sloping forward curve occurs because forwardation indicates that futures prices are higher than current prices. - The use of forwarding is justifiable as well as an estimation of the additional costs associated with the commodity’s delivery, insurance, and storage.
- Using forwardation, traders can try to make money by buying spot at the current price and selling futures at a higher price.
Understanding Forwarding
A futures contract is a legal agreement to buy or sell a specific asset or commodity at a predetermined price at a particular point in the future. In order to facilitate trading on a futures exchange, futures contracts are standardized in terms of quality and quantity.
Forwarding is when a commodity’s current price is lower than the price of contracts that expire in the future. To put it another way, forwardation indicates that the forward curve slopes upward. The high costs of delivery, insurance, and storage of the commodity may account for the futures contract’s higher price than the spot price today.
Backwardation, on the other hand, occurs when spot prices are higher than futures contract prices. In this case, the forward curve would be inverted.
Special Considerations
Over time, the market continuously receives new information, resulting in changes to the expected future spot price—the most rational future price—of a futures contract and fluctuations in commodity spot prices.
The price of futures typically falls or rises as a result of more information. The futures price is determined by these variables in a forwardation market; However, the anticipated price will frequently differ from the actual spot price.
Example of Forwardation
A plastics manufacturing company needs to buy oil for the next year because their products are made with oil. Utilizing futures contracts could help the manufacturer secure a price for purchasing the oil. When the futures contract expires in a year, the manufacturer will receive the oil.
The manufacturer is aware in advance of the price they will pay for the oil—the futures contract price—and that they will receive the oil when the contract comes to an end.
For instance, the manufacturer requires one million barrels of oil over the course of the following year; these barrels will be delivered within a year. The manufacturer could put off paying for the oil until next year. However, they have no idea how much oil will cost in a year. The market price at that point could be significantly different from the current price because of the volatility of oil prices.
Assume the futures contract is valued at $85 for a one-year settlement and the current price of $75 per barrel. One illustration of forwardation would be the rising price of oil.
It’s possible that the manufacturer will choose not to set a price right away if they believe that the price of oil will fall in a year. By entering into a futures contract, the manufacturer could secure a guaranteed purchase price if they anticipate that oil will cost more than $85 in a year.
Forwardation and Market Prices
Futures contracts for forwardaction and market prices can be used to protect against currency or commodity volatility. However, just because a futures contract’s price is higher than the commodity’s spot price at the present time does not imply that the spot price will also rise to match the futures contract price. All in all, the ongoing cost of a one-year prospects contract isn’t really an indicator of where costs will be in a year.
It goes without saying that portfolio managers and retail traders have no interest in either delivering or receiving the underlying asset. A retail trader doesn’t need 1,000 barrels of oil, but they might be interested in making money when oil prices change. A retail trader may, for a gain or loss, offset the contract or unwind the position upon settlement of the futures contract.
