Managing Retroactive Benchmark Substitution Spread Discrepancies in Physical Swaps
Resolve retroactive benchmark substitution discrepancies by aligning physical contract fallbacks with financial hedge mechanics and capping true-up lookbacks.
Backwardation
Meaning
Market conditions where spot prices for a commodity trade at a premium to prices for future delivery represent a state of immediate supply constraint. Producers often see backwardation as a signal to release inventory into the market for immediate sale. The curve slopes downward, indicating that the market expects prices to normalize in the future.
Spot Premium
High demand for immediate delivery forces buyers to pay more for goods today than for goods arriving in several months. This situation frequently occurs when stocks at a delivery hub fall below critical levels. Supply shocks or unexpected outages often trigger this price inversion.
Supply Scarcity
Shortages in the physical market make holding inventory expensive due to the opportunity cost of not selling. When the market is in this state, the cost of carry is effectively negative. Traders avoid holding long positions for future delivery because the value of the commodity decreases over time.
A lack of available product at the point of consumption drives the front month price higher than the outer months. This premium for prompt delivery is often called the convenience yield.
Inventory Economics
Warehouse operators find little incentive to store products when future prices are lower than current prices. Selling the physical asset and buying a future contract allows a participant to capture the premium while maintaining exposure. This dynamic helps clear the market by encouraging consumption and discouraging hoarding.