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.
Contango
Meaning
Pricing structures in futures markets where the price of a commodity for future delivery exceeds the expected spot price at maturity define a state of surplus. Markets in contango typically feature ample supply and low immediate demand. The upward sloping price curve includes the costs of storage, insurance and financing.
Storage Premium
Holding physical inventory becomes profitable when the price difference between the current month and a future month exceeds the cost of carry. Market participants buy the physical asset and simultaneously sell a future contract to lock in a guaranteed return. This arbitrage trade absorbs excess supply and prevents spot prices from falling further.
Warehouse space becomes highly valuable as traders compete for room to store the surplus. The availability of tankers or silos determines the upper limit of the price spread between the front month and the outer months.
Future Premium
Investors who take long positions in distant contracts pay more than those buying in the spot market. This premium reflects the market expectation that prices will rise or simply the convenience of not having to store the goods. It is a common state for non perishable commodities during periods of high production.
Carry Economics
Total costs of maintaining a position include the interest paid on capital used to purchase the goods. Financial institutions often fund these positions when the spread is wide enough to cover the risk. If the spread narrows, the incentive to store the product disappears.