Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

What condition exists when the expected spot price of a commodity in one year exceeds its one-year forward price?

1. Price normalcy

2. Contango

3. Normal backwardation

4. Market equilibrium

The correct answer is: Normal backwardation

When the expected spot price of a commodity in one year exceeds its one-year forward price, this situation is referred to as normal backwardation. In this context, normal backwardation indicates that the market participants anticipate price increases in the future, which leads to a higher expected spot price compared to the forward price. Traders use this strategy to hedge against expected price increases, often resulting in lower forward prices as producers are willing to sell their commodities at those prices to mitigate risk. This condition reflects a natural market dynamic where the forward market fails to fully account for the expected rise in demand or scarcity of the commodity, resulting in the spot price being forecasted to surpass the conventional forward price. This is crucial for investors and traders to understand as it shapes their trading strategies and expectations regarding future market movements.