Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

What factor primarily determines whether a commodity futures market is in contango or backwardation?

1. Seasonal demand fluctuations

2. The Slope of the term structure based on carrying costs

3. Regulatory changes affecting commodity trading

4. The number of participants in the futures market

The correct answer is: The Slope of the term structure based on carrying costs

The primary determinant of whether a commodity futures market is in contango or backwardation is the slope of the term structure based on carrying costs. This concept arises from the economics of storage, transportation, and interest associated with holding physical commodities. In contango, futures prices are higher than the spot price, reflecting the carrying costs of holding the commodity until the contract expiry. These costs include storage fees, insurance, and the opportunity cost of capital. As these costs increase or are anticipated to increase, the term structure slopes upward, indicating that future prices incorporate these expenses. Conversely, in backwardation, the futures prices are lower than the spot price. This often occurs when there is a high demand for the commodity in the short term or when there are anticipated shortages. The market reflects an immediate scarcity or increased urgency for the commodity, leading to futures prices that don't adequately cover the carrying costs. Whereas seasonal demand fluctuations might impact prices and can influence market behavior, they do not fundamentally govern the structure of contango and backwardation. Similarly, regulatory changes and the number of market participants can affect liquidity and speculative pressures but are secondary to the fundamental economic factors regarding carrying costs in determining the slope of the term structure.