Understanding Roll Yield in Commodity Futures

Roll yield is a type of return in commodity futures investing. It is driven by the difference in the price of shorter-dated, closer to maturity commodity contracts and their longer-dated counterparts.

A futures contract is a promise to either buy or sell a commodity in the future but at a pre-determined price or forward price. The real market value at which an instrument or asset is traded on the date of expiry or execution of the contract is called the spot priceSpot PriceThe spot price is the current market price of a security, currency, or commodity available to be bought/sold for immediate settlement. In other words, it is the price at which the sellers and buyers value an asset right now..

Roll yields can be either positive or negative, depending upon whether the market is in contango or backwardation. It is important to note that the roll return is only one of the multiple sources of return for commodity futures.

Roll return offers the added advantage of providing an insight into the expected price movement of a commodity futures contractFutures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price., be it a drop in prices from contango, which is the opposite in case of backwardation. Thus, normal contango and normal backwardation refer to a phenomenon that cannot be observed or proved in real-time.

Summary

• Roll yield is a type of return in commodity futures investing. It is driven by the difference in the price of shorter-dated, closer to maturity commodity contracts and their longer-dated counterparts.
• Roll yields can either be positive or negative, depending on whether the market is in backwardation or contango.
• Roll return offers the added advantage of providing an insight into the expected price movement of a commodity futures contract, be it a drop in prices from the contango or the opposite in the case of backwardation.

What is Contango?

When the prices of longer-dated contracts are higher than that of shorter-dated contracts, the market is said to be in contango. Contango occurs due to costs incurred by the commodity owner for holding or storing a particular commodityCommoditiesCommodities are another class of assets just like stocks and bonds. Most commodities are products that come from the earth that possess.

An investor looking to invest in the commodity will select a particular contract to purchase. In such a case, they will select a longer-dated contract. From a roll yield perspective, as time passes, the price of a contract will fall or roll down towards that of the next nearest contract. It, in turn, will fall lower towards the price of the nearest contract, and so on.

The process is called roll yield, and in the case of contango, the return is negative due to falling prices. In such a case, the investor will choose to sell the current contract or wait for it to expire to maintain commodity exposure in the future. They will then reinvest in a longer-dated contract, thus repeating the cycle.

What is Backwardation?

When the prices of longer-dated contracts are lower than that of shorter-dated contracts, the market is said to be in backwardation. It can happen in cases when the current inventory of a commodity is low.

For example, drought or excessive rainfall can cause poor agricultural harvest. In such cases, commodities for the current season would be in short supply, making contracts related to this year’s harvest to skyrocket. The price of the longer-dated contract would roll up to the next nearest contract, as a typical investor buying at market price would sell the contract at a slightly higher price. It is how investors earn a positive roll yield.

Calculating Roll Yield

In order to calculate roll yield, an investor needs to know the rates of the two futures contracts and the spot price of the underlying asset, which in this case, is a commodity. For example, assume that June soybean futures are trading at $100, while in July, they are trading at $95, the spot price being $100.

Investor X expected the rates of soybean to either remain the same or increase. Therefore, she decided to roll the contract up to July, but on the date of the expiration, the spot price remains the same ($100). Investor X’s roll yield would be as follows:

• Change in the Future’s Price = $100 – $95 = $5
• Change in the Spot Price = $100 – $100 = $0
• Roll Yield = $5 – $0 = $5

Additional Resources

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Contango vs BackwardationContango vs BackwardationContango vs backwardation are terms used to describe the shape of the futures curve for commodity markets. The futures curve has two dimensions, plotting time across the horizontal axis and delivery price of the commodity across the vertical axis.
• Expiration DateExpiration Date (Derivatives)The expiration date refers to the date in which options or futures contracts expire. It is the last day of the validity of the derivatives contract.
• Forward CommitmentsForward CommitmentsA forward commitment refers to a contractual agreement between two parties to carry out a planned transaction, i.e., a transaction in the future. Forward
• Trading MechanismsTrading MechanismsTrading mechanisms refer to the different methods by which assets are traded. The two main types of trading mechanisms are quote driven and order driven trading mechanisms