What you will learn
- Separate curve shape from a forecast of spot direction.
- Recognize why a related contract is not a perfect hedge.
Contango
It often reflects the cost of carry: financing, storage and insurance for holding the physical good until later delivery. A fund or trader who wants continuous exposure must roll, selling the expiring contract and buying the next one, and in contango the next contract costs more.
If the curve keeps its shape and spot is unchanged, a long futures position tends to lose value as it converges down toward spot, called negative roll return. Roll return is only one component of results: spot changes can easily outweigh it in either direction, so contango says nothing certain about where spot will go.
Backwardation
It often appears when the physical good is scarce today and buyers pay up for immediate supply, or when holding stock has a high convenience value. Shortages, supply disruptions and low inventories are common causes, though the exact reasons differ by market.
If the curve keeps its shape and spot is unchanged, a long futures position tends to gain as the contract converges up toward spot, giving a positive roll return when rolling into cheaper later contracts. That is only one component: if spot falls enough, losses can exceed the roll gain, so backwardation is not a prediction that prices will rise.
Correlation
The usual measure, the Pearson coefficient, equals the covariance of two return series divided by the product of their standard deviations. It should be computed on returns, not price levels, because two trending price series can look strongly correlated even when their returns are unrelated.
Correlation depends on the window and data frequency, and it is not stable: relationships estimated in calm periods often strengthen in market stress. It captures only linear co-movement, says nothing about causation, and is not beta, which also depends on relative volatility.
Worked example: Offsetting changes need not match
Illustrative: a physical exposure loses HK$1,000 while a fictional related hedge gains HK$800 over the same interval, leaving a HK$200 net loss before costs. Different grades, locations, dates or contract units can create this mismatch. A futures curve above or below spot does not guarantee either the next spot move or the final return from rolling a hedge.
Check your understanding
An exposure loses HK$600 and its hedge gains HK$450. What is the combined pre-cost result? Does high historical correlation rule this out?
Show answer and explanation
−600 + 450 = −HK$150. High historical correlation is not identical price movement and may change; sizing, basis changes and costs still matter.