Additional Notes on Contango, Backwardation and Roll Return

Andrew Chiu
Let me use an example to illustrate how roll return works. There exists an asset with a current
price of 100 and eventually rises to 120 in 1 year. Consider three scenarios: (a) the futures is
priced the same as the underlying asset, (b) futures is in contango, (c) futures is in
backwardation. Now lets see how these different types of pricing patterns affect the investors
P&L.
Scenario 1 (S = F):
S0 = 100, F0 = 100
Investor buys a future at 100. Then in one year:
S1 = 120, F1 = 120 (futures price converges to spot price at maturity)
The investor exits with a profit of 20. There is no roll return.
Scenario 2 (S < F):
S0 = 100, F0 = 110 (contango)
Investor buys a future at 110. Then in one year:
S1 = 120, F1 = 120 (futures price converges to spot price at maturity)
The investor exits with a profit of 10 (F moves from 110 to 120). We can decompose
this return into two parts: (a) return from movement in the spot price and (b) roll return.
10 = 20 (return from spot price going up from 100 to 120) 10 (roll return)
This -10 arises from the contango and is costly to the investor. Even though the investor
made a profit of 10, he/she would have made 20 if there was no contango.
Scenario 3 (S > F):
S0 = 100, F0 = 95 (backwardation)
Investor buys a future at 95. Then in one year:
S1 = 120, F1 = 120 (futures price converges to spot price at maturity)
The investor exits with a profit of 25 (F moves from 95 to 120). We can decompose this
return into two parts: (a) return from movement in the spot price and (b) roll return.
25 = 20 (return from spot price going up from 100 to 120) + 5 (roll return)
This extra +5 arises from the backwardation and is beneficial to the investor.

In all three cases, the return that arises from the spot price movement is the same. The
difference is in the roll return components.
This roll return is the same even if the spot price went down. Lets revisit the three scenarios for
the case where the spot price drops from 100 to 80.
Scenario 1 (S = F):
S0 = 100, F0 = 100
Investor buys a future at 100. Then in one year:
S1 = 80, F1 = 80 (futures price converges to spot price at maturity)
The investor exits with a loss of 20. There is no roll return.
Scenario 2 (S < F):
S0 = 100, F0 = 110 (contango)
Investor buys a future at 110. Then in one year:
S1 = 80, F1 = 80 (futures price converges to spot price at maturity)
The investor exits with a loss of 30 (F moves from 110 to 80).
-30 = -20 (return from spot price going down from 100 to 80) 10 (roll return)
The roll return is -10 (because of the contango) and it is the same as the previous case
when the spot price rises from 100 to 120.
Scenario 3 (S > F):
S0 = 100, F0 = 95 (backwardation)
Investor buys a future at 95. Then in one year:
S1 = 80, F1 = 80 (futures price converges to spot price at maturity)
The investor exits with a loss of 15 (F moves from 95 to 80).
-15 = -20 (return from spot price going down from 100 to 80) + 5 (roll return)
This extra +5 arises from the backwardation and is beneficial to the investor.
Notice that it is the same as the previous case when the spot price rises from 100 to 120.
As you can see, the profit and loss from spot price movement is independent from the profit
and loss (roll return) arising from contango or backwardation. This roll return is the same
whether the spot price moves up or down. The roll return does depend on whether you are
long or short the futures. For a short futures position you can see that contango will lead to a
positive roll return, while backwardation leads to a negative roll return.