101 Concepts for the Level I Exam

Essential Concept 88: Theories Explaining Futures Returns

There are three theories of commodity futures returns:

  1. Insurance theory: Commodity producers sell the commodity in futures market in order to make their revenues predictable. This implies that the futures price must be less than the spot price as a payment to the speculator for providing insurance to the producer.
  2. Hedging pressure hypothesis: Producers and consumers sell and buy (respectively) in the futures market in order to remove price uncertainty. The number of sellers as against the number of buyers would determine whether the futures market would be in contango or backwardation.
  1. Theory of storage: Commodity futures prices are affected by the costs of storage and convenience yield. Convenience yield is inversely related to general available of the commodity. Futures price = Spot price + Direct Storage costs – Convenience yield