Roll yield

Last updated

The roll yield is the difference between the profit or loss of a futures contract and the change in the spot price of the underlying asset of that futures contract. Unlike fixed income or dividend yields, a roll yield does not provide a cash payment, and may not be counted as a profit in certain cases if it accounts for the underlying asset's cost-of-carry. Nonetheless, the roll yield is often characterized as a return that a futures investor capture in addition to the price change of the underlying asset of a futures contract.

Contents

Source of roll yield

The Theory of storage explains roll yield as a combination of storage costs, convenience yield, and asset yield, or a cost-of-carry in aggregate. In a theoretical efficient market equilibrium with no barriers to arbitrage, an investment strategy of investing in a futures contract should be no more or less profitable than an investment strategy of holding the underlying asset and paying its cost-of-carry. If one of these strategies is relatively more profitable, participants in the other strategy would shift resources to arbitrage the relatively more profitable strategy until the return advantage disappear. So the profit or loss from holding a futures contract to a certain time should be equal to the profit or loss from storing an asset to sell at that same time and paying the cost-of-carry for that asset. In most cases, the cost-of-carry is harder to observe than the spot price of the underlying asset, which leads market participants to ignore the cost-of-carry, and compare the profit and loss of futures contracts to the spot price of the underlying assets directly as the roll yield. The roll yield in this case is exactly equal to the cost-of-carry due to arbitrage. [1]

In most practical cases, it is difficult to confirm that the roll yield is equal to the cost-of-carry, as the convenience yield portion of the cost-of-carry is only observable in perfectly efficient futures and spot markets, which rarely exists in the real world. When positive, convenience yield is the money that spot market participants would pay futures market participants to avoid selling an asset at the current moment, and to have the real option of selling it later. Market participants would pay this amount in order to have assets in storage to meet unexpected demand of that asset or its products, to use those assets to avoid shortages of inputs into a production process, or due to some other incentive for storing the asset to sell later. When negative, convenience yield is the money that spot market participants would charge futures market participants to avoid selling an asset at the current moment. Market participants would charge this amount to compensate themselves for not selling the asset immediately; they might require this compensation if their storage capacity is running out, if the underlying asset spoils with time, or if they have some other incentive to get rid of the asset immediately. Storage costs and asset yields are relatively easy to observe, and under perfectly efficient markets, the convenience yield can theoretically be measured as difference between the roll yield, and the sum of storage costs and asset yield. However, in the less-than-perfectly efficient markets in the real world, that difference might contain price biases that do not reflect the convenience yield.

Since the cost-of-carry is difficult to observe, the roll yield may or may not be a gain or loss to investors.

Characterization as a gain or a loss

Roll yield is often characterized as an extra gain or loss that a futures investor captures in addition to the change in the spot price of the underlying asset. However, this is only the case for less-than-perfectly efficient markets when the roll yield is greater than the cost-of-carry.

For example, suppose the spot price of oil is $58 and the market is inverted because inventories are relatively low. This means the first futures price might be at $59 and the next contract at $60. Investors can go long the front contract as described above. Suppose that the spot price remains constant, the futures contract you own moves toward the spot price as delivery approaches, and the spread between the current futures contract and the next futures contract stays at a dollar. Investors can sell the maturing futures near the $58 spot price and buy the next future for around $59. The $1 difference between the maturing futures contract sell price, $58, and the spot price, $59, is the roll yield. In the above characterization, the profit from holding physical oil is assumed to be $0, while the loss from holding the futures contract is calculated as -$1; however, this is only true if the cost-of-carry equals $0. Suppose the cost-of-carry equals $1, from $1 in storage costs and $0 from convenience yield, the roll yield is fully explained by the cost-of-carry. In this case, investors did not suffer a loss by paying roll yield, since as an alternative investors would have to pay an equal amount of cost-of-carry to hold the physical asset. [2]

Now suppose that the cost-of-carry equals $0.50, from $0.50 in storage costs and $0 from convenience yield. The futures market is inefficient, since it would be profitable for market participants to conduct the following arbitrage: purchase spot oil at $58, pay storage costs of $0.50, sell short futures contracts at $59, deliver oil at $58 at contract expiry, and gain $1 from the short futures contracts at expiry to gain risk-free profits of $0.50. Market participants would have incentive to conduct this arbitrage until the selling pressure brings futures contract prices down to $58.50, when they no longer have incentive to conduct the above arbitrage. However, market participants may face obstacles to conduct the above arbitrage; they might have difficulty obtaining physical oil storage, they might lack to scale to purchase oil at the spot market price, and they might face other obstacles. In this case, when futures traders suffer a -$1 loss from purchasing futures at $59 and rolling the contracts at $58, $0.50 of the roll yield will be justified storage cost, and $0.50 will be from an inefficient price bias that could be described as a real roll yield loss.

In the above example, the price bias is visible because the convenience yield is held constant at $0. Since convenience yield is often measured as the residual of subtracting the storage cost and any asset yield from the roll yield, it is difficult to separate that residual into a true convenience yield and a true market price bias. Consider the above example in one case where the true convenience yield is $1, and another case where the true convenience yield is -$1. In both cases, the observed difference between the roll yield and the cost-of-carry is still $0.50, but the price bias is -$0.50 and $1.50. In these cases, the observed difference between the roll yield and the cost-of-carry is neither a good estimator for the cost-of-carry nor for the price bias.

Effect on commodity returns

Roll yield can have a strong impact on the return of futures trading. The contango exhibited in Crude Oil in 2009 explains the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradeable instruments for Crude Oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase, because of the strong negative roll yield. [3] The USO ETF (using futures contracts) also failed to replicate Crude Oil's spot price performance.

Levine, Ooi, Richardson, and Sasseville (2018) found that the roll yield, after adjusting for interest rates, made up the majority of average returns for a long-run index of commodity futures going back 140 years.

Related Research Articles

In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalise on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.

<span class="mw-page-title-main">Normal backwardation</span> Situation when futures prices are below the expected spot price at maturity

Normal backwardation, also sometimes called backwardation, is the market condition where the price of a commodity's forward or futures contract is trading below the expected spot price at contract maturity. The resulting futures or forward curve would typically be downward sloping, since contracts for further dates would typically trade at even lower prices. In practice, the expected future spot price is unknown, and the term "backwardation" may refer to "positive basis", which occurs when the current spot price exceeds the price of the future.

<span class="mw-page-title-main">Contango</span> Situation when futures prices are above the expected spot price at maturity

Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity. In a contango situation, arbitrageurs or speculators are "willing to pay more [now] for a commodity [to be received] at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today." On the other side of the trade, hedgers are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market, or carrying-cost market.

In finance, a put or put option is a derivative instrument in financial markets that gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.

In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative.

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

In finance, a spot contract, spot transaction, or simply spot, is a contract of buying or selling a commodity, security or currency for immediate settlement on the spot date, which is normally two business days after the trade date. The settlement price is called spot price. A spot contract is in contrast with a forward contract or futures contract where contract terms are agreed now but delivery and payment will occur at a future date.

Rational pricing is the assumption in financial economics that asset prices – and hence asset pricing models – will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

<span class="mw-page-title-main">West Texas Intermediate</span> Grade of crude oil used as a benchmark in oil pricing

West Texas Intermediate (WTI) is a grade or mix of crude oil; the term is also used to refer to the spot price, the futures price, or assessed price for that oil. In colloquial usage, WTI usually refers to the WTI Crude Oil futures contract traded on the New York Mercantile Exchange (NYMEX). The WTI oil grade is also known as Texas light sweet, oil produced from any location can be considered WTI if the oil meets the required qualifications. Spot and futures prices of WTI are used as a benchmark in oil pricing. This grade is described as light crude oil because of its low density and sweet because of its low sulfur content.

The forward price is the agreed upon price of an asset in a forward contract. Using the rational pricing assumption, for a forward contract on an underlying asset that is tradeable, the forward price can be expressed in terms of the spot price and any dividends. For forwards on non-tradeables, pricing the forward may be a complex task.

Fixed-income arbitrage is a group of market-neutral-investment strategies that are designed to take advantage of differences in interest rates between varying fixed-income securities or contracts. Arbitrage in terms of investment strategy, involves buying securities on one market for immediate resale on another market in order to profit from a price discrepancy.

The cost of carry or carrying charge is the cost of holding a security or a physical commodity over a period of time. The carrying charge includes insurance, storage and interest on the invested funds as well as other incidental costs. In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost of the funds necessary to buy the instrument.

A convenience yield is an implied return on holding inventories. It is an adjustment to the cost of carry in the non-arbitrage pricing formula for forward prices in markets with trading constraints.

<span class="mw-page-title-main">Box spread</span>

In options trading, a box spread is a combination of positions that has a certain payoff, considered to be simply "delta neutral interest rate position". For example, a bull spread constructed from calls combined with a bear spread constructed from puts has a constant payoff of the difference in exercise prices assuming that the underlying stock does not go ex-dividend before the expiration of the options. If the underlying asset has a dividend of X, then the settled value of the box will be 10 + x. Under the no-arbitrage assumption, the net premium paid out to acquire this position should be equal to the present value of the payoff.

Spot–future parity is a parity condition whereby, if an asset can be purchased today and held until the exercise of a futures contract, the value of the future should equal the current spot price adjusted for the cost of money, dividends, "convenience yield" and any carrying costs. That is, if a person can purchase a good for price S and conclude a contract to sell it one month later at a price of F, the price difference should be no greater than the cost of using money less any expenses from holding the asset; if the difference is greater, the person has an opportunity to buy and sell the "spots" and "futures" for a risk-free profit, i.e. an arbitrage. Spot–future parity is an application of the law of one price; see also Rational pricing and #Futures.

In finance, a stock market index future is a cash-settled futures contract on the value of a particular stock market index. The turnover for the global market in exchange-traded equity index futures is notionally valued, for 2008, by the Bank for International Settlements at US$130 trillion.

Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future —and selling a similar asset forward for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal, and thus one profits by the amount of convergence.

In finance, a dividend future is an exchange-traded derivative contract that allows investors to take positions on future dividend payments. Dividend futures can be on a single company, a basket of companies, or on an Equity index. They settle on the amount of dividend paid by the company, the basket of companies, or the index during the period of the contract.

References

  1. ↑ Bessembinder, Hendrik (2018), "The "Roll Yield" Myth", Financial Analysts Journal, 74 (2): 41–53, doi:10.2469/faj.v74.n2.5, S2CID   158158302
  2. ↑ Bessembinder, Hendrik (2018), "The "Roll Yield" Myth", Financial Analysts Journal, 74 (2): 41–53, doi:10.2469/faj.v74.n2.5, S2CID   158158302
  3. ↑ Liberty, Jez. "Crude Oil, Contango and Roll Yield for Commodity Trading".
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.