Investments, tenth edition

  Normal Backwardation 

 This theory is associated with the 

famous British economists John 

Maynard Keynes and John Hicks. 

They argued that for most com-

modities there are natural hedgers 

who wish to shed risk. For exam-

ple, wheat farmers desire to shed 

the risk of uncertain wheat prices. 

These farmers will take short posi-

tions to deliver wheat at a guaran-

teed price; they will short hedge. 

To induce speculators to take the 

corresponding long positions, the 

farmers need to offer them an 

expectation of profit. They will 

enter the long side of the contract 

only if the futures price is below the 

expected spot price of wheat, for 

an expected profit of  E ( P  

 T 

 )  2   F  

0

 . 

The speculators’ expected profit 

is the farmers’ expected loss, but 

farmers are willing to bear this 

expected loss to avoid the risk of uncertain wheat prices. The theory of  normal backward-

ation  thus suggests that the futures price will be bid down to a level below the expected spot 

price and will rise over the life of the contract until the maturity date, at which point  F  

 T 

   5   P  

 T 

 . 

 Although this theory recognizes the important role of risk premiums in futures markets, 

it is based on total variability rather than on systematic risk. (This is not surprising, as 

Keynes wrote almost 40 years before the development of modern portfolio theory.) The 

modern view refines the measure of risk used to determine appropriate risk premiums.  

  Contango 

 The polar hypothesis to backwardation holds that the natural hedgers are the purchasers of 

a commodity, rather than the suppliers. In the case of wheat, for example, we would view 

grain processors as willing to pay a premium to lock in the price that they must pay for 

wheat. These processors hedge by taking a long position in the futures market; therefore, 

they are called long hedgers, whereas farmers are short hedgers. Because long hedgers 

will agree to pay high futures prices to shed risk, and because speculators must be paid a 

premium to enter the short position, the  contango  theory holds that  F  

0

  must exceed  E ( P  

 T 

 ). 

 It is clear that any commodity will have both natural long hedgers and short hedgers. 

The compromise traditional view, called the “net hedging hypothesis,” is that  F  

0

  will be 

less than  E ( P  

 T 

 ) when short hedgers outnumber long hedgers and vice versa. The strong 

side of the market will be the side (short or long) that has more natural hedgers. The strong 

side must pay a premium to induce speculators to enter into enough contracts to balance 

the “natural” supply of long and short hedgers.