Ideal price of Futures contract = Spot price + Cost of carry – Inflows

As discussed earlier, inflows may be in the form of dividend (in case of equity) and interest (in case of debt). However, sometimes inflows may also be situational or intangibles.

Intangible inflows are essentially values perceived by the market participants just by holding the asset. These values may be in the form of just convenience derived from holding the asset or perceived mental comfort.

For instance, in case of natural disaster like flood in a particular region, or war, people start storing essential commodities like grains, vegetables and energy products (heating oil) etc. This causes a spike in the spot market and increases the price of the underlying asset for immediate delivery. So, holding the asset/commodity immediately, is better, than availing the asset at some time in the future, or by holding futures contract. This is termed as convenience yield.

The convenience yield can be larger than the cost of carry, at times, causing the futures price to be lower than the spot price. Futures price are lower than spot price of an asset, market participants may expect the spot price to come down in future. This is called Backwardation.

As stated, Backwardation can occur as a result of a higher demand for an asset currently than the contracts maturing in the coming months through the futures market. The forward curve indicating the prices of futures for different expiries highlights that spot is greater than the futures quotes, hence a Backwardation market.

In a normal scenario, the futures price could be at a higher price than the spot, due to cost of carry, which is called Contango market. The forward curve indicating the prices of futures for different expiries indicates that spot is lower than the futures quotes, hence a Contango market.

Convenience yield is the benefit or premium associated with holding an underlying product or physical good, i.e. in spot, rather than the derivative or futures contract of the underlying.

When the demand supply mismatch occurs and there is scarcity is spot markets, then the convenience yield rises or increases. This results in spot prices of the underlying to be higher than the futures price, a phenomenon called backwardation.

In a normal scenario, the futures price could be at a higher price than the spot, due to cost of carry, which is called Contango market. However, the convenience yield can be larger than the cost of carry, at times (especially when there is scarcity in spot markets), causing the futures price to be lower than the spot price. Futures price are lower than spot price of an asset, market participants may expect the spot price to come down in future. This is called Backwardation. Backwardation in equity futures often times appear ahead of big dividend announcement. While the dividend is not announced but is in expectation which gets discounted from Cost of Carry and could be higher than cost of carry as well resulting in Backwardation.

Convenience yield is influenced by demand and supply mismatches, especially in case of commodities, for eg. Crude, A sudden scarcity of crude due to geopolitical tensions, pushes up spot price as compared to futures contract, due to convenience yield.

Backwardation occurs when the spot markets are higher than the near month futures, which are in turn higher than the other far dated futures. This primarily occurs when the convenience yield rises (may be due to scarcity in spot markets), causing the spot to remain elevated as compared to futures.