Chartered Financial Analyst (CFA) Practice Exam Level 2

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What signifies a backwardation condition in commodity pricing?

Futures prices are equal to spot prices
Storage costs exceed convenience yield
Spot prices exceed futures prices
Convenience yield exceeds storage costs

The correct answer is: Spot prices exceed futures prices

A backwardation condition in commodity pricing occurs when the spot price of a commodity is higher than its futures price. This situation typically indicates that there is immediate demand for the commodity that is not being met by current supply, making it more valuable in the present than in the future. In other words, buyers are willing to pay a premium for immediate possession of the commodity, reflecting factors such as scarcity, high demand, or urgency. In a backwardation scenario, as the futures contract approaches its expiration, the futures price tends to rise towards the spot price, aligning the two as the delivery date approaches. This dynamic is often driven by expectations of falling prices or reduced production in the future. Hence, the relationship illustrated by spot prices exceeding futures prices is a clear indicator of backwardation. Understanding how backwardation impacts investor behavior and market dynamics is crucial for interpreting market signals and making trading decisions in futures markets.