What is roll yield in futures investing?

Answer 1

Investment in a commodity index generally entails (i) the bulk of the investment's being put into secure instruments such as Treasury bills and (ii) the remainder of the investment going into futures. The most liquid futures tend to be those in the very near term, and they usually have short maturities, typically 1 month, so investment in liquid futures means investing in a contract that is likely to mature in the near future. Given that the investment term in the index is open-ended, the futures investment component is going to move from one future to the next succeeding future during the life of the underlying index investment. For example, a 5 year investment might involve a change in the underlying futures on 60 monthly occasions. The investment is "rolled" from one futures contract to the next at which time if the price of the expiring contract is higher than the replacement contract (positive roll yield), selling the expiring and buying the replacement will yield a positive cash result. If the replacement contract is higher in price than the expiring contract, the reverse is true (negative roll yield). This can be visualized by considering that the initial futures investment is at a point on a curve of futures price (y-axis) v. time (x-axis). For the most liquid commodities such as crude oil and natural gas, monthly futures contracts are priced from next month right out to a point more than 5 years from today. If, moving out in time, successive futures prices are higher, the price curve is said to be in "contango". If the later prices are lower, the curve is said to be in "backwardation". A moment's consideration should show that a positive roll yield will occur in a backwardated curve, while a negative roll yield will occur in a contango curve. This is because the initial investment point on the curve moves to the left as time elapses and contract roll is approached. Moving to the left in a backwardated curve would mean the the price of the contract that the investor currently holds will rise (if nothing else changes in the market, and the spot price of the commodity is constant). At the point of rolling, the point on the curve jumps back to the right as a new contract is purchased. In a backwardated curve, this point to the right must be below the price point at which the contract was rolled, i.e. a positive roll yield. Investment in a commodity index generally entails (i) the bulk of the investment's being put into secure instruments such as Treasury bills and (ii) the remainder of the investment going into futures. The most liquid futures tend to be those in the very near term, and they usually have short maturities, typically 1 month, so investment in liquid futures means investing in a contract that is likely to mature in the near future. Given that the investment term in the index is open-ended, the futures investment component is going to move from one future to the next succeeding future during the life of the underlying index investment. For example, a 5 year investment might involve a change in the underlying futures on 60 monthly occasions. The investment is "rolled" from one futures contract to the next at which time if the price of the expiring contract is higher than the replacement contract (positive roll yield), selling the expiring and buying the replacement will yield a positive cash result. If the replacement contract is higher in price than the expiring contract, the reverse is true (negative roll yield). This can be visualized by considering that the initial futures investment is at a point on a curve of futures price (y-axis) v. time (x-axis). For the most liquid commodities such as crude oil and natural gas, monthly futures contracts are priced from next month right out to a point more than 5 years from today. If, moving out in time, successive futures prices are higher, the price curve is said to be in "contango". If the later prices are lower, the curve is said to be in "backwardation". A moment's consideration should show that a positive roll yield will occur in a backwardated curve, while a negative roll yield will occur in a contango curve. This is because the initial investment point on the curve moves to the left as time elapses and contract roll is approached. Moving to the left in a backwardated curve would mean the the price of the contract that the investor currently holds will rise (if nothing else changes in the market, and the spot price of the commodity is constant). At the point of rolling, the point on the curve jumps back to the right as a new contract is purchased. In a backwardated curve, this point to the right must be below the price point at which the contract was rolled, i.e. a positive roll yield.