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Derivative Instruments

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What is the difference between a contango market and a backwardation market?
What exactly is meant by a basis?
Are there any ethical concerns that need to be addressed when using derivative instruments?

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Solution Summary

The differences between a contango market and a backwardation market are provided. The ethical concerns that need to be addressed when using derivative instruments.

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Difference between a Contango Market and a Backwardation Market

Contango and backwardation markets are conditions in future market that state about the position of future price as compared to the expected spot price at contract maturity. In contango market, future prices are generally greater than the spot price because of the impact of cost of carry. The cost of carry is the cost of carrying the commodity from the current month to the delivery month that includes costs of storage, insurance, interest, etc. In contrast to this, backwardation is a specific situation, where the futures prices can be determined by factors other than cost of carry. For example, in condition of a stock market scam, the stock market would be driven by pessimistic opinions rather than basics or fundamentals. In this case, futures may be traded below the value of underlying asset (Etukuru, 2011).

Apart from this, contango market has negative basis, while backwardation market possesses a positive basis. In contango market, basis decreases with tenure ...

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