Mar

6

Futures prices, particularly financial futures like S&P and Bond prices, have a relationship to the cash markets which can be arbitraged. It is a function of cash flows usually interest borrowing costs and dividends, but it depends on being able go short and long the cash/spot markets. My questions is this: seems to not hold in hard assets like crude where there is currently large backwardation. You can buy Dec 24 Crude at a large discount and have been able to do so for some time. Specifically, is it possible to short the spot market for crude? Is there a counterparty that will accept this trade? It seems that for term structures like crude futures, the prices are an actual prediction of supply and demand and not an interest rate arbitrage.

Zubin Al Genubi responds:

With crude, storage (or not to store) is part of the future price. I read there is a lot of Russian crude stored in ships now. I'm not sure how that figures in.

In backwardation (tight market) normally one buys the future waiting for convergence with spot. Selling spot- yes you can, but delivery is an issue.

Big Al ruminates:

Not sure what "shorting the spot price" would even mean, other than Zubin's point where you have to have crude for delivery. Doesn't the concept of shorting a contract inherently involve a future price point? You could have 1-day futures, but then the vig might be far more significant.

If we model it on stocks, then shorting spot crude would involve "borrowing" somebody else's oil and then selling it for delivery. But then you're just back to why futures exist in the first place, aren't you?

But speaking of the term structure of crude, I ran across this:

Forecasting WTI crude oil futures returns: Does the term structure help?

Abstract
Nelson-Siegel (NS) factors extracted from the term structure of WTI oil futures are shown to predict subsequent WTI holding period returns in-sample. This in-sample predictability is not diminished by augmenting with macroeconomic indicators or oil market specific predictors. Allowing the decay factor in the Nelson-Siegel model to vary over time improves in-sample predictions at medium horizon return forecasts. We conduct out-of-sample forecasting exercises on models that use NS factors, such as a simple two factor model that uses a composite leading indicator along with the NS decay factor, and a LASSO model that combines NS factors with macroeconomic indicators and oil market specific predictors. These models significantly reduce forecast errors relative to a no change benchmark across a range of return horizons and futures contract maturities. We also find consistent evidence that models that use the NS factors result in trading strategies with higher Sharpe ratios and better skewness properties than buy and hold strategies and historical mean strategies.

Relatedly, the Nelson-Siegel model.


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