Economic roll yield: Meaning, Criticisms & Real-World Uses

What Is Economic Roll Yield?

Economic roll yield refers to the gain or loss generated when an investor "rolls" a futures contract from one expiration date to another, typically to maintain continuous exposure to an underlying commodity. This concept is a critical component of investment returns within futures trading and falls under the broader category of commodity markets analysis. It reflects the difference in price between the expiring front-month contract and the next contract in the series, influencing the overall profitability of a commodity futures position.

History and Origin

The concept of roll yield is inherently tied to the evolution of commodity markets and the development of futures contracts. Early forms of commodity trading date back thousands of years, with formalized markets emerging in ancient civilizations. The modern futures market, however, began to take shape in the mid-19th century in the United States, particularly with the establishment of the Chicago Board of Trade (CBOT) in 1848. The CBOT introduced standardized futures contracts for grains in 1865, creating a more reliable system for buyers and sellers to manage price risk.⁹

As these markets matured, participants regularly needed to extend their positions beyond a single contract's expiration. This practice, known as "rolling," became standard. The price difference encountered during these rollovers—whether a gain or a loss—gave rise to the understanding of roll yield as a distinct component of a futures contract's total return, separate from the change in the underlying spot price. Over time, institutions like the Chicago Mercantile Exchange (CME), which originated from the Chicago Butter and Egg Board in 1898, expanded their offerings to include a wide array of agricultural, energy, and financial futures, further solidifying the role of roll yield in commodity investment strategies.

Key Takeaways

Economic roll yield is the profit or loss from replacing an expiring futures contract with a new one that has a later expiration date.
It is a crucial component of total returns for investments in commodity futures and can be positive or negative.
A positive roll yield occurs in a "backwardated" market, where later-dated contracts are cheaper than nearer-dated ones.
A negative roll yield occurs in a "contango" market, where later-dated contracts are more expensive than nearer-dated ones.
Understanding economic roll yield is vital for portfolio management and for evaluating the performance of commodity investments, especially commodity index funds.

Formula and Calculation

The economic roll yield is calculated based on the difference between the price of the expiring (near-month) futures contract and the price of the next (far-month) futures contract into which the position is rolled.

The formula for calculating the economic roll yield is:

\text{Roll Yield} = \frac{\text{Near-Month Futures Price} - \text{Far-Month Futures Price}}{\text{Near-Month Futures Price}}

Where:

Near-Month Futures Price: The price of the futures contract that is about to expire.
Far-Month Futures Price: The price of the futures contract with a later expiration date that the investor intends to buy.

A positive value indicates a gain from rolling, while a negative value indicates a loss.

Interpreting the Economic Roll Yield

Interpreting the economic roll yield involves understanding the structure of the futures curve for a particular commodity. When a market is in backwardation, the price of the near-month futures contract is higher than the price of the far-month contract. This scenario generates a positive economic roll yield because an investor sells the expiring contract at a higher price and buys the new contract at a lower price. Backwardation often occurs when there is high immediate demand for a commodity, or a perceived shortage, leading to a premium on current supply.

Co⁸nversely, when a market is in contango, the price of the near-month futures contract is lower than the price of the far-month contract. This results in a negative economic roll yield, as the investor sells low and buys high. Contango is a more common market state for many commodities, often driven by cost of carry expenses like storage, financing, and insurance. The⁷ impact of roll yield can significantly affect the overall returns from holding commodity futures, sometimes even offsetting gains from favorable spot price movements.

Hypothetical Example

Consider an investor holding a futures contract for crude oil that expires in August. As August approaches, the investor wishes to maintain their exposure to oil prices and decides to roll their position to a September contract.

Assume the August crude oil futures contract is trading at $80.00 per barrel (Near-Month Futures Price).
Assume the September crude oil futures contract is trading at $82.00 per barrel (Far-Month Futures Price).

To roll the position, the investor sells the August contract and simultaneously buys the September contract.

Using the economic roll yield formula:

\text{Roll Yield} = \frac{\$80.00 - \$82.00}{\$80.00} = \frac{-\$2.00}{\$80.00} = -0.025 \text{ or } -2.5\%

In this scenario, the market is in contango, and the investor experiences a negative economic roll yield of -2.5%. This means that to maintain their position, they effectively "lost" 2.5% on the roll, separate from any change in the actual spot price of crude oil. If, however, the September contract was trading at $78.00, the roll yield would be positive, indicating a market in backwardation.

Practical Applications

Economic roll yield is a vital consideration for various participants in commodity markets. For investors seeking diversification or inflation protection through commodities, understanding roll yield is crucial as it directly impacts total investment returns. Many commodity index funds and exchange-traded products (ETPs) are structured to hold and regularly roll futures contracts, making their performance highly susceptible to this yield component. For instance, some commodity strategies actively seek to maximize positive roll yield by dynamically selecting contracts.

Fo⁶r producers and consumers, who often use futures contracts for hedging purposes, roll yield affects the effective price at which they lock in future costs or revenues. For example, an airline hedging its fuel costs must account for the roll yield when purchasing crude oil futures. Similarly, large institutional investors and money managers use insights from roll yield to inform their speculation and portfolio management strategies. The World Bank's Commodity Markets Outlook often details the dynamics of various commodity prices, which directly influence the roll yield environment, providing crucial context for market participants.

##⁵ Limitations and Criticisms

While essential, economic roll yield presents certain limitations and criticisms, primarily when markets are persistently in contango. In such environments, the continuous negative roll yield can significantly erode investment returns, even if the underlying spot price of the commodity remains stable or increases. This phenomenon is often referred to as a "cost of carry" drag. Investors in passively managed commodity index funds may experience lower returns than expected due to this structural drag.

Cr⁴itics argue that traditional commodity indices, by consistently buying the most liquid front-month futures contracts, expose investors to this significant cost of rolling in contango markets. This can lead to underperformance relative to other asset classes, as highlighted by various academic and industry research. Mor³eover, factors such as high inventory levels can increase the cost of carry and contribute to sustained contango, negatively impacting the economic roll yield. The interplay between market supply and demand, storage costs, and the convenience yield (the benefit of holding the physical commodity) all influence whether a market is in contango or backwardation, directly affecting the roll yield an investor experiences.

Economic Roll Yield vs. Contango and Backwardation

Economic roll yield is not synonymous with contango or backwardation; rather, it is the result or manifestation of these market conditions. Contango and backwardation describe the shape of the futures curve, indicating the relationship between the current spot price and prices of futures contracts with different expiration dates.

Contango occurs when the price of a far-month futures contract is higher than a near-month contract, or higher than the current spot price. In a market exhibiting contango, rolling a futures position typically results in a negative economic roll yield because an investor must buy the more expensive far-month contract to replace the cheaper, expiring near-month contract.
² Backwardation occurs when the price of a far-month futures contract is lower than a near-month contract, or lower than the current spot price. In a market exhibiting backwardation, rolling a futures position typically results in a positive economic roll yield because an investor sells the expiring near-month contract at a higher price and buys the cheaper far-month contract.

Th¹e confusion often arises because the terms are closely related in the context of futures trading. However, contango and backwardation describe the state of the market's forward curve, while economic roll yield quantifies the gain or loss incurred when navigating that curve by rolling a position.

FAQs

What is the primary factor influencing economic roll yield?

The primary factor influencing economic roll yield is the relationship between the prices of near-term and far-term futures contracts, which determines whether the market is in contango or backwardation.

Can economic roll yield be negative?

Yes, economic roll yield can be negative, particularly when a market is in contango. This means that to maintain a futures position, an investor sells an expiring contract at a lower price and buys a new, more expensive contract, resulting in a loss on the roll.

Why is economic roll yield important for investors?

Economic roll yield is important because it is a significant component of the total investment returns from commodity futures. Ignoring it can lead to a misunderstanding of a commodity investment's true profitability, especially for long-term holdings in commodity index funds that regularly roll contracts.

How does economic roll yield relate to the spot price?

While roll yield is distinct from changes in the spot price, both contribute to the overall return of a futures contract. The roll yield reflects the structural difference between futures prices at different maturities, whereas the spot price change reflects the underlying commodity's immediate market value fluctuations.

Does economic roll yield affect all types of investments?

Economic roll yield primarily affects investments that involve futures contracts or other derivatives that require periodic rolling, most notably in commodity markets. It is not directly relevant to traditional equity or bond investments unless they gain exposure to commodities or other asset classes through futures.