Roll yield

What Is Roll Yield?

Roll yield is a component of the total investment return generated from holding a futures contract. It specifically refers to the gain or loss that arises when an investor closes out an expiring futures contract and simultaneously opens a new, longer-dated futures contract for the same underlying commodity or asset. This phenomenon, central to futures markets, falls under the broader financial category of derivatives and investment analysis. Roll yield is influenced by the shape of the futures curve, which illustrates the prices of futures contracts across different expiration dates.

History and Origin

The concept underlying roll yield is intrinsically linked to the evolution of futures markets themselves. Modern futures trading originated in the agricultural sector, driven by the need for farmers and merchants to manage price risk over time. In the United States, formalized trading in forward agreements began in the mid-19th century. The Chicago Board of Trade (CBOT), established in 1848, was instrumental in this development, introducing standardized futures contracts in 1865. These contracts provided a mechanism for buyers and sellers to lock in prices for future delivery, stabilizing volatile markets.⁴

As these markets matured, participants naturally encountered the need to maintain their exposure to an underlying asset as current contracts approached expiration. The act of "rolling over" a position—closing the near-term contract and opening a new, further-dated one—became a routine practice. The financial outcome of this rollover, whether positive or negative, gradually became recognized as a distinct component of the overall return, especially in commodity markets where storage costs and supply/demand dynamics heavily influence the futures curve.

Key Takeaways

Roll yield is the profit or loss from rolling a futures position from a near-term contract to a longer-term one.
It is positive when the market is in backwardation (near-term prices are higher than longer-term prices).
It is negative when the market is in contango (near-term prices are lower than longer-term prices).
Roll yield is a significant factor affecting the total return of investments in commodity futures.
Understanding roll yield is crucial for investors engaging in long-only commodity strategies.

Formula and Calculation

Roll yield is calculated based on the difference between the price of the expiring futures contract and the price of the new, longer-dated futures contract into which the position is rolled, relative to the price of the expiring contract. It can also be viewed as the difference between the change in the futures price and the change in the spot price over a specific period.

A simplified formula for approximating roll yield when rolling from one contract (F1) to another (F2):

\text{Roll Yield} = \frac{P_{F1} - P_{F2}}{P_{F1}}

Where:

(P_{F1}) = Price of the expiring (front-month) futures contract
(P_{F2}) = Price of the next-month or longer-dated futures contract

More precisely, roll yield is often considered the difference between the change in the futures price and the change in the spot price. This is because, at expiration, a futures contract's price is expected to converge with the underlying asset's spot price.

Interpreting the Roll Yield

The interpretation of roll yield depends on the structure of the futures curve.

Positive Roll Yield (Backwardation): When a futures market is in backwardation, the price of the near-term contract is higher than the price of longer-term contracts. In this scenario, when an investor rolls a long position from the expiring, higher-priced contract to a lower-priced, further-dated contract, they theoretically "sell high" and "buy low," generating a positive roll yield. This often occurs in commodity markets when there is high immediate demand or supply shortages for the physical commodity, making the near-term delivery more valuable.
Negative Roll Yield (Contango): Conversely, when a futures market is in contango, the price of the near-term contract is lower than the price of longer-term contracts. Rolling a long position in a contango market means selling the expiring, lower-priced contract and buying a higher-priced, further-dated contract. This results in a negative roll yield, as the investor "sells low" and "buys high." Contango is more common in markets for storable commodities, where carrying costs (storage, insurance, financing) are reflected in higher prices for future delivery.

Roll yield provides insight into the cost of holding a futures position and is a key driver of total investment return for commodity-linked investments.

Hypothetical Example

Consider an investor holding a long position in a crude oil futures contract expiring in July. As July approaches, the investor wishes to maintain their exposure to crude oil prices and decides to roll their position to the August contract.

On June 20th, the July crude oil futures contract is trading at $75.00 per barrel.
On the same day, the August crude oil futures contract is trading at $75.50 per barrel.

In this scenario, the market is in contango because the August price ($75.50) is higher than the July price ($75.00).

To roll the position, the investor sells their July contract at $75.00 and simultaneously buys an August contract at $75.50. The difference in price is $0.50 ($75.50 - $75.00). Since the investor is buying the more expensive contract and selling the cheaper one, they incur a loss of $0.50 per barrel on the roll, representing a negative roll yield. This effectively reduces their overall profit or adds to their loss from the pure price movement of the underlying commodity.

Practical Applications

Roll yield is a critical consideration for investors and portfolio managers, particularly those involved in commodity-linked investment products like commodity exchange-traded funds (ETFs) or mutual funds that track commodity indices. Since these products must continuously roll their futures positions to maintain exposure, the impact of roll yield can significantly affect their performance.

Commodity Investing: For investors seeking exposure to commodities, understanding the dynamics of contango and backwardation and their effect on roll yield is essential for evaluating potential returns. Strategies often attempt to maximize positive roll yield or minimize negative roll yield.
Portfolio Management: Roll yield is a factor in determining the overall investment return and risk characteristics of a portfolio that includes commodity futures. Researchers at the National Bureau of Economic Research (NBER) have highlighted how commodity futures returns, including those from roll yield, can contribute to diversification benefits in a portfolio due to their low correlation with stocks and bonds, especially during inflationary periods.
³ Risk Management and Hedging: Producers and consumers of commodities use futures markets for hedging price risks. While their primary goal is price stability, understanding roll yield helps them assess the cost or benefit of maintaining their hedge positions over time.
Regulatory Oversight: Regulatory bodies, such as the U.S. Commodity Futures Trading Commission (CFTC), oversee futures markets to ensure fair practices and transparency. Whi²le not directly regulating roll yield, their oversight of market mechanisms and reporting influences the efficiency and pricing dynamics that give rise to roll yield.

Limitations and Criticisms

While widely used, the term "roll yield" faces some academic criticism. Some argue that it is a misnomer because it does not represent an actual cash flow at the time of the roll trade. Instead, it reflects the difference between the profit or loss from a futures contract and the change in the spot price of the underlying asset. Thi¹s perspective suggests that the "yield" isn't a direct payment but rather a component of the total return that accounts for the "cost of carry" (storage, insurance, interest) or "convenience yield" (benefit of holding the physical asset).

Another limitation is that roll yield alone does not determine the profitability of a futures investment. The total investment return also includes the change in the futures price itself, which is influenced by shifts in supply and demand for the underlying commodity or asset. A positive roll yield can be offset by a significant decline in the futures price, and vice versa. Furthermore, the shape of the futures curve can change rapidly, making consistent prediction of roll yield challenging and highlighting the importance of robust risk management strategies.

Roll Yield vs. Contango

Roll yield and contango are closely related but represent different concepts.

Roll Yield: This is the actual gain or loss realized when an investor closes an expiring futures contract and opens a new one for a later expiration date. It is a measure of return.
Contango: This describes a market condition where the price of a futures contract for a distant delivery is higher than the price for a nearer delivery. It refers to the upward slope of the futures curve.

In a market experiencing contango, investors holding long positions in futures contracts will typically incur a negative roll yield. This is because they are selling a cheaper, expiring contract and buying a more expensive, longer-dated one to maintain their exposure. Conversely, in a market experiencing backwardation (the opposite of contango, where near-term prices are higher), a long position would typically generate a positive roll yield. Therefore, contango (or backwardation) describes the state of the futures market, while roll yield describes the financial outcome of navigating that state as contracts mature.

FAQs

How does roll yield affect commodity ETFs?

Commodity exchange-traded funds (ETFs) or other commodity-tracking products often invest in futures contracts to replicate the price movements of underlying commodities. Because futures contracts have finite expiration dates, these funds must continuously "roll" their positions from expiring contracts to new ones. If the market is in contango, this rolling process generates a negative roll yield, which can be a drag on the fund's overall investment return and cause it to underperform the spot price of the commodity.

Is positive roll yield always good for investors?

A positive roll yield indicates that, at the time of rolling a position, you are "selling high" and "buying low" in the futures market due to backwardation. While this component adds to your total return, the overall profitability of your investment depends on the actual price movement of the underlying commodity. A positive roll yield can be offset if the futures price declines significantly after the roll.

Why do futures markets experience contango or backwardation?

The shape of the futures curve (which determines whether a market is in contango or backwardation) is influenced by factors like supply and demand for the physical asset, storage costs, interest rates, and convenience yield (the benefit of holding the physical commodity). For instance, high current demand or supply disruptions can lead to backwardation, while abundant supply and significant storage costs typically lead to contango. These dynamics are central to understanding the components of investment return in futures.