Futures contracts are agreements that allow investors to deal in specific commodity assets or securities. With these contracts, investors can fix their future prices for a particular time in the future. Futures contracts allow investors to hedge against various risks associated with price changes. With these contracts, investors undertake an obligation to conduct the transaction in the future.
Futures contracts are primarily helpful for hedging purposes. However, investors can also invest in these contracts through various markets. These can provide the diversity necessary for investors when managing their portfolios. Like other investments, futures contracts can also be highly beneficial to investors. These contracts produce returns in various forms, one of which includes roll yields.
What is Roll Yield?
Roll yield is a term often associated with futures markets. It represents the yield or returns investors can generate in the futures market by rolling a short-term contract into a long-term one. Due to the difference in the price of these contracts, investors can make a profit. This profit constitutes the roll yield for investors. Effectively, it allows investors to benefit from the convergence of futures prices toward the spot price.
The roll yield arises due to the difference between the holding period return for futures contracts varying from the spot price return during the same period. Once futures contracts expire, investors have to pay compensation or settlement. However, they can avoid this by closing their position or rolling over their futures contracts. This way, they can sell contracts close to maturity and buy similar contracts with longer maturity periods.
How does the Roll Yield work?
Roll yield is a type of profit that investors can make from future markets, among various others. This profit occurs due to the price difference between futures contracts with varying maturity or expiration dates. Roll yields can either be positive or negative based on whether the market is in contango or backwardation. Regardless, investors can profit from both circumstances.
Roll yields come from investors' obligations due to future contracts. When investors acquire these contracts, they must buy or sell securities in the future. However, they also have the option to roll over their position before the delivery date. Due to this, investors can close their position before expiration by selling their futures contracts with short expiration dates. Instead, they invest in similar contracts with longer expiration dates.
How to calculate the Roll Yield?
Investors can calculate the roll yield by using the formula for roll yield. As mentioned, the roll yield can either be positive or negative. In the case of contango in the futures market, the futures prices of longer-dated contracts are higher than those of short-dated contracts. For backwardation, the opposite applies. The roll yield in contango is negative, while for backwardation, it is positive.
Investors can use the following roll yield formula to calculate the returns they can get from rolling over.
Roll Yield = Price of short-term contract - Price of long-term contract / Price of short-term contract
Conclusion
The futures market, like other investments, provides a decent opportunity for an investor to diversify their portfolios. Investors can also benefit from roll yields. Roll yield represents the returns investors can get from rolling over their short-term futures contracts for long-term ones. The price difference between both contracts represents the roll yield that investors can achieve.
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