Essays in the Tradition of Jane D'Arista
Edited by Gerald A. Epstein, Tom Schlesinger and Matías Vernengo
In his Treatise on Money, Keynes proposed what later generations have known as his theory of “normal backwardation” to explain the relationship between spot and forward prices in organized markets for basic commodities. If supply and demand are balanced, the spot price must exceed the forward price by the amount which the producer is ready to sacrifice in order to ‘hedge’ himself, i.e. to avoid the risk of price fluctuations during his production period. Thus in normal conditions the spot price exceeds the forward price, i.e. there is a backwardation. (Keynes, 1930, II, p. 143) The speculator who provides the hedge by buying forward expects to profit by selling spot at the maturity of the forward contract, and Keynes suggests that such profit runs typically about 10 per cent per annum, or even higher for less organized markets. In his Value and Capital, Hicks extended the theory of normal backwardation to the money market. It appears that the forward market for loans (like the forward market for commodities) may be expected to have a constitutional weakness on one side, a weakness which offers an opportunity for speculation. . . . The forward short rate will thus exceed the expected short rate by a risk-premium which corresponds exactly to the ‘normal backwardation’ of the commodity markets. (Hicks, 1939, pp. 146–7)
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