1.4.1. Normal and Inverted Markets
A market whose cost of carry tends to increase with time is called a normal market. In other words, the price of futures contracts in nearby months is lower than the price of distant months. When the price difference between two contracts having two different delivery months equals the full cost of carry, the market is known as a full carry market. If the price difference is greater or less than full carry, arbitrage will close the difference quickly, as those who could profit by buying and storing the commodity would do so for a risk-free profit.
Example: Assume that the full cost of carry from month to month for NYMEX crude oil is $0.50. If the cost of the January contract is $38.00 and of the February contract is $38.50, then the difference of $0.50 is the full carry. This $0.50 can be broken down into interest, storage, and insurance costs. The full carry price for March will be $39.00, as these costs are additive.
In an inverted market, the price of futures contracts becomes progressively lower as the expiration months extend in time. An inverted market might be caused by some natural disaster or geopolitical event that disrupts production in the near-term. For example, if severe dry weather has stunted the current wheat harvest, then the shortage of supply will cause spot prices to spike, while expectations of