Debunking the “Roll Yield” Myth in Futures Markets (Summary)

In futures markets, contracts expire before their specified delivery dates. To maintain an ongoing position, futures investors need to exit contracts close to expiration and enter contracts with more distant expiration dates. This fact has given rise to the idea of a roll yield, where investors can make gains or losses when rolling from one contract to the next on the same underlying good.

It is often implied in the financial press that investors can benefit from the roll yield by taking advantage of the difference between the gain on a futures position that is periodically rolled forward and the change in the underlying spot price over the same period.

But this reasoning is a fundamental misunderstanding of how gains and losses on futures positions are determined. Although the word “yield” intuitively gives the impression of a periodic cash flow, no such cash flow actually occurs. The author notes that a phrase like “term structure effect” would be a more accurate description, because it is the futures term structure that, in fact, determines the magnitude of the roll yield. In this study, he sets out to demonstrate why the popular concept of the roll yield is a myth and then shows how it should be properly understood.

By considering the experience of an investor with a long position in the crude oil futures market from the first to last trading dates of September 2007, the author uses a numerical illustration to show that roll yield does not entail a cash flow. He then describes how the concept of roll yield can be useful in other ways by applying an economic theory—the cost-of-carry model, which considers the relationships between inventory levels, spot prices, and volatility.

Next, the author explains how actual gains and losses to investors in futures markets are determined, illustrated with data from the Chicago Mercantile Exchange (CME) Crude Oil contract from 1990 to 2013. Finally, he explores whether roll yield might have some ability to predict or explain actual returns to futures positions by estimating simple ordinary least-squares regressions for crude oil futures—lines of best fit between the actual daily gain or loss to a long trader and the prior day’s roll yield—for two periods over the 23 years.

An investor in the crude oil futures market in September 2007 would have made a gain that was entirely determined by changes in the prices of individual contracts while positions were held. In other words, the purported roll yield is not a component of the investor’s gain on the date that the position is rolled—or on any other date. This finding is not simply a matter of semantics; because roll yield is not added to or subtracted from the margin account, it does not affect the investor’s purchasing power.

The concept of roll yield can be useful in different circumstances. Properly understood, it explains when futures gains surpass or fall short of spot price changes—even in such markets as electricity futures, where the underlying good is not readily storable, and volatility futures, where the underlying is not an asset.

In markets where the cost-of-carry relationship is relevant, the author shows that the roll yield can be interpreted in terms of the net benefit to the marginal holder of inventory. This can be important in commodity markets, where storage costs and convenience yields can diverge among market participants.

By analyzing the data for CME crude oil futures from 1990 to 2013, the author shows that changes in roll yields in the days prior to roll trades affect investor outcomes—substantially so during the period 2004–2009 and more subtly in the preceding period. The reason is consistent with the author’s assertion that a futures roll does not precipitate a cash flow; rather, changes in roll yield reveal gains or losses across open futures positions. The ordinary least-squares regressions on the data show that roll yield had statistically significant forecasting power for oil futures over the period examined but explained only 0.2% of the variation in daily futures gains.

This study shows that, contrary to common beliefs, futures investors should not choose their market positions to capture positive roll yields. Nor should they eschew positions to avoid losing money from negative roll yields. Investors should instead focus on managing portfolio risk and on the returns they expect to realize through changes over time in the price of individual futures contracts.

But roll yield is a useful concept in other ways: It explains when futures gains exceed or fall short of spot price changes, and it provides information regarding benefits to the marginal holder of a spot position in storable assets. There is some evidence that roll yield has a degree of forecasting power—and, to a greater extent, explanatory power—over gains and losses in futures markets. This fact raises the possibility that roll yield could be an economically relevant state variable for changes in futures prices over time. In other words, like market interest rates or equity dividend yields, it could have a degree of forecasting power for equity returns.