3.1 Forward and Futures

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3.1 Forwards and Futures

Question 1

Client A buy one July wheat contract from Client B. On the same day, client B buy the same wheat contract from Client C. Assuming open interest started out at Zero, and no delivered were made, what is the addition to open interest for July wheat contracts?

A. $0$
B. $1$
C. $2$
D. $3$

Answer: B
Open interest includes contracts not yet liquidated either by an offsetting futures market transaction or delivery. When Client A buys one contract from Client B, the current open interest is one, assuming neither party started with a position in that contract. When Client B buys the same contract from Client C, Client B closes out their short transaction with an offsetting long transaction. The open interest would not change because Client C would simply take the place of Client B. Client A would still be long one contract, and now Client C would be short one contract. Thus, open interest would be one.

Open interest is the number of contracts in existence at any time.

when both members are taking new positions, the open interest increases by one.
when one member is closing out a position while the other is taking a new position, the open interest remains the same.
When both members are closing out their respective position, the open interest decreases by one.

Question 2

Consider four different futures market transactions between a buyer and a seller:

I. Both buyer and seller are each taking on a new position (long and short, respectively).
II. Buyer (seller) is taking on a new position, but seller (buyer) is offsetting an existing long (short) position.
III. Both buyer and seller are offsetting existing positions.
IV. An existing short makes delivery to an existing long.

Which of the above causes a decrease in the open interest?

A. None of the above decrease the open interest.
B. Il and IV decrease the open interest.
C. IIl and IV decrease the open interest.
D. All of the above decrease the open interest.

Answer: C
Both buyer and seller are each taking on a new position (long and short, respectively): open interest increases by one.

Buyer (seller) is taking on a new position, but seller (buyer) is offsetting an existing long (short) position: no change in open interest.

Both buyer and seller are offsetting existing positions: open interest decrease by one.

An existing short makes delivery to an existing long: open interest decrease one.

Question 3

PE2018Q31 / PE2019Q31 / PE2020Q31 / PE2021Q31
An experienced commodities risk manager is examining corn futures quotes from the CME Group. Which of the following observations would the risk manager most likely view as a potential problem with the quotation data?

A. The volume in a specific contract is greater than the open interest.
B. The prices indicate a mixture of normal and inverted markets.
C. The settlement price for a specific contract is above the high price.
D. There is no contract with maturity in a particular month.

Answer: C
Learning Objective: Define and describe the key features of a futures contract, including the asset, the contract price and size, delivery, and limits.

The reported high price of a futures contract should reflect all prices for the day, so the settlement price should never be greater than the high price.

The number of contracts traded in a day is referred to as the trading volume. The trading volume can be greater than the open interest at the end of the day if many traders are closing out their positions.

Question 4

A portfolio manager is examining data regarding various index futures contracts traded at the CME Group. Which of the following observations would the portfolio manager most likely view as a potential problem?

A. The volume in a specific contract is greater than the open interest.
B. One specific contract is of a much smaller size than the others.
C. The prior settlement price for a specific contract is above the opening price.
D. In a specific contract, the last day on which trading can occur is not specified.

Answer: D
For any type of futures contract, the exchange specifies the first day and the last day that trade can occur in a particular month.

Question 5

Please use the following information to evaluate the price relationship between the S&P500 cash and futures markets.

Futures Expiry	03/2020	06/2020	09/2020
Futures Price	$2, 845$	$2, 867$	$2, 897$

How would you describe the structure of this market?

A. The market is normal
B. The market is backwardation
C. The market is mixed
D. The market is inverted

Answer: A
If the futures price increases as time to maturity increases, this is referred to as a normal market.
If the futures price decreases as time to maturity increases, this is referred to as a inverted market.

Question 6

On September $15\text{th}$ a small energy company estimated that $20000$ barrels of crude oil would be needed on October $20\text{th}$ . The company decided to hedge its price risk with a USD $75.00$ a barrel November futures contract. On October $20\text{th}$ , the company bought crude oil at a spot price of USD $79.50$ per barrel when the futures price is USD $77.50$ per barrel. What is the actual price per barrel including hedging?

A. USD $77.00$
B. USD $77.50$
C. USD $79.50$
D. USD $82.00$

Question 7

Jack Johnson is going to receive a physical commodity from a settling long futures trade. Which of the following statements best describe the role of Johnson and the clearinghouse in this process?

A. The clearinghouse will coordinate Johnson’s settlement with any eligible settling shorts.
B. Johnson will have to contact the clearinghouse to coordinate with any eligible settling short.
C. Johnson will have to close his position with the original counter-party.
D. The clearinghouse will coordinate Johnson’s settlement with the original counter-party.

Answer: A
Futures market physical delivery is made easier by having the clearinghouse as the counter-party
on every trade. Direct deliveries can be made by a short to a long even though the two parties never actually trade with one another. The clearinghouse receives delivery notices from sellers. (shorts) and assigns the notices to buyers (longs).

Question 8

In futures trading, clearinghouses play an important role. Which of the tasks can one expect the clearing houses to fulfill in the settlement process of futures?

A. In case of physical settlement. The clearinghouses guarantees that the longs will receive the specified merchandise.
B. The clearinghouse performs the function of receiving delivery notices from longs and assigning the notices to shorts.
C. When a seller wants to make a delivery, he or she instructs the clearinghouse to submit a notice of intention to deliver.
D. When the clearinghouse receives a delivery notice, it must immediately identify a buyer to receive the delivery.

Question 9

Assume you have a long position in a stock with a current market price of USD $35$ . You have two goals. First, to retain ownership as long as the stock continues to go up. Second, to exit the position completely if the stock drops below USD $30$ . Which order best meets your dual objectives?

A. Sell market order
B. Sell limit order at USD $37$
C. Stop-loss sell order at USD $30$
D. Stop-and-limit sell order at USD $30$

Answer: C
In regard to A, a market order sells immediately and does not meet the first objective.

In regard to B, a sell limit will try to execute if the price rises to $37$ and does not meet the first objective.

In regard to C, the stop-loss becomes a market order once the stock drops to $30$ and therefore best meets the second objective.

In regard to D, the stop becomes a limit at $30$ and risks not being filled so does not meet the second objective as well as the stop-loss.

Market order is a request to buy or sell futures (i.e., take a long or short position) as quickly as possible at the best available price.

Limit order is that the trader specifies a price limit. A limit order can only be executed at the specified price or at a price more favorable to the trader.

Stop-Loss order is the order that becomes a market order once the asset reaches a specified or a less favorable price.Stop-loss orders (as the name implies) are orders that are designed to limit a trader’s loss on a certain position.

Stop-Limit order becomes a limit order when the stop price is reached.Two prices must be specified: the stop price and limit price.

Question 10

PE2018Q75 / PE2019Q75 / PE2020Q75 / PE2021Q75 / PE2022Q75
A portfolio manager at an asset management firm is examining an existing portfolio to determine if it still holds an optimal asset mix based on the firm’s latest market expectations. The manager identifies a long position in a futures contract that is no longer consistent with the goals of the portfolio and wants to close out the position using a market-if-touched order. Which of the following actions would be consistent with the use of this type of order?

A. Execute at the best available price once a trade occurs at the specified or better price.
B. Execute at the best available price once a bid/offer occurs at the specified or worse price.
C. Allow a broker to delay execution of the order to get a better price.
D. Execute the order immediately or not at all.

Answer: A
Learning Objective: Evaluate the impact of different trading order types.

A market-if-touched order executes at the best available price once a trade occurs at the specified or better price.

A stop order executes at the best available price once a bid/offer occurs at the specified or worse price.

A discretionary order allows a broker to delay execution of the order to get a better price.

A fill-or-kill order executes the order immediately or not at all.

Question 11

A natural gas producer wants to hedge the risk of a decline in the price of natural gas over the next three months. The trader representing the producer wants a short position in the 3-month natural gas futures contract to mitigate this risk and puts in an order to short the contract at a price of USD $5$ per MMBtu or above. Which of the following describes this type of order?

A. Market-not-held order
B. Stop-loss order
C. Discretionary order
D. Limit order

Question 12

PE2018Q62 / PE2019Q62 / PE2020Q62 / PE2021Q62 / PE2022Q62
A German housing corporation needs to hedge against rising interest rates. It has chosen to use futures on 10-year German government bonds. Which position in the futures should the corporation take, and why?

A. Take a long position in the futures because rising interest rates lead to rising futures prices.
B. Take a long position in the futures because rising interest rates lead to declining futures prices.
C. Take a short position in the futures because rising interest rates lead to rising futures prices.
D. Take a short position in the futures because rising interest rates lead to declining futures prices.

Answer: D
Learning Objective: Define and differentiate between short and long hedges and identify their appropriate uses.

Government bond futures decline in value when interest rates rise, so the housing corporation should short futures to hedge against rising interest rates.

Question 13

Which of the following statements are true with respect to basis risk?

I. Basis risk arises in cross-hedging strategies but there is no basis risk when the underlying asset and hedge asset are identical.
II. Short hedge position benefits from unexpected strengthening of basis.
III. Long hedge position benefits from unexpected strengthening of basis.

A. I and II
B. I and III
C. Il only
D. Ill only

Answer: C
II is the only true statement. A short hedge position or a short forward contract benefits from any unexpected decline in future prices and subsequent strengthening of basis. An increase in basis is known as a strengthening of the basis. The payoff to the short hedge position is spot price at maturity ( $S_2$ ) and the difference between futures price i.e., ( $F_1- F_2$ ). Thus, $\text{Payoff} = S_2+ F_1 -F_2 = F_1+ b_2$ , where $b_2$ is the basis.

Basis risk can also arise if underlying asset and hedge asset are identical. This can happen if the maturity of the hedge contract and the delivery date of asset do not match.

A short hedge is appropriate when the hedger already owns or will receive certain assets and expects to sell it at some time in the future.

A long hedge is appropriate when a company knows it will have to purchase certain assets in the future and wants to lock in a price now.

Long the basis refers to a set of positions that consists of a short futures position and a long cash position. Position that are long the basis benefit when the basis is strengthening.

Short the basis refers to a set of positions that consists of a long futures position and a short cash position. Position that are short the basis benefit when the basis is weakening.

Question 14

A buffalo farmer is concerned that the price he can get for his buffalo herd will be less than he has forecasted. To protect himself from price declines in the herd, the farmer has decided to hedge with live cattle futures. Specifically, he has entered into the appropriate number of cattle future position for September delivery that he believes will help offset any buffalo price declines during the winter slaughter season. The appropriate position and the likely sources of basis risk in the hedge are, respectively:

A. Short; choice of futures delivery date.
B. Short; choice of futures asset.
C. Short; choice of futures delivery date and asset.
D. Long; choice of futures delivery date and asset.

Answer: C
The farmer needs to be short the futures contracts. The two sources of basis risk confronting the farmer will result from the fact that he is using a cattle contract to offset the price movement of his buffalo herd. Cattle prices and buffalo prices may not be perfectly positively correlated. As a result, the correlation between buffalo and cattle prices will have an impact on the basis of the cattle futures contract and spot buffalo meat. Also the delivery date is a problem in this situation, because the farmer’s hedge horizon is winter, which probability will not commence until December or January. In order to maintain a hedge during this period, the farmer will have to enter into another futures, which will introduce an additional source of basis risk.

Question 15

PE2020Q5/PE2021Q5
Pear, Inc. is a manufacturer that is heavily dependent on plastic parts shipped from Malaysia. Pear wants to hedge its exposure to plastic price shocks over the next $7.5$ months. Futures contracts, however, are not readily available for plastic. After some research, Pear identifies futures contracts on other commodities whose prices are closely correlated to plastic prices. Futures on Commodity A have a correlation of $0.85$ with the price of plastic, and futures on Commodity B have a correlation of $0.92$ with the price of plastic. Futures on both Commodity A and Commodity B are available with $6$ -month and $9$ -month expirations. Ignoring liquidity considerations, which contract would be the best to minimize basis risk?

A. Futures on Commodity A with $6$ months to expiration
B. Futures on Commodity A with $9$ months to expiration
C. Futures on Commodity B with $6$ months to expiration
D. Futures on Commodity B with $9$ months to expiration

Answer: D
Learning Objective: Define the basis and explain the various sources of basis risk, and explain how basis risks arise when hedging with futures.

In order to minimize basis risk, one should choose the futures contract with the highest correlation to price changes, and the one with the closest maturity, preferably expiring after the duration of the hedge.

Question 16

A construction company that was hired for a multiyear expects to purchase $1, 000.000$ gallons of diesel fuel on the market over the next year to run its machinery. To hedge possible changes in the spot price of diesel fuel, the construction company buys diesel futures. Which of the following statements regarding basis risk in this situation is correct?

A. Basis risk will arise if there is a mismatch between the maturity dates of the futures contracts and the dates that spot purchases will have to be made.
B. Basis risk will arise if the construction company’s actual need for diesel fuel exceeds the expected need when the futures were purchased.
C. Basis risk will not arise from a mismatch between the delivery location specified in the futures contract and the location the diesel fuel is needed if the spot purchases are made over-the-counter for delivery to the exact project location.
D. Basis risk will not arise from a mismatch between the grade of diesel specified in the futures contract and the grade required to run the machinery unless delivery occurs.

Question 17

PE2018Q80 / PE2019Q80 / PE2020Q80 / PE2021Q80 / PE2022Q80
A risk manager wishes to hedge an investment in zirconium using futures. Unfortunately, there are no futures that are based on this asset. To determine the best futures contract to hedge with, the risk manager runs a regression of daily changes in the price of zirconium against daily changes in the prices of similar assets that have futures contracts associated with them.

Change in Price Zirconium = $\alpha+\beta$ (Change in Price of Asset)

Asset	$\alpha$	$\beta$	$R^2$
A	$1.25$	$1.03$	$0.62$
B	$0.67$	$1.57$	$0.81$
C	$0.01$	$0.86$	$0.35$
D	$4.56$	$2.30$	$0.45$

Based on the results, futures tied to which asset would likely introduce the least basis risk into your hedging position?

A. Asset A
B. Asset B
C. Asset C
D. Asset D

Answer: B
Learning Objective: Define cross hedging, and compute and interpret the minimum variance hedge ratio and hedge effectiveness.

Futures on an asset whose price changes are most closely correlated with the asset you are looking to hedge will have the least basis risk. This is determined by examining the $R^2$ of the regressions and choosing the highest one. $R^2$ is the most applicable statistic in the above chart to determine correlation with the price of zirconium.

Question 18

PE2018Q72 / PE2019Q72 / PE2020Q72 / PE2021Q72 / PE2022Q72
On Nov. 1, a fund manager of a USD $60$ million U.S. medium-to-large cap equity portfolio, considers locking up the profit from the recent rally. The S&P 500 index and its futures with the multiplier of $250$ are trading at $2110$ and $2120$ , respectively. Instead of selling off the holdings, the fund manager would rather hedge two-thirds of his market exposure over the remaining two months. Given that the correlation between the portfolio and the S&P 500 index futures is $0.89$ and the volatilities of the equity fund and the futures are $0.51$ and $0.48$ per year, respectively, what position should the manager take to achieve the objective?

A. Sell $71$ futures contracts of S&P 500
B. Sell $103$ futures contracts of S&P 500
C. Sell $148$ futures contracts of S&P 500
D. Sell $167$ futures contracts of S&P 500

Answer: A
Learning Objective: Compute the optimal number of futures contracts needed to hedge an exposure, and explain and calculate the “tailing the hedge” adjustment.

The optimal hedge ratio is the product of the correlation coefficient between the change in the spot price and the change in futures price and the ratio of the volatility of the equity fund and the futures.

The optimal hedge ratio computed:
$0.89\times \cfrac{0.51}{0.48}= 0.946$

Two-thirds of the equity fund is worth USD $40$ million.

Computing the number of futures contracts:
$N=0.945\times \cfrac{40,000,000}{2120\times250} =71.04=71$ , round up to nearest integer.

Question 19

You manage a US equity portfolio with the following characteristics:

Value	Volatility	Benchmark	Benchmark value	Benchmark volatility	Portfolio beta
USD $5$ million	$12\%$ per year	S&P 500	$1750$	$13\%$ per year	$2.0$

Fears of a declining economy prompt you to reduce your market exposure, and you want to lower your beta to $0.8$ for the next six months using S&P futures. If the 6-month S&P futures is at $2, 000$ and each contract is for USD $250$ times the index value, which position will reduce your portfolio’s beta to $0.8$ ?

A. Short $12$ futures contracts
B. Short $14$ futures contracts
C. Long $12$ futures contracts
D. Long $14$ futures contracts

Answer: A
$\text{Number\;of\;contracts}=(\beta^*-\beta)\times\cfrac{V_A}{V_F}=(0.8-2)\times \cfrac{5,000,000}{2000\times250}=-12$

Negative result indicates that selling futures to decrease systematic risk.

Positive result indicates that buying futures to increase systematic risk.

Question 20

Consider three assets wish the following factor betas to Risk Factor 1 and Risk Factor 2, defined as $\beta_1$ and $\beta_2$ , respectively:

Risk Factor	Asset A	Asset B	Asset C
$\beta_1$	$1.5$	$0.8$	$- 1.2$
$\beta_2$	$1.4$	$- 0.6$	$0.2$

You are holding CHF $1, 000, 000$ of Asset A, which of the following strategies will maintain your exposure to Risk Factor 1 while fully hedging your exposure to Risk Factor 2?

A. Long CHF $3, 000, 000$ of Asset B and long CHF $2, 000, 000$ of Asset C
B. Short CHF $3, 000, 000$ of Asset B and short CHF $2, 000, 000$ of Asset C
C. Long CHF $3, 000, 000$ of Asset B
D. Short CHF $7, 000, 000$ of Asset C

Answer: A
$\begin{cases} 0.8B-1.2C=0, \\1.4-0.6B+0.2C=0, & \end{cases} \to \begin{cases}B =3 \text{million} \\C=2 \text{million}{}& \end{cases}$

Question 21

PE2018Q71
A stock index is valued at USD $750$ and pays a continuous dividend at the rate of $2\%$ per annum. The 6-month futures contract on that index is trading at USD $770$ . The risk free rate is $3.50\%$ continuously compounded. Assuming no transaction costs or taxes, which of the following numbers comes closest to the arbitrage profit that can be realized by taking a position in one futures contract?

A. USD $1.35$
B. USD $6.76$
C. USD $14.35$
D. There is no arbitrage opportunity.

Answer: C
Learning Objective: Calculate the forward price given the underlying asset’s spot price, and describe an arbitrage argument between spot and forward prices.

The formula for computing the forward price on a financial asset is: $F_{0,T} = S_0e^{(r-q)T}$

Where $S_0$ is the spot price of the asset, $r$ is the continuously compounded interest rate, and $q$ is the continuous dividend yield on the asset.

The no-arbitrage futures price is computed as follows: $750\times e^{(0.035-0.02)\times0.5} = 755.65$

Since the market price of the futures contract is higher than this price, there is an arbitrage opportunity. The futures contract could be sold and the index purchased.

Arbitrage profit $= 770 - 755.65 = 14.35$

Question 22

PE2018Q2 / PE2020Q2 / PE2021Q2 / PE2022Q2
A trader in the arbitrage unit of a multinational bank finds that an asset is trading at USD $1000$ , the price of a 1-year futures contract on that asset is USD $1010$ , and the price of a 2-year futures contract is USD $1025$ . Assume that there are no cash flows from the asset for 2 years. If the term structure of interest rates is flat at $1\%$ per year, which of the following is an appropriate arbitrage strategy?

A. Short 2-year futures and long 1-year futures
B. Short 1-year futures and long 2-year futures
C. Short 2-year futures and long the underlying asset funded by borrowing for 2 years
D. Short 1-year futures and long the underlying asset funded by borrowing for 1 year

Answer: C
Learning Objective: Calculate the forward price given the underlying asset’s spot price, and describe an arbitrage argument between spot and forward prices.

When compounding annually, the no-arbitrage forward price is given by: $F_0(T)=S_0\times(1+R)^T$

When compounding continuously, the forward price is given by: $F_0(T)=S_0\times e^{rT}$

$F_0(T)$ : Forward price of asset at time 0.
$T$ : Time to maturity of the forward contract.
$S_0$ : Spot price of asset at time 0.
$R / r$ : Risk-free interest rate per year for maturity $T$ with annual/continuous compounding.

The 1-year futures price should be $1000\times e^{0.01}=1010.05$

The 2-year futures price should be $1000\times e^{0.01\times2}=1020.20$

The current 2-year futures price in the market is overvalued compared to the theoretical price. To lock in a profit, you would short the 2 year futures, borrow USD $1000$ at $1\%$ , and buy the underlying asset. At the end of the $2 n d$ years, you will sell the asset at USD $1025$ and return the borrowed money with interest, which would be, resulting in a USD $4.8$ gain.

Question 23

PE2018Q33 / PE2019Q33 / PE2020Q33 / PE2021Q33 / PE2022Q33
A 15-month futures contract on an equity index is currently trading at USD $3759.52$ . The underlying index is currently valued at USD $3625$ and has a continuously-compounded dividend yield of $2\%$ per year. The continuously compounded risk-free rate is $5\%$ per year. Assuming no transactions costs, what is the potential arbitrage profit per contract and the appropriate strategy?

A. USD $4$ , buy the futures contract and sell the underlying.
B. USD $189$ , buy the futures contract and sell the underlying.
C. USD $4$ , sell the futures contract and buy the underlying.
D. USD $189$ , sell the futures contract and buy the underlying.

Answer: B
Learning Objective: Calculate the forward price given the underlying asset’s spot price, and describe an arbitrage argument between spot and forward prices.

The no-arbitrage value of the futures contract can be calculated as the future value of the spot price:

$F_0(T)=S_0\times e^{(r_f - \text{dividend yield})\times t}$

where $S_0$ equals the current spot price of the index(USD $3625$ ) and $t$ equals the time in years( $15/12 = 1.25$ ).

Therefor, theoretical future price: $3625\times e^{(5\% - 2\%)\times1.25} = 3763.52$

Since this value is different from the current futures contract price, a potential arbitrage situation exists. Since the current futures price is lower than the theoretical future price in this case, one can short the higher priced futures contract, and buy the underlying stocks in the index at the current price.

The arbitrage profit would equal $3763.52 - 3759.52 = 4$ .

Question 24

A risk analyst wants to enter into a 6-month forward contract on a USD $1000$ bond paying a $6\%$ coupon semi-annually. A coupon is scheduled to be paid in three months. If the bond currently trades at par and the risk-free is $2\%$ per year, the forward price should be closest to:

A. USD $960$
B. USD $975$
C. USD $980$
D. USD $1040$

Answer: C
$F_0(T)=(S_0-I)\times e^{rT}=(1000-1000\times0.06/2)\times e^{0.02\times0.5}\approx980$

Question 25

A risk analyst observes that an emerging market stock index has hit a new all-time high with a value of $10000$ , measured in the emerging market’s currency. The analyst suggests buying futures on the index as a hedge on the firm’s short exposure to this market. If the interest rate is $4\%$ annually in this market and the average annualized dividend yield on the index for the next six months is $1\%$ , what is the approximate price of a 6-month futures contract on the index in the emerging market’s currency?

A. $9700$
B. $9850$
C. $10150$
D. $10300$

Answer: C
$F_0(T)=S_0\times \left(\cfrac{1+R}{1+Q}\right)^T=1000\times\left(\cfrac{1+0.04}{1+0.01}\right)^{0.5}=10147\approx10150$

Question 26

Three months ago, a company entered in a one-year forward contract to buy $100$ ounces of gold. At the time, the one-year forward price was USD $1000$ per ounce. The nine-month forward price of gold is now USD $1050$ per ounce. The continuously-compounded risk-free rate is $4\%$ per year for all maturities, and there are no storage costs. Which of the following is closest to the value of the contract?

A. USD $1897$
B. USD $4852$
C. USD $5000$
D. USD $7955$

Answer: B
The forward price is computed as follows: $F=100\times(F_0 - K)e^{-rT}= 100\times(1050-1000)e^{-0.04*0.75} = 4852$

Question 27

PE2018Q1 / PE2020Q1 / PE2021Q1 / PE2022Q1 / PE2022PSQ11
A risk manager is deciding between buying a futures contract on an exchange and buying a forward contract directly from a counterparty on the same underlying asset. Both contracts would have the same maturity and delivery specifications. The manager finds that the futures price is less than the forward price. Assuming no arbitrage opportunity exists, what single factor acting alone would be a realistic explanation for this price difference?

A. The futures contract is more liquid and easier to trade.
B. The forward contract counterparty is more likely to default.
C. The asset is strongly negatively correlated with interest rates.
D. The transaction costs on the futures contract are less than on the forward contract.

Answer: C
Learning Objective: Explain the relationship between forward and futures prices.

When an asset is strongly negatively correlated with interest rates, futures prices will tend to be slightly lower than forward prices. When the underlying asset increases in price, the immediate gain arising from the daily futures settlement will tend to be invested at a lower than average rate of interest due to the negative correlation. In this case futures would sell for slightly less than forward contracts, which are not affected by interest rate movements in the same manner since forward contracts do not have a daily settlement feature.

The other three choices would all most likely result in the futures price being higher than the forward price.

Question 28

PE2018Q35 / PE2019Q35 / PE2020Q35 / PE2021Q35 / PE2022Q35
The six-month forward price of commodity $X$ is USD $1000$ . Six-month, risk-free, zero-coupon bonds with face value USD $1000$ trade in the fixed income market. When taken in the correct amounts, which of the following strategies creates a synthetic long position in commodity $X$ for a period of $6$ months?

A. Buy the forward contract and buy the zero-coupon bond.
B. Buy the forward contract and short the zero-coupon bond.
C. Short the forward contract and buy the zero-coupon bond.
D. Short the forward contract and short the zero-coupon bond.

Answer: D
Learning Objective: Explain how to create a synthetic commodity position, and use it to explain the relationship between the forward price and the expected future spot price.

A synthetic commodity position for a period of $T$ years can be constructed by entering into a long forward contract with $T$ years to expiration and buying a zero-coupon bond expiring in $T$ years with a face value of the forward price. The payoff function is as follows:

Payoff from long forward position equals to $S_T-F_0(T)$ , where $S_T$ is the spot price of the commodity at time $T$ and $F_0(T)$ is the current forward price.

Payoff from zero coupon bond: $F_0(T)$ at time $T$ .

Hence, the total payoff function equals $S_T-F_0(T))+F_0(T)$ or $S_T$ . This creates a synthetic commodity position.

Question 29

Which of the following types of risk is least likely to be a source of risk in the commodities markets?

A. Earnings risk
B. Price risk
C. Counterparty risk
D. Quality risk

Answer: A
Modern futures markets allow producers, distributors, dealers, and investors to manage the uncertainty of prices over time and participate in efficient price discovery. In addition to supply/demand price risk, risk can also come from storage problems, quality risk, and lack of standard payment terms, lack of price transparency, resale problems, counterparty risk, and lack of standardized contracts.

Question 30

An analyst is examining the futures curve with respect to lean hog futures prices. The spot price is USD $0.90$ per pound and the February 2015 futures contract is priced at USD $1.00$ per pound. The difference between the futures and spot prices:

A. Is most likely due to the carrying costs of lean hogs.
B. Is most likely due to the expected increase in supply of lean hogs from today until February 2015.
C. Must be positive during the life of the futures contract and zero at maturity.
D. Should be constant after accounting for the time value of money.

Question 31

An oil producer has an obligation under an agreement to supply $75, 000$ barrels of oil every month for one year at a fixed price. He wishes to hedge his liability to address the event of an upward surge in oil prices. The producer has opted for a stack and roll hedge rather than a strip hedge. Which of the following two statements are correct?

I. A strip hedge increases transaction costs owing to active trading each month.
II. A strip hedge tends to have wider bid-ask spreads as compared to a stack & roll hedge.

A. I only
B. Il only
C. I and II
D. Neither

Answer: B
Statement Il is correct. A strip hedge tends to have lower liquidity and wider bid-ask spreads owing to longer maturity contracts.

A strip hedge involves hedging a stream of obligations by offsetting each individual obligation with a futures contract matching the maturity and quantity of the obligation. Stacking futures contracts in the near-term contract and rolling over into the new near-term contracts is referred to as a stack and roll.

Statement I is incorrect. A strip hedge involves one time buying of futures contracts to match the maturity of liabilities.

Question 32

PE2018Q79 / PE2019Q79
An oil producer has an obligation under an agreement to supply one million barrels of oil at a fixed price.The producer wishes to hedge this liability using futures in order to address the possibility of an upward movement in oil prices. In comparing a strip hedge to a stack and roll hedge, which of the following statements is correct?

A. A stack and roll hedge tends to involve fewer transactions.
B. A strip hedge tends to have smaller bid-ask spreads.
C. A stack and roll hedge tends to have greater liquidity.
D. A strip hedge tends to realize gains and losses more frequently.

Answer：C
Learning Objective: Evaluate the differences between a strip hedge and a stack hedge and explain how these differences impact risk management.

A strip hedge involves one-time buying of futures contracts to match the maturity of liabilities, whereas the stack and roll hedge involves multiple purchases over time. A strip hedge tends to have wider bid- ask spreads due to the use of longer maturity contracts. A strip hedge also tends to have lesser liquidity than a stack and roll hedge due to longer maturity contracts. Both a strip hedge and stack and roll hedge would realize gains/losses daily using futures.

Question 33

The current price of Commodity $X$ in the spot market is $42.47$ . Forward contracts for delivery of Commodity $X$ in one year are trading at a price of $43.11$ . If the current continuously compounded annual risk-free interest rate is $7.0\%$ , calculate the implicit lease rate for Commodity $X$ . Holding the calculated implicit lease rate constant, would the forward market for Commodity $X$ be in backwardation or contango if the continuously compounded annual risk-free rate immediately fell to $5.0\%$ ?

A. The implicit lease rate is $1.49\%$ . Holding this rate constant, the forward market would be in contango if the continuously compounded annual risk-free rate immediately fell to $5.0\%$ .
B. The implicit lease rate is $5.50\%$ . Holding this rate constant, the forward market would be in backwardation if the continuously compounded annual risk-free rate immediately fell to $5.0\%$ .
C. The implicit lease rate is $1.49\%$ . Holding this rate constant, the forward market would be in backwardation if the continuously compounded annual risk-free rate immediately fell to $5.0\%$ .
D. The implicit lease rate is $5.50\%$ . Holding this rate constant, the forward market would be in contango if the continuously compounded annual risk-free rate immediately fell to $5.0\%$ .

Answer: B
$F=S(\cfrac{1+R}{1+L})^T \to L=(\cfrac{S}{F})^{1/T}(1+R)-1$
$F=S*e^{(r-l)T} \to l=r-\cfrac{In(F/S)}{T}$

Step1: Calculate implicit lease rate: $5.5\%$ .

Step2: The forward price $43.11$ is higher than the spot price ( $42.47$ ), the market for Commodity X is currently in contango.

Step 3: If annual risk-free rate immediately fell to $5.0\%$ , holding the lease rate constant, forward price $42.47e^{0.05-0.055}$ is lower than the spot price ( $42.47$ ) the market would be in backwardation.

Question 34

A commodities trader observes quotes for futures contracts as follow:

Spot Price	July, 2014	October, 2014	December, 2014
$321$	$312$	$310$	$309$

This commodity is trading:

A. As a normal futures market since the futures prices are consistent with the commodity’s seasonality.
B. As an inverted futures market since more distant delivery contracts are trading at lower prices than nearer-term ones.
C. As a normal futures market because it is typical for more distant delivery contracts to trade lower than nearer-term delivery contracts.
D. Consistently with convergence as futures prices will rise when the delivery period nears.

Question 35

In commodity markets, the complex relationships between spot and forward prices are embodied in the commodity price curve. Which of the following statements is true?

A. In a backwardation market, the discount in forward prices relative to the spot price represents a positive yield for the commodity supplier.
B. In a backwardation market, the discount in forward prices relative to the spot price represents a positive yield for the commodity consumer.
C. In a contango market, the discount in forward prices relative to the spot price represents a positive yield for the commodity supplier.
D. In a contango market, the discount in forward prices relative to the spot price represents a positive yield for the commodity consumer.

Answer: B
When forward prices are as a discount to spot prices, a backwardation market is said to exist.

The relatively high spot price represents a convenience yield to the consumer that holds the commodity for immediate consumption.

Question 36

PE2018Q73 / PE2019Q73 / PE2020Q73 / PE2021Q73 / PE2022Q73
A risk analyst at a commodity trading firm is examining the supply and demand conditions for various commodities and is concerned about the volatility of the forward prices for silver in the medium term. Currently, silver is trading at a spot price of USD $20.35$ per troy ounce and the 6-month forward price is quoted at USD $20.50$ per troy ounce. Assuming that after $6$ months the lease rate rises above the continuously compounded risk-free interest rate, which of the following statements is correct about the shape of the silver forward curve after $6$ months?

A. The forward curve will be downward sloping.
B. The forward curve will be upward sloping.
C. The forward curve will be flat.
D. The forward curve will be humped.

Answer: A
Learning Objective: Apply commodity concepts such as storage cost, carry markets, lease rate, and convenience yield.

A is correct. The forward price is computed as:

$F =Se^{(r+c-y)T}$

where $r$ is the risk-free rate, $c$ is the storage cost rate and $y$ is the convenience yield rate, the $T$ is the time to maturity of the forward (measured in years), and $S$ is the spot price.

The commodity lease rate is computed as $l = y - c$ .

So, the forward price can alternatively be expressed in terms of risk-free rate and lease rate as $F=Se^{(r-l)T}$

Therefore, as the risk-free rate falls below the lease rate, we can see from the forward price formula above that $F < S$ , and the forward curve will be downward sloping(in backwardation).

Question 37

PE2018Q59 / PE2019Q59 / PE2020Q59/ PE2021Q59 / PE2022PSQ10 / PE2022Q59
A French bank enters into a $6$ -month forward contract with an importer to sell GBP $60$ million in $6$ months at a rate of EUR $1.15$ per GBP. If in $6$ months the exchange rate is EUR $1.13$ per GBP, what is the payoff for the bank from the forward contract?

A. EUR $- 2, 000, 000$
B. EUR $- 1, 200, 000$
C. EUR $2, 000, 000$
D. EUR $1, 200, 000$

Answer: D
Learning Objective: Calculate and compare the payoffs from hedging strategies involving forward contracts and options.

The value of the contract for the bank at expiration: $60\times1.15=69\;\text{EUR\;million}$

The cost to close out the contract for the bank at expiration: $60\times1.13=67.8\;\text{EUR\;million}$

Therefore, the final payoff to the bank can be calculated as $\;\text{EUR\;million}$

Question 38

PE2019Q71 / PE2020Q71 / PE2021Q71 / PE2022PSQ2 / PE2022Q71
An analyst wants to price a 6-month futures contract on a stock index. The index is currently valued at USD $750$ and the continuously compounded risk-free rate is $3.5\%$ per year. If the stocks underlying the index provide a continuously compounded dividend yield of $2.0\%$ per year, what is the price of the 6-month futures contract?

A. USD $744.40$
B. USD $755.65$
C. USD $763.24$
D. USD $770.91$

Answer: B
Learning Objective: Calculate the forward price given the underlying asset’s spot price, and describe an arbitrage argument between spot and forward prices.

The formula for computing the forward price on a financial asset is:

$F_{0,T} = S_0e^{(r-q)T}$

where $S_0$ is the spot price of the asset, $r$ is the continuously compounded risk-free interest rate, $q$ is the continuous dividend yield on the asset and $T$ is time until delivery date in years.