Reading 63: LOS e ～ Q1- 7

1.A situation where the futures price is above the spot price of the underlying asset is called:

A)   positive carry.

B)   contango.

C)   normal backwardation.

D)   normal.

The correct answer was B)

A situation where the futures price is above the spot price of the asset is called contango.

2.Which of the following best defines contango? A contango is known as when the futures price lies:

A)   below the expected future spot price and the futures price falls over the life of the contract.

B)   below the expected future spot price and the futures price rises over the life of the contract.

C)   above the expected future spot price and the futures price rises over the life of the contract.

D)   above the expected future spot price and the futures price falls over the life of the contract.

The correct answer was D)

A pattern of falling futures prices is known as a contango. This situation occurs if hedgers are net long.

3.Backwardation refers to a situation where:

A)   long hedgers outnumber short hedgers.

B)   the futures price is above the spot price.

C)   the futures price is below the spot price.

D)   speculators have a greater long position than the physical amount of the asset can support.

The correct answer was C)

Backwardation refers to a situation where the futures price is below the spot price. For backwardation to occur, there must be a significant benefit to holding the asset, either monetary or non-monetary.

4.How is market backwardation related to an asset's convenience yield? If the convenience yield is:

A)   positive, this will cause the futures price to be below the spot price and the market is in backwardation.

B)   negative, this will cause the futures price to be below the spot price and the market is in backwardation.

C)   lower than the risk free interest rate, this will cause the futures price to be below the spot price and the market is in backwardation.

D)   larger than the borrowing rate, this will cause the futures price to be below the spot price and the market is in backwardation.

The correct answer was D)

When the convenience yield is more than the borrowing rate, the no-arbitrage cost-of-carry model will not apply. It means that the value of the convenience of holding the asset it is worth more than the cost of funds to purchase it. This usually applies to non-financial futures contracts.

5.A situation where the futures price is below the spot price of the asset is called:

A)   negative carry.

B)   contango.

C)   convenience yield.

D)   backwardation.

The correct answer was D)

A situation where the futures price is below the spot price of the underlying asset is called backwardation.

6.Which of the following is TRUE in normal backwardation? Futures prices tend to:

A)   fall over the life of the contract because hedgers are net short and have to receive compensation for bearing risk.

B)   rise over the life of the contract because speculators are net long and have to receive compensation for bearing risk.

C)   fall over the life of the contract because speculators are net short and have to receive compensation for bearing risk.

D)   rise over the life of the contract because hedgers are net long and have to receive compensation for bearing risk.

The correct answer was B)

Normal backwardation means that expected futures spot prices are greater than futures prices. It suggests that when hedgers are net short futures contracts, they must sell them at a discount to the expected future spot prices to get speculators to assume the risk of holding a net long position. The futures price rises over the life of the contract, which compensates speculators for the exposure of their long positions.

7.Which of the following best defines backwardation? The market is said to be in backwardation if:

A)   the futures price exceeds the cash price.

B)   the cash price exceeds the futures price.

C)   the cash price equals the futures price.

D)   the futures price exceeds the cash price or the distant futures price exceeds the nearby futures price.

The correct answer was B)

Backwardation occurs when there is a convenience, or security, associated with holding the spot asset, usually when it is uncertain whether the asset will even be available in the future. Backwardation is rare with financial futures.