Reading 63: LOS f ～ Q1- 5

1.What is the situation called when a futures price continuously increases over its life because most hedging strategies are short hedges?

A)   A normal market.

B)   A market that is in backwardation.

C)   Normal backwardation.

D)   Contango.

The correct answer was C)

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 investors to buy them. The futures price rises as the contract matures to converge with spot prices.

2. Suppose the soybean market is in backwardation with a cash price of $6.50/bushel and a futures price of $6.00/bushel. Also assume that a trader owns 5,000 bushels of soybeans and does not need the soybeans until after futures expiration. Which of the following is the best strategy for the trader?

A)   Do nothing since the convenience yield is so high.

B)   Sell the soybeans in the spot market, buy an appropriate futures, and profit $2,500.

C)   Sell the soybeans in the spot market, buy an appropriate futures, and profit $1,250.

D)   Sell the soybeans in the spot market, buy an appropriate futures, and profit $30,000.

The correct answer was B)

Since the trader does not need the soybeans now he should monetize the convenience yield by selling in the spot market and simultaneously buy soybean futures for his later needs. The total profit is computed as follows:

Total profit = (Cash Price – Futures Price) x Amount = ($6.50 - $6.00) x 5,000 = $2,500.

3.Under the view that futures markets are primarily a mechanism for short hedgers and long hedgers to offset their respective asset price risks:

A)   forward prices will be greater than futures prices.

B)   expected future asset prices are less than the futures prices.

C)   futures prices are greater than the expected price of the asset at contract expiration.

D)   futures prices will be unbiased predictors of future spot rates.

The correct answer was D)

Under the view that futures markets are primarily a mechanism for short hedgers and long hedgers to offset their respective risks, futures prices will be unbiased predictors of future spot rates.

4.The theoretical question of whether futures prices are unbiased predictors of future spot rates focuses on:

A)   whether futures buyers are taking on asset owners’ price risk.

B)   the correlation between interest rate changes and asset price changes.

C)   whether futures markets are efficient.

D)   the relation between asset cash flows and the risk-free rate of interest.

The correct answer was A)

The theoretical analysis of whether futures prices are unbiased predictors of spot rates at futures expiration dates depends on whether futures buyers are being compensated for taking on the asset price risk that futures sellers are avoiding. Under the assumption that futures transactions are driven by those with natural short price risk transacting with those who have natural long positions, expected future spot prices are equal to futures prices.

5.Under the view that futures transfer risk from asset holders to futures buyers, the:

A)   expected asset price in the future will be less than the futures price.

B)   cost of carry is less than the risk-free rate.

C)   convenience yield is positive.

D)   futures price will be less than the expected future spot price.

The correct answer was D)

Under the view that futures transfer risk from asset holders to futures buyers, the futures price will be less than the expected future spot price. The longs (speculators) must be compensated for bearing asset price risk by receiving a lower future purchase price for the asset.