karoliukas

Which of the following statements regarding the convenience yield is least accurate?

A) The forward price may appear higher at times, when the convenience yield is not considered.

B) The convenience yield can be earned by the average investor who does not have a business reason for holding the commodity.

C) The commodity borrower is willing to pay the value of the convenience yield less the cost of storage.

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The convenience yield cannot be earned by the average investor who does not have a business reason for holding the commodity.

karoliukas

A given commodity has a convenience yield but not all owners of the commodity have a business reason for holding the commodity. If the convenience yield increases, the no-arbitrage range of futures prices would tend to:

A) be unaffected but still positive.

B) narrow.

C) widen.

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The owner of a commodity is able to create a range of no-arbitrage prices as follows:

where:
λ = storage costs
c = convenience yield

The upper bound depends on storage costs but not on the convenience yield. The lower bound adjusts for the convenience yield. If c increases, then the range widens.

karoliukas

Which of the following statements regarding commodity spreads is least accurate?

A) A trader creates a crush spread by holding a long position in soybeans and a short position in soybean meal and soybean oil.

B) The difference in prices of crude oil, heating oil, and gasoline is known as a crush spread.

C) A commodity spread results from a commodity that is an input in the production process of other commodities.

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The difference in prices of crude oil, heating oil, and gasoline is known as a crack spread.

karoliukas

Granite Investment Bank provides investment and risk management advice to large investors. Granite also advises corporations on the issuance of securities. Jill Carr is a senior portfolio manager for the firm.
One of Granite’s corporate clients, Argyle Inc., is planning to issue a USD10 million, 5-year, floating-rate bond. The firm has an AA credit rating and expects to pay a 125 bp premium to comparable maturity Treasuries (which currently have a 4.2% yield to maturity). Argyle’s CFO, Tom Davis, is concerned about increases in interest rate volatility and a possible increase in interest rates, but believes the spread to Treasuries will remain constant.
Granite also has an investor who would like to hedge the credit risk of a bond using either a binary credit put option or credit spread call option. The semi-annual bonds were issued at par by the Stedman Corporation with a 5.5% coupon and an original 5-year maturity.
The strike price on the put option is 200 bp to comparable maturity Treasuries. The credit spread call option has a strike spread of 190 bp, a notional principal of USD10 million, and specifies the benchmark rate as the 4-year Treasury rate with a risk factor of 3.2.
After one year has passed, the bond’s rating has decreased to BBB, the yield to maturity (YTM) on 4-year Treasuries has fallen to 3.9%, and the Stedman bonds are trading with a YTM of 6.2%.
During a presentation to investors, Carr discusses commodity derivative contracts as investments and risk reduction devices. Discussing her presentation, Carr describes a strategy where an investor can take one position in crude oil and an opposite position in gasoline and heating oil. She illustrates this hedge with the following example. Suppose crude oil was overpriced relative to gasoline and heating oil. Furthermore, 7 gallons of crude oil produces 4 gallons of gasoline and 3 gallons of heating oil. The investor would go short 7 crude oil futures contracts and long 4 gasoline futures contracts and long 3 heating oil futures contracts. Carr states that this is known as a crack spread and is a perfect hedge.
Later in the afternoon, Carr discusses the pricing of commodity futures contracts with Tonya Dugans, her assistant. Carr states that the futures price will incorporate the spot price, the risk-free rate, the convenience yield, and storage costs. Dugans states that the futures price will be higher when the convenience yield and storage costs are higher.
Carr points out that positions in storable commodities can be a good hedge against inflation. She states, however, that non-storable commodities, such as agricultural commodities, do not provide as good an inflation hedge as do storable commodities, such as oil. In order to most effectively protect Argyle from the expected change in interest rates on their anticipated borrowing costs, Davis should:

A) buy bond futures.

B) buy an interest rate cap.

C) enter into a swap as the fixed payer.

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The borrowing costs for Argyle will be higher if rates rise, so an effective hedge will generate profits when rates rise. If interest rates rise, the interest rate cap, which is a series of interest rate calls, will provide a payoff. To fully hedge the floating interest payments on the bond, Argyle would buy an interest rate cap with a maturity of five years. The other responses will not provide an effective hedge for Argyle. Bond futures will decrease in value when interest rates rise. Since interest rate volatility is expected to increase this means interest rates are likely to fall as well as increase. Being the fixed rate payer in an interest rate swap will experience losses in the event interest rates fall. This is not a position the firm will want to undertake. (Study Session 15, LOS 37.d)

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What is the value of the binary credit put option to an owner of USD10 million of Stedman bonds one year after bond issuance?

A) USD104,000.

B) USD246,700.

C) USD102,500.

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The strike price is the PV of the bond (5.5% coupon, 4 years to maturity) at a 5.9% YTM (= 3.9% + 2.0%), which is 98.593 (% of par). On your TI-BAII Plus, the inputs are: 5.9/2=I/Y; 27.50=PMT; 1000=FV; 8=N; CPT PV= 985.93.
The current bond value is the PV with a yield to maturity of 6.2%, which is 97.553 (% of par). On your TI-BAII Plus, the inputs are: 6.2/2=I/Y; 27.50=PMT; 1000=FV; 8=N; CPT PV= 975.53. The option is in the money by (0.98593 − 0.97553) × 10,000,000 = $104,000. (Study Session 10, LOS 25.g)

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What is the value of the credit spread call option to an owner of USD10 million of Stedman bonds one year after bond issuance?

A) 0, they are out-of-the-money.

B) USD128,000.

C) USD64,000.

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Given the relevant yield of 6.2% relative to the Treasury yield of 3.9%, the spread on the bonds is 2.3% (= 6.2% − 3.9%). This is greater than the strike spread of 1.9%, so the option is in the money.
The option value is Max (0, 0.023 − 0.019)(3.2)(10,000,000) = $128,000. (Study Session 10, LOS 25.g)

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Regarding her statements about commodity contracts, Carr is:

A) correct.

B) incorrect because this will not be a perfect hedge.

C) incorrect because her example is not representative of a commodity contract strategy.

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Carr is incorrect. This crack spread will not create a perfect hedge because crude oil can be used for other outputs such as jet fuel. This strategy is also known as a commodity spread. (Study Session 13, LOS 33.b)

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Regarding her statements about pricing commodity contracts, Dugans is:

A) incorrect because the futures price will be higher when the convenience yield is lower.

B) correct.

C) incorrect because the futures price will be higher when storage costs are lower.

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Dugans is incorrect because the futures price will be higher when the convenience yield is lower. In other words, when an asset does not have value for its convenience yield, holding the spot asset will not be as advantageous and the futures contract will be more attractive. Dugans is correct, though, that higher storage costs for the spot asset will make the futures contract more attractive. (Study Session 13, LOS 33.b)

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Regarding her statements about commodities as inflation hedges, Carr is:

A) correct.

B) incorrect because non-storable commodities provide an inflation hedge.

C) incorrect because storable commodities do not provide an inflation hedge.

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Carr is correct. Positions in storable commodities are a hedge against inflation. Non-storable commodities do not provide as good a hedge as they tend to have a negative correlation with inflation. (Study Session 13, LOS 31.o)

karoliukas

A trader in soybean futures contracts has discovered an arbitrage opportunity involving soybean futures and futures on soybean meal and soybean oil. Of the following, this most likely can occur with a:

A) crack spread by holding a long position in soybeans and a long position in soybean meal and short position in soybean oil.

B) crack spread by holding a long position in soybeans and a long position in soybean meal and soybean oil.

C) crush spread by holding a short position in soybeans and a long position in soybean meal and soybean oil.

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The only possible answer is a position in the input (e.g., short) and the opposite position (long in this case) in both of the outputs. This is called a crush spread.

karoliukas

In order to minimize basis risk, it is ideal to find a futures contract:

A) that is highly correlated with the price of the hedged asset.

B) that is uncorrelated with the price of the hedged asset.

C) that is highly correlated with the size of the hedged asset.

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In order to minimize basis risk, it is ideal to find a futures contract that is highly correlated with the price of the hedged asset.

karoliukas

Which of the following hedged positions is least likely to be subject to basis risk?

A) A jewelry maker is expecting to make large monthly purchases of gold in each of the next nine months but is afraid the price will rise. The company enters into a long strip hedge using gold futures.

B) A grain company must deliver 1 million bushels of corn in six, nine, and twelve months. The company enters into a short stack hedge using 3-month futures contracts on corn.

C) A jet-fuel wholesaler expects the price of jet fuel to fall in one year. The wholesaler therefore establishes a short position in a one-year crude oil contract to offset price declines.

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Basis risk occurs when a derivatives instrument used to hedge a position does not exactly correspond to the position being hedged. Hedging jet-fuel with oil futures and hedging Spanish natural gas futures for delivery in Louisiana are not perfect hedges and are therefore subject to basis risk. Basis risk can also occur when the maturity of the underlying position and the maturity of the derivative used to hedge are significantly different. Stack hedges, in which multiple future liabilities are hedged with a single near-term futures contract, are subject to basis risk. Strip hedges match the dates of the underlying position and the derivatives positions and, assuming the commodity in the futures contract matched the commodity to be hedged, are not subject to basis risk.

karoliukas

Commodity futures may tend to have more basis risk than financial futures because:

A) of timing.

B) there can be more than one risk-free rate.

C) commodity futures contracts can have different geographical points of delivery.

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Imperfect hedges cause basis risk in commodity futures. For commodities, this can be caused by hedging an oil contract with delivery on the East Coast with a NYMEX oil contract that calls for delivery in the South. Such geographic considerations are less important for financial futures.

karoliukas

Basis risk will arise in both commodity and financial futures due to:

A) grade.

B) timing.

C) storage costs.

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Basis risk will arise in both commodity and financial futures due to timing. Basis risk arising from storage costs, grade, and/or transportation costs is exclusive to commodity futures.

karoliukas

Hedging a transaction to take place in five years with one-year futures contracts would produce basis risk in:

A) both commodity futures and financial futures.

B) financial futures but not commodity futures.

C) commodity futures but not financial futures.

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In order to minimize basis risk, it is ideal to find a futures contract that is highly correlated with the price of the hedged asset. In addition, the timing of the delivery should match the expiration of the hedge in both financial and commodity futures. Basis risk can result in both commodity futures and financial futures from an imperfect hedge caused by a desired distant delivery but hedged with near term contracts.