LOS f: Discuss whether futures prices equal expected spot prices.

Q1. Which of the following best defines normal contango? A contango is known as when the futures price lies:

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

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

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

Q2. Which of the following is TRUE in normal backwardation? Futures prices tend to:

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

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

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

Q3. 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)   convenience yield is positive.

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

Q4. What is the situation called when a futures price continuously increases over its life because most hedging strategies are short hedges?

A)   Contango.

B)   Normal backwardation.

C)   A normal market.

Q5. 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)   whether futures markets are efficient.

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

Q6. 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 will be unbiased predictors of future spot rates.

Q7. 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.

LOS f: Discuss whether futures prices equal expected spot prices. fficeffice" />

Q1. Which of the following best defines normal contango? A contango is known as when the futures price lies:

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

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

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

Correct answer is C)

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

Q2. Which of the following is TRUE in normal backwardation? Futures prices tend to:

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

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

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

Correct answer is A)

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.

Q3. 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)   convenience yield is positive.

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

Correct answer is C)

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.

Q4. What is the situation called when a futures price continuously increases over its life because most hedging strategies are short hedges?

A)   Contango.

B)   Normal backwardation.

C)   A normal market.

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

Q5. 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)   whether futures markets are efficient.

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

Correct answer is 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.

Q6. 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 will be unbiased predictors of future spot rates.

Correct answer is C)

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.

Q7. 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.

Correct answer is 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) × Amount = ($6.50 ? $6.00) × 5,000 = $2,500.

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