Chapter 11 CAIA Flashcards - Commodity Forward Pricing
Open Interest
The outstanding quantity of unclosed contracts is known as open interest.
Mark to Market
The term marked-to-market means that the side of a futures contract that benefits from a price change receives cash from the other side of the contract (and vice versa) throughout the contract’s life. The cash exchanges resulting from positions being marked-to-market are intended to cause each side of the derivative to have a zero market value at the end of each day.
Crisis at Maturity
A crisis at maturity is when the party owing a payment is forced at the last moment to reveal that it cannot afford to make the payment or when the party obligated to deliver the asset at the original price is forced to reveal that it cannot deliver the asset.
Maintenance Margin
A maintenance margin requirement is a minimum collateral requirement imposed on an ongoing basis until a position is closed.
Margin Call
A margin call is a demand for the posting of additional collateral to meet the initial margin requirement. If the investor cannot meet the margin call, the futures commission merchant has the right to liquidate the investor’s positions in the account. (The positions may be closed at market prices without the investor’s direction.) This daily process ensures that promises to make and take delivery have reduced counterparty risk.
Rolling Contracts
Rolling contracts refers to the process of closing positions in short-term futures contracts and simultaneously replacing the exposure by establishing similar positions with longer terms.
Front Month Contract
On an exchange, the futures contract with the shortest time to settlement is often referred to as the front month contract. The front month contract is sometimes referred to as the front contract, the nearby contract, or the spot contract.
Storage Costs
Storage costs of physical commodities involve such expenditures as warehouse fees, insurance, transportation, and spoilage.
Convenience Yield
Convenience yield, y, is the economic benefit that the holder of an inventory in the commodity receives from directly holding the inventory rather than having a long position in a forward contract on the commodity.
Inelastic Supply
Inelastic supply is when supplies change slowly in response to market prices or when large changes in market prices are necessary to effect supply changes.
Contango
Contango also refers to a forward price exceeding the current spot price (viewing a spot price as a forward price with zero time to delivery may provide clarity).
Backwardation
When the slope of the term structure of forward prices is negative, the market is in backwardation, or is backwardated. The concept of backwardation is the complement to contango.
Normal Backwardation
In normal backwardation, the forward price is believed to be below the expected spot price. We say “believed to be” because we cannot observe the expected spot price; we can only estimate it, and those estimations may differ between market participants.
Normal Contango
In normal contango, the forward price is believed to be above the expected spot price. In normal contango, the entity on the short side of the forward contract should expect to earn a profit from bearing the risk of being short the commodity. Conversely, the entity on the long side of the forward contract should expect to bear a loss.
Law of One Price
The law of one price states that in the absence of trading restrictions, two identical assets will not persist in trading at different prices in different markets because arbitrageurs will buy the relatively underpriced asset and sell the relatively overpriced asset until the discrepancy disappears.
