Commodity Forward Pricing

Question 1

1. List the primary advantage of forward contracts to the parties involved.

Answer 1

• Forward contacts are ad hoc contracts negotiated between two parties with flexibility regarding details that help meet the needs and preferences of the parties. Futures contracts tend to be standardized.

Question 2

2. What is the name of the credit-related event affecting a derivative contract that is mitigated at the settlement date by the mark-to-market process?

Answer 2

• Crisis at maturity, when payment exchanges are deferred until settlement.

Question 3

3. After a margin call, to what level must an investor return the account’s margin?

Answer 3

• To the initial margin requirement

Question 4

4. What is another name for deferred contracts or back contracts?

Answer 4

• Distant contracts

Question 5

5. What are the three costs of carry that determine the price of a forward contract on a physical asset?

Answer 5

• Storage costs, convenience yield (when viewed as a negative cost), and interest (financing) charges.

Question 6

6. An analyst calculates the theoretical price of a forward contract on a physical commodity using the spot price and the cost-of-carry model. What is the primary reason that the forward price could be substantially smaller than the price generated by the model?

Answer 6

• The analyst has underestimated the commodity’s high convenience yield (i.e., a benefit -of-carry) such as in the case of a crop in short supply but with an anticipation of a large harvest.

Question 7

7. Why might lumber have inelastic supply?

Answer 7

• It is difficult to increase the amount of timber available rapidly due to the long time between planting and harvesting.

Question 8

8. What is the name of the condition in which the expected spot price of a commodity in one year exceeds the one-year forward price of the commodity?

Answer 8

• Normal backwardation

Question 9

9. What is the name of the following quantity: the spot price of a commodity minus a forward price on the commodity?

Answer 9

• The basis of the commodity contract

Question 10

10. An investor has established a calendar spread using forward contracts on a commodity. The investor is long the contract has a longer time to settlement. With carrying costs held constant, generally, what would be the effect on the calendar spread of an increase in the spot price of the commodity?

Answer 10

• Changes in the spot price will not affect calendar spreads as long as the sum of the carrying costs does not change. All forward prices will move up and down by the same quantity with the trader hedged against changes in the spot price by holding an equal number of long and short contracts.

Question 11

basis

Answer 11

in a forward contract is the difference between the
spot (or cash) price of the referenced asset, S, and the price (F)
of a forward contract with delivery T.

Question 12

calendar spread

Answer 12

can be viewed as the difference between
futures or forward prices on the same underlying asset but
with different settlement dates.

Question 13

Contango

Answer 13

When the term structure of forward prices is upward sloping
(i.e., when more distant forward contracts have higher prices
than contracts that are nearby), the market is this.

Question 14

convenience yield

Answer 14

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.

Question 15

cost of carry

Answer 15

in the context of futures and forward contracts it is any financial difference between
maintaining a position in the cash market and maintaining a
position in the forward market.

Question 16

crisis at maturity

Answer 16

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.

Question 17

distant contracts, deferred contracts, or back contracts

Answer 17

Contracts with longer times to settlement are often called

Question 18

Front month contract

Answer 18

On an exchange, the futures contract with the shortest time

to settlement is often referred to as the this.

Question 19

inelastic supply

Answer 19

is when supplies change slowly in response to
market prices or when large changes in market prices are
necessary to effect supply changes.

Question 20

An informationally inefficient term structure

Answer 20

has pricing

relationships that do not properly reflect available information.

Question 21

law of one price

Answer 21

The collateral deposit made at the initiation of a long or short
futures position is called this

Question 22

law of one price

Answer 22

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.

Question 23

maintenance margin requirement

Answer 23

is a minimum collateral
requirement imposed on an ongoing basis until a position is
closed.

Question 24

margin call

Answer 24

is a demand for the posting of additional

collateral to meet the initial margin requirement.

Question 25

marginal market participant

Answer 25

to a derivative contract is
any entity with individual costs and benefits that make the
entity indifferent between physical positions and synthetic
positions.

Question 26

marked-to-market

Answer 26

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.

Question 27

normal backwardation

Answer 27

the forward price is believed to be

below the expected spot price.

Question 28

normal contango

Answer 28

the forward price is believed to be above

the expected spot price.

Question 29

open interest

Answer 29

The outstanding quantity of unclosed contracts is known as this.

Question 30

perfectly elastic supply

Answer 30

With regard to supply, on one end of the spectrum is this, in which any quantity demanded of
a commodity can be instantaneously and limitlessly supplied
without changes in the market price.

Question 31

rolling contracts

Answer 31

refers to the process of closing positions in
short-term futures contracts and simultaneously replacing the
exposure by establishing similar positions with longer terms.

Question 32

storage costs

Answer 32

of physical commodities involve such
expenditures as warehouse fees, insurance, transportation, and
spoilage.

Question 33

swap

Answer 33

is a string of forward contracts grouped together that

vary by time to settlement.