I have provided a very long, analytical solution to the hypothetical case study I have discussed on 19.04.2013. I think if you are regularly watching the blog, by this time your doubts would get clarified.
Futures price curve
as on 20.04.2012
Analysis of graph:
What does it
indicate?
Traders who have taken a long position in April 2011 can
close their positions with gains. For them the corn futures market is in normal
backwardation.
What do we understand
from this?
The suppliers of corn are expecting increased prices of
corn.
What does a corn
trader want to do?
The trader would like to enter into futures market with a
long position. He would take a long position for April 2013 corn futures.
What does the corn trader expect by taking a
long position in April 2013 futures?
He expects to buy corn at 650 cents per bushel in April 2013
and sell it at a higher price (or close the position with a higher price) to
gain in futures prices.
What about the corn
futures prices in April, 2013?
Analysis:
What will happen to a
trader who has taken a long position as on 19.04.2012 in corn futures?
The trader looking into the increasing futures prices as on 19.04.2012
took a long position. He expected to close his position with gains.
Who has taken a long
position in our case study?
Mr George took a long position in corn futures on 19.04.2012.
He agreed to buy corn after one year from 19.04.2012. In other words, he agreed to buy on
19.04.2013.
At what price he
entered into the contract?
Mr George agreed with a long futures price, after including
the risk-free rate and storage cost in futures pricing (hypothetical).
It is at S0e (r+u)t
(‘u’ is the storage cost)
610 x e(0.03+0.0375)
652.60
They agreed
to a futures price of 652.60. The buyer of corn (trader with long position)should
take delivery at a price of 652.60 on 19.04.2013.
What was the expected spot price as
on 19.04.2013?
On the basis of mathematical calculations, the Mr George
entered into long futures, expecting the spot prices to be higher than the
agreed futures price. He expected the spot prices to be higher than 652.60
(agreed futures price), so that he can buy at 652.60 and sell at a higher
price.
But what is the futures price or spot
price as on 19.04.2013?
The actual
futures price as on 19.04.2013 is 650 cents per bushel and it is equal to the
spot price also (I will discuss this issue later on). In other words, the
futures prices get converged to spot prices.
What happened to Mr George position?
The agreed
futures price (652.60 cents per bushel) is higher than the expected spot price
(650 cents per bushel).
What will happen to Mr George and how
do we refer such markets?
He has to
buy at 652.60 (as agreed), and he has to sell in the futures or spot market at
650 cents per bushel. This is a loss for Mr George. With reference to his
agreed futures price, the market is now Contango.
Why Mr George incurred losses?
Mr George
expected the market to be normal backwardation on the maturity date of
contract. But the market turned out to be Contango.
Name the organization which incurred
losses due to the same scenario?
Metallgeschaft, a German company in 1993 suffered huge losses
in oil futures. One of the reasons for the closure of the company is market
being turned to Contango from backwardation. It is one of the important case
studies for risk managers.
