Solutions to the Quiz

Dear friends

The solution to the yesterday's quiz is a very important aspect to understand the derivatives market, especially forward or futures market. I am using both forward and futures interchangeably, as the concepts are almost similar.

If you fail to understand what I am discussing today, please come back to me, without hesitation. Because, the today's blog is one of the most important blogs of all the blogs, I have written so far.

Question: A commodity trader collected the following wheat futures prices from CME group on 15.04.2013: All the prices are quoted in cents per bushel. Assume that risk free rate in terms of Libor (London Interbank Offer Rate) is 4.25% for one year. The spot price of wheat (cents per bushel) is 710 (cents / bushel).

May 2013	706.2
July 2013	710.6
Sep 2013	716.2
Dec 2013	729.4
Mar 2014	743.2

 

Solution:

     1. If we take the static picture of above prices, by plotting term to maturity on X-axis and the futures prices on Y-axis, we get an upward sloping curve. This is a normal futures curve. The futures curve has an impact on traders with long position and short position in futures market.

     2. The futures curve conveys an in-depth meaning for traders in forward markets. Let us correlate the futures curve to the position of traders to understand about contango and normal backwardation.

    3. Suppose we enter into a long futures contract on today’s date: 15.04.2013 to buy in future. The agreement is made today on 15.04.2013 to buy at 743.20 after one year.

    4. After one year, if we enter into a long futures contract, what do we expect? It is a very important question.

     5. We expect the spot prices to be more than our agreed purchase price. Because, we buy from the futures market and sell at higher price in the spot market.

6. Or, we are long in futures on 15.04.2013 and we will close our futures position on 15.04.2014 (after one year) with a short position. 

     7. When we have entered into a long futures contract, we need to close our position on the maturity date with an opposite position (with a short position in futures).

     8. Now, what can be the futures prices on maturity? What can be the futures curve at the time of maturity? I mean after one year, say on 15.04.2014. If we take futures prices on Y-axis and time on X-axis, on 15.04.2014, there are three possibilities for the futures price curves. They are: 

a.       equal to 743.20 ( A flat curve of futures market);

 

 

 

b.       Less than 743.20 (a decreasing curve of futures prices)

 

c.       More than 743.20 (an increasing futures price)

9.   If the prices price is more than 743.20, it is profitable for us, as we have entered into a long forward position.  Because, we can buy at 743.20 from the futures market and sell it at more than 743.20 and we can gain from it.

10.       As a trader, we expect that after we enter into futures contract, the prices of futures move upward. This will help us to buy at 743.20 and sell at higher prices. This is a situation of gain for the trader.

11.       But, after we entered into the contract, if the futures prices started falling, then our agreed futures price will be higher than the spot price on maturity. This situation is not expected by the trader and the trade ends up with loss.

12..       Therefore, at the time of closing the positions, if the expected spot price is lower or prices of futures are falling with a downward slope, then such a situation is known as market in contango, with reference to our position. (the expected spot price on maturity and futures price on maturity are supposed to be equal)

13.       At the same time, if the expected spot price is higher than our futures prices or the futures price is showing a upward sloping position, the market is said to be exhibiting normal backwardation with respect to our position.

 

     This is the solution to the first part of my question.  The present wheat curve is a normal backwardation market for those who are holding the asset "wheat" and likely to close their positions as on 15.04.2013 (yesterday). This is a favorable position for them. 

Please do not hesitate to come back to to me on my personal mail id: 

cfa.surya@gmail.com 

I will try to solve your queries to the best of my abilities. 

Taking leave for today.....Surya