2009 FRM Level 1 PRACTICE EXAM - Q 22

[notjusttp]

Hi David,

I have some confusion in the way this question has been answered. It states that "Expected decline in supply should increase further term commodity price"

Though i can see that the reason is due to the escalated storage cost taking cost of carry higher and hence in Contango, i have a specific doubt in terms of convenience yield here.

If i know that supply for a product is going to decline i would find it " MORE CONVENIENT" to hold the commodity now and release it rationally thus taking my convenience yield high..probably much higher that my Storage costs thus spinning marked in Backwardation.

Pls clarify if i am missing some point here as based on this logic i had marked B as the answer while the correct as suggested by GARP IS A.

Thanks and best rgds
Amit

 

[David Harper CFA FRM]

Amit,

I don't think your logic is wrong, but (a) still looks to me like a better answer because it's more direct. The idea that lower future supply implies higher future convenience yield, I agree, would inform the "future forward curve" into backwardation ... this seems logical but also more complex (2nd-order) than the more direct logic of (a) which simply concerns the future expected spot rate: higher demand (or lower supply) implies a higher future spot rate, which if seasonal (e.g., natural gas), has a tendency toward backwardation. So, i think (a) is better because it speaks to a first-order dynamic: supply/demand impacts on (expected) spot price...I mean, i follow your logic and it makes sense to me, so i guess you could argue the choice (A) versus (B) could use more precision...but your answer (B), I would argue, presumes answer (A) is therefore a "2nd order" dynamic...

David

 

[notjusttp]

Thanks david for the prompt reply..I tend to agree with you once i saw your detailed explanation..Amit