P1.T3.404. Long/short the basis

[Nicole Seaman]

AIMs: Define the terms “long the basis” and “short the basis”. Explain exchange for physical (EFP) transactions and their role in the energy and financial futures markets. Describe and calculate the payoffs on the various scenarios for hedging with options on futures.

Questions:

404.1. Assume the basis equals the cash (spot) price minus the futures price. Consider a farmer who produces cotton and is therefore "naturally long" the cash crop. The futures curve is approximately flat when the farmer hedges her future crop sales with a short futures hedge (a.k.a., "selling hedge"). Consider four scenarios:

I. Basis strengthens
II. Basis weakens
III. Futures curve shift to contango
IV. Futures curve shifts to backwardation (inverted)

Under which scenario(s) will the farmer profit?

a. None
b. II. and III.
c. I. and IV.
d. All

404.2. Gold Mining Corporation owns 10,000 ounces of unsold gold (i.e., owns the physical commodity) and decides to enter into an exchange for physical transaction (EFP). After the EFP is posted, which will be true of Gold Minining Corporation's position?

a. Will be short gold futures
b. Will be long gold futures
c. Will still be long the physical commodity
d. Will have no position in either the physical (cash) or futures market

404.3. It is March. A soybean farmer plans to harvest 100,000 bushels of beans in October. She uses put options to hedge. Cash beans are no $11.70 per bushel and the November 1200 soybean put has a premium of $0.80 per bushel. The farmer buys 20 of these puts. Seven months later, in October, she sells her cash beans for $9.90 per bushel and her 20 puts at a premium of $2.30 per bushel. Ignoring transaction costs (and time value of money) what was the effective price the farmer received for her beans, per bushel? (note: this is a modified version of IFM Question 7.15).

a. $9.90
b. $10.70
c. $11.40
d. $12.20

Answers here:

• In forum

 

[abhinav0131]

1.c
2.d
Could someone pls be kind enough to answer the third one.
I am doing this which is definitely wrong
Final selling price = 9.90 + profit on puts per bushel = 9.90 + 20*100*(2.30-0.80)/100000 = 9.93

 

[David Harper CFA FRM]

Hi @abhinav0131

404.3 is a direct tweak of IFM 7-15, so candidly I am not overly proud of it. Your idea looks right, but notice the question asks "per bushel" so you don't need to adjust for contract size/etc:
404.3. C. $11.40 = $9.90 + 2.30 premium received - 0.80 premium paid

we have a different answer for 404.2 than (D)

 

[abhinav0131]

Hi @David Harper CFA FRM CIPM

in 404.3, doesn't the number of put options bought matter ? Because as per my understanding, 20 put options dont hedge entire 100000 bushels. If the question said entire holding is hedged, then I would definitely agree with you. Am I incorrect ?

And 404.2, I initially thought it should be a, but then I thought (A) and (C) are the same. Is the answer is (B) ? But clearly I need to do my homework on this topic.

 

[Nicole Seaman]

Hello @abhinav0131,

I just wanted to point out that we provide the answers in a different thread on the forum that is accessible to paid members. At the end of the questions, you will notice that it shows "Answers here: In forum" and when you click on that it will bring you to the answers.

Thank you,

Nicole

 

[David Harper CFA FRM]

Hi @abhinav

• Re 404.3, yes, typically the number of put options matters (typically, we would to inform put quantity with option delta, or correlation) but the IFM authors did not make such an assumption. They assumed a "cruder" hedge based on equal quantities: an expected sale of 100,000 bushels hedged by 20 contracts * 5,000 bushels = 100,000 bushels (ie., 1:1). The actual source 7.15 question (that I copy-tweaked) hedges 50,000 with 10 put contracts. (It's a new FRM reading. I'm not delighted by the question, but I felt obligated to include at least one reference based on their approach)
• Re 404.2: yes answer is (B), I don't see how (A) and (C) are the same

 

[abhinav0131]

Hi @Nicole Manley

I knew it and agree, was just hoping of some activity by the other non-paid members like me .

Hi @David Harper CFA FRM CIPM

Thanks again for your comments.

 

[Nicole Seaman]

@abhinav0131,

We definitely encourage you to discuss things on the forum. We just leave the answers for paid members because it wouldn't be fair to them if we gave out the answers to non-paid members since that is what they are paying for Thanks for understanding and have fun in the discussions!!

Nicole

 

[achieverbc]

how can the answer to 404.2 be option b?? after getting into exchange for physical gold, the investor will be short the future as then only he can exchange for physical gold...someone plz help...

 

[Nicole Seaman]

H

how can the answer to 404.2 be option b?? after getting into exchange for physical gold, the investor will be short the future as then only he can exchange for physical gold...someone plz help...

Hello @achieverbc,

If you look in original post above, there is a link for the answers of our daily practice questions. These answers and their explanations are available to all paid members.

Thanks,

Nicole