Questions

[abhinav0131]

Hi

Hoping for someone to clear some doubts for me please. Really appreciate it.

1> The spot price of corn on April 10 is 207 cents/bushels. The futures price of the September contract is 241.5 cents/bushels. If hedgers are net short, which of the following statements is most accurate concerning the expected spot price of corn in September?
Choose one answer.
a.) Exp spot price of corn is higher than 207.
b.) Exp spot price of corn is lower than 207.
c.) Exp spot price of corn is higher than 241.5.
d.) Exp spot price of corn is lower than 241.5.
Issue : Doesn't hedgers being net short mean they are short the futures ? Or hedgers are the corn producers ?

2> Consider the following. A 7-year, zero-coupon bond carries an annual yield of 6.75% and a 6-year zero-coupon bond carries an annual yield of 5.87%. Calculate the 1-year forward rate 6 years from now. Assume annual compounding.
Issue : If I use (6.75%*7-5.87%*6)/(7-6), answer is 12.03%, and if I use (1+6.75%)^7/(1+5.87%)^6, the answer is 12.19%. Unfortunately, both are in the options.

3> A 90-day Eurodollar futures contract has a constant PVBP of $25.00 per million. The 90-day bank bill futures contract on the Futures Exchange trades on a discount basis and the Price Value of a Basis Point (PVBP) is different for each yield level. In this example, what are the two major risks associated with using 90-day bank bill futures to hedge a Eurodollar futures position?
a. Basis Risk and Credit Risk
b. Basis risk and Currency Risk
Issue : How does this hedge have a currency risk ?

Thanks in advance!

Abhinav

 

[David Harper CFA FRM]

@abhinav0131 what's the source of these questions, please? (I'd just like to credit work done by competitors, or GARP, if that is the case; we've explicitly told GARP we would do our best with respect to attribution, although (a) (b) only doesn't look like GARP to me). Thanks,

 

[abhinav0131]

@David Harper CFA FRM CIPM

Hi, these are questions from the material of Edupristine (another trainer authorized by GARP). I was not satisfied with the explanations that they gave hence thought of asking you. I eliminated c and d from the options myself as they were incorrect for sure.

 

[abhinav0131]

@David Harper CFA FRM CIPM

I have got the answer to the 2nd question(it specifically states annual compounding) so pls ignore that now.

 

[David Harper CFA FRM]

Hi @abhinav0131 Thanks for the source, that's fine: we have partnered with Pristine, we have a nice relationship with them.

1> This is a good question, IMO (except it has one minor problem: as C is intended to be correct, by definition so is A correct; such that A should be replaced with a better false).

"Hedgers are net short" is shorthand for theory of normal backwardation, which is basically Hull's (assigned) theory. It refers more to your "hedgers are the corn producers" assumption. It says that, on average, hedgers (the ones who are reducing risk) have entered more short futures positions than long futures. Risk-reducers who need short contracts (commodity producers with intent to sell at future unknown spot prices) outnumber risk-reducers who need long contracts (future commodity buyers). Liquidity for these (net short hedger) contracts is made possible by the other side of the trade: speculators willing to go long. But speculators are not risk-reducers, speculators are risk-seekers who demand compensation. Their [speculator's] compensation--in exchange for assuming the price risk--is a positive expected profit: at maturity, their EXPECTED net gain will be E[S(t)] - F(0); i.e., as longs, they promise to pay F(0) in the future for a commodity that they expect to be worth more than F(0). It makes no sense for them to assume any risk, if their future expected profit is zero, if E[S(t)] - F(0) = 0? For their price risk, they demand an expectation of future E[S(t)] > F(0). It's a long way to say, on whichever side of the trade are speculators, their expected future gain, which is the difference between E[S(t)] and F(0), is positive. If hedgers are net short, then speculators are net long, so they will "pay" F(0) and "receive" E[S(t)].

In short, risk reducers need to pay the speculators to assume the price risk; if they (risk reducers) are net short, then E[S(t)] > F(0). There is specific math for this in Hull, including the additional implicit CAPM-related assumption that the commodity has positive beta.

And I think it's an important idea because it explains why, under assumptions, the hedger has an expected loss on the hedge position (not necessarily the net position!). Or put another way, in this context, hedging price volatility is not free, it's cost is an expected loss (on the hedge instrument).

2> I don't know either why currency risk. Candidly, I get stuck at "The 90-day bank bill futures contract on the Futures Exchange." I am not immediately sure to what that refers, perhaps that is meant to refer to a non-LIBOR interest rate, like an AUD rate, but I think it maybe should specify. And i don't know if Futures Exchange is real/fictional?)

...This is a good assumption "A 90-day Eurodollar futures contract has a constant PVBP of $25.00 per million." It's good for an FRM candidate to already know this, this is a design feature of the ED contract, and using PVBP is a nice way to say it. We definitely want to understand that sentence. Thanks,

 

[abhinav0131]

Hi @David Harper CFA FRM CIPM

I really like the way you explain things, thanks vm for your help again. With just a week left before the exam, I have some more unanswered questions which I can post here if you don't mind helping out.

 

[David Harper CFA FRM]

Thanks @abhinav0131 thanks for the nice words. Of course you are welcome to post questions, that's what the forum is for, but it will be especially busy in the next week (obviously) so I personally may not be able to reply to them all. Thanks,