Question

Which of the following hedged positions would be subject to basis risk?

I. A drilling company expects to have two million barrels of crude oil available for sale in September. It is currently March, so the company takes a short 6-month crude oil futures position on two million barrels.

II. A sunflower oil wholesaler expects that the price of sunflower oil to fall in six months. The wholesaler therefore establishes a short position in a 6-month soybean oil futures contract.

	A.	Neither I nor II.
	B.	I only.
	C.	Both I and II.
	D.	II only.

A trader enters into a short forward contract on 2,000 ton iron ore. The forward price is $116.9 per ton. How much does the trader gain or lose if the price of iron ore at the end of the contract is 112. 5 per ton?

	A.	8,800
	B.	-8,800
	C.	233,880
	D.	225,000

A four-month call option on MAR stock with a strike price of $95 costs $9.2; a four-month put option on the stock with a strike price of $95 costs $10.5. Suppose that a trader buys one call option and one put option. What is the gain if the stock price is $102 at expiration?

	A.	-$8.3
	B.	-$12.7
	C.	$8.3
	D.	$12.7

Answer 1

(1)

Basis Risk arises when a company or investor hedges a position with a contract that does not expire on the same date as the position being hedged.

Here (II) seems that it will have lesser probability of having difference in time to expiry of spot and forward contract, then comparing it to the (I) where the month September is given but the exact date is not given so crude oil could available for sale in any date of September thus the forward contract might differ in maturity thus creating the Basis Risk.

So only (I) seems that it would impacted by he basis risk. Now this is based on the assumption that there exist the uncertainty on the exact date of sale of crude oil.

(2)

Here the trader enters into the short forward contract means he would be liable to sale the underlying asset at the fixed strike price of $116.9 per ton on maturity.

But the spot price on the maturity is $112.5per ton. Means here the opportunity to gain profit exist as the trader could buy iron or from spot @ $112.5 and sell to the forward contract buyer @ $116.9,

Thus gaining: = 116.9 - 112.5

= $4.4 per ton

The size of forward contract is 2000 tons so total profit will be = 2000*4.4

= $8,800

(3)

Intital cash outlay on buying the option contract = price to buy call option + price to buy put option

= 9.2 + 10.5

= -$19.7

At maturity:-

Intrinsic value of Call option = Spot Price - Strike Price, only if the this value is greater than zero.

= $102 - $95

= $7

Intrinsic value of Put option = Strike Price - Spot Price, only if the this value is greater than zero.

= $95 - $102

= -$7, which is <0

So the intrinsic value of put option = $0

Now the total profit/loss = Intrinsic value of Call Option + Intrinsic value of Put Option + Initial Cash flow

= $7 + $0 + (-19.7)

= -$12.70