Question

2.         Question 2                                                                                

[Total: 20 marks]

It is January and a company has to purchase 30,000 barrels of oil in May. The company enters into a long futures agreement for delivery of oil in June. The futures price for June delivery is $25 per barrel of oil. When the company closes out the futures position in May, the spot price of oil is $30 per barrel and the futures price is $29 per barrel.

a) Please calculate the effective price per barrel of oil and the total effective price to pay in May.                                                                                                                           [5 marks]

    

b) Please compute the size of the basis.                                                       

[5 marks]

c) Please explain why a long hedger’s position worsens if the basis strengthens unexpectedly and improves when the basis weakens unexpectedly.          

[10 marks]

Answer 1

a]

effective price per barrel = spot price in May - (futures price in May - futures price in January)

effective price per barrel = $30 - ($29 - $25)

effective price per barrel = $26

total effective price = effective price per barrel * number of barrels

total effective price = $26 * 30,000

total effective price = $780,000

b]

basis = spot price - futures price

basis = $30 - $29 = $1

c]

basis = spot price - futures price

If the basis strengthens, the difference between the spot price and futures price is higher. Thus, the gains on the futures contract are less than the increase in spot price, which increases the effective price paid per barrel. Therefore the long hedger’s position worsens.

If the basis weakens, the difference between the spot price and futures price is lower. Thus, the gains on the futures contract are more than the increase in spot price, which decreases the effective price paid per barrel. Therefore the long hedger’s position improves.