Chapter 2- Speculation, hedging, and spreading

Question 1

Pyramiding

Answer 1

Speculative strategy that involves increasing the size of an open, profitable position by declining increments as the commodity price rises. Can be utilized in any profitable account, whether that account is long or short.

Question 2

Switching strategy

Answer 2

a speculator extends the holding period by liquidating a position in a contract month nearing delivery and simultaneously establishes a position in a contract of a more distant contract month (rolling).

Question 3

Hedging

Answer 3

strategy used by producers and users to protect their respective interest. Hedging is the purchase or sale of a futures contract as a temporary substitute for a later cash transaction. it is a method of transferring risk

Question 4

What type of risk does a hedged position still carry

Answer 4

Basis risk- the potential adverse change in the relationship of the cash price and futures price (a change in basis) while the hedged position is open. Because basis is more stable than cash or futures market prices alone, a hedged position entails less risk than an unhedged position.

Question 5

Basis Risk

Answer 5

The potential adverse change in the relationship of the cash price and futures price while the hedged position is open.

Question 6

Short hedger

Answer 6

sells futures to lock in a cash price (the price when the hedge was placed)

Question 7

When are short hedges used?

Answer 7

to protect the value of inventory or the future selling price of a commodity.

Question 8

what happens to p/l if the basis strengthens in a short hedge?

Answer 8

There will be larger profit.

Question 9

Who uses short hedge?

Answer 9

any owner or producers of a commodity, who may suffer from falling prices.

Question 10

would a hedger who is long or short the basis sell a futures contract to protect against a decline in price.

Answer 10

Long basis. Also known as short (selling) hedge.

Question 11

Does a short hedger want the basis to strengthen or weaken

Answer 11

Strengthen. In a normal market, the hedger wants the difference between the cash and futures price to decrease.

Question 12

Strengthening basis

Answer 12

increase in basis- the cash price may increase more quickly than the futures price, or the cash price may decrease more slowly than the futures price. Widening cash over futures spread, narrowing futures over cash spread.

Question 13

Someone who owns or will own the commodity is long or short the basis?

Answer 13

Long

Question 14

7 traits of a short hedge

Answer 14

• Futures contracts are sold
• The short hedge is a substitute sale.
• if prices decline, the profit on futures will offset cash market losses.
• The hedge seeks to protect against falling prices
• If prices rise, loss on futures is offset by a higher sale price in the cash market.
• The short hedger is long the basis
• The short hedger wants the basis to strengthen.

Question 15

Effective (true) price calculation

Answer 15

adjusting his initial cash cost when the hedge is placed by the change in the basis.
Effective sale price= Cash cost when hedge is placed + or - basis CHANGE
Effective price = Sale price + or - change in futures

Question 16

Effective Price

Answer 16

the final cash price plus or minus the hedge of the futures or the original cash price plus or minus the basis change.

Question 17

how to calculate the effect of the hedge on revenue

Answer 17

multiply the basis change by the number of units hedged.

Question 18

Profit from selling hedged position

Answer 18

revenue minus production costs and hedging costs.

Question 19

Short hedge

Answer 19

used to protect inventory by locking in a selling price for later cash sale.

Question 20

Long hedge

Answer 20

used to protect a later cash purchase or a short actuals position.

Question 21

When does a short actuals position occur

Answer 21

from a forward sale of (or other promise to sell) goods yet to be purchased by a distributor or manufactured by a producer or processor.

Question 22

How is a forward sale hedged

Answer 22

long futures because the person is promising to deliver a good she doesn’t have.

Question 23

Are long hedgers long or short the basis?

Answer 23

Short the basis. A long hedger has a short cash position (receiving now and owning later) hedged with a long futures position.

Question 24

What is a weakening basis?

Answer 24

decrease in the cash price relative to the futures price

Question 25

Why does a long hedge benefit from a weakening basis?

Answer 25

it reduces the effective cost of the asset purchased later in the cash market.

Question 26

What is the true cost of assets purchased through a hedge?

Answer 26

the cash market price on the day the hedge was placed reduced by the amount by which the basis weakened.

Question 27

How is effective cost (price) calculated

Answer 27

adjusting the cash price at the time the hedge was placed by any change of the basis after the hedge is lifted.

Question 28

Why are spreads considered less risky?

Answer 28

Because the tend to move in the same direction

Question 29

What is intracommodity spread?

Answer 29

A spreader is long and short futures contracts on the SAME commodity

Question 30

what is intradelivery spread?

Answer 30

contracts mature during the same delivery month.

Question 31

What does “Inter” mean in regards to spreads?

What are the 3 main types?

Answer 31

different. intercommodity spread means different commodities, intermarket spread is different markets, and interdelivery spreads are different delivery months.

Question 32

What is a bull spread in a normal market?

Answer 32

profit if the price of the commodity rises. The investor goes long nearby futures contract and short the distant futures. The investor wants the spread to narrow.

Question 33

Does an investor want a bull spread to widen or narrow in an inverted market?

Answer 33

Widen

Question 34

What is a bear spread

Answer 34

an investment strategy seeking to profit if the price of the commodity falls. The trader goes short the nearby contract and long the distant contract. The investor wants the price difference to widen in a normal market.

Question 35

How do interest rate futures bull and bear spreads differ from regular commodity spreads

Answer 35

the use reverse positions.

Question 36

Do bull or bear spreads have limited risk

Answer 36

Bull spreads do

Question 37

Bull Spread in a normal market traits 3

Answer 37

called long spread
long nearby and short distance
profits if spread narrows

Question 38

Bear spread in a normal market 3 traits

Answer 38

called a short spread
long distant and short nearby
profits if spread widens

Question 39

Bull Spread in an inverted market 3 traits

Answer 39

also called long spread
long nearby and short distance
profits if spread widens

Question 40

Bear spread in an inverted market

Answer 40

called short spread
long distant and short nearby
profits if spread narrows

Question 41

When can a p/l be calculated on a spread

Answer 41

When the spread is closed

Question 42

What does a processor do

Answer 42

a business that buys raw material or semifinished goods (input) and adds value to make a finished product. Finished products (output) are ultimately sold to others.

Question 43

What is a processing spread

Answer 43

a manufacturer or processsor buys futures to hedge a later purchase of raw material (input) and sells futures to hedge the later sale of a finished product (output).

Question 44

When do processing spreads occur

Answer 44

processor simultaneously buy (long) and sell (short) related futures contracts.

Question 45

Processor conditions 2

Answer 45

1) long hedgers on input- that is they buy futures now to hedge against rising costs associated with the later purchase of inputs.
2) Short hedgers on output- that is, they sell futures now to hedge against declining prices from sales of their products (output).

Question 46

What is a processor hedge

Answer 46

buyst futures on his input and sells futures on his output. any other type of position is a speculative position.

Question 47

3 types of processor spreads

Answer 47

Crack Spread
Feeder spread
Crush Spread

Question 48

Crack Spread positions

Answer 48

• long crude oil futures to hedge the later purchase of crude oil and
• short heating oil and gasoline futures to hedge the later sale of the distillates.

Question 49

What is cracking?

Answer 49

the process for turning crude oil into distillates

Question 50

cattle feeder spreads us futures positions that are:

Answer 50

• Long feeder cattle and corn or soy meal futures to hedge the later purchase of young cattle and their feed; and
• short live cattle futures to hedge the later sale of fat (live) cattle.

Question 51

What is the difference between live cattle and feeder cattle futures contracts?

Answer 51

Feeder cattle (thin cows) are processed (fattened) on feed lots; live cattle (fat cows) are the product of the cattle feeding process and are cattle ready for slaughter.

Question 52

Crush Spread

Answer 52

long soybean futures and short oil and meal futures. Soybeans used to be crushed in vats to produce oil and meal hence the name crush spread.

Question 53

a processors Crush spread futures spreads position

Answer 53

• Long soybean futures to hedge the purchase of the beans and
• short soybean oil and soybean meal futures to hedge the later sale of the bean products.

Question 54

Gross processing margin (GPM)

Answer 54

identifies the gross return from processing on bushel of beans. it is also called gross margin because it accounts for the expense of only the input, the beans.

Question 55

Reverse crush spread

Answer 55

Speculators may profit from the same situation that hurts the bean crusher with a reverse crush spread. The speculator sells soybean futures and buys soybean oil and soybean meal futures to profit on a decrease in bean prices and an increase in bean meal and oil prices.