Question 1:
(a)
(b)
As we can see from Figure 1, while the forward curves of 23 February 2015 and of 21 April
2020 shows an upward shape, the forward curve of 29 March 2022 presents a downward
slope. In details, the gold line of 23 February 2015 is upward sloping with prices rising from
$50.10 as of April 2015 to $60.24 as of March 2016. Similarly, the orange line of 21 April
2020 is sharply upward from negative –$4.55 as of May 2020 to $34.42 as of April 2012. In
contrast, the red line of 29 March 2022 presents a downward from $105.21 as of May 2022
to $85.54as of March 2023.
When a futures curve is upward sloping, the market is said to be in contango, meaning
futures contracts trade at a price higher than the current spot price (Wahab, Mohamad &
Sifat 2019). This situation typically reflects a positive cost of carry, which includes expenses
such as storage and financing. For instance, in February 2015, a modest contango prevailed.
This was largely because U.S. storage gluts following 2014, evidenced by EIA inventory builds
, drove a modest positive cost of carry, however, low interest rates at the time contributed to
keeping the upward slopes of the curve relatively shallow (EIA 2014). By April 2020, an
extreme contango and even negative front‐month futures reflected the COVID demand
shock: near‐zero storage capacity in Cushing, OK led to negative spot – futures spreads as
traders paid to “park” oil, then roll into later contracts (EIA 2020). In March 2022, the market
was in backwardation (futures below spot), which was driven by a tight physical supply after
the Russia – Ukraine conflict: immediate oil very costly, while forward barrels priced lower
on expectations of demand slowdown and increased investment in alternatives (Razek et al.
2023).
(c) & (d)
Using the cost-of-carry relation as F ( 0 , T )=S0 e (r +u− y )T and assuming a negligible risk-free
−1 F
rate r = 0 and a storage cost u = 0, we back out y= ln ( ).
T S0
By taking S0 =$ 105.21 that was May 2022 futures, Figure 2 plots y(%) versus months to
maturity. The convenience yield rises steeply from 0% for the front ‐month to approximately
13.5% at 2 months, then continues up to nearly 26.5% by 7 months. Technically, high
convenience yields reflect strong incentive to hold physical oil today rather than futures, due
to a tight immediate availability or storage/supply bottlenecks (Razek et al. 2023).
Accordingly, the rising curve suggests the market places greater value on near ‐term barrels
relative to future ones.
(e)
An East-Coast manufacturer needs to buy 80,000 barrels of crude oil of WTI around end of
August 2022. One NYMEX WTI futures contract equals 1,000 barrels of crude oil.
As can be seen from the above calculations, we recommend the manufacturer to enter a
short position in 91 August 2022 futures today. This will “lock in” most of the later purchase
cost or they will roll or unwind that position around end-August as they take delivery.
(f)
Assumptions:
Spot price (end of August): $74.50 per barrel.
Futures price (September 2022 delivery): $73.85 per barrel.
Without hedge:
Total cost = 80,000 x 74.50 = $5,960,000.
With hedge:
Future loss = 91 x 1,000 x (97.10 - 73.85) = $2,115,750.
Total cost = Spot cost + Future loss = $5,960,000 - $2,115,750 = $3,844,250.
Effective purchase price = $3,844,250 / 80,000 = $48.05 per barrel.
As can be seen from the above calculations, the effective purchase price with hedge was
$48.05 per barrel while that without hedge was $74.50 per barrel. In conclusion, because
the futures price fell, their short position made money and offset most of the drop in spot,
which delivered that $48.05 figure. Had oil instead risen, their futures loss would have
exactly offset the higher spot cost, leaving them still paying close to their locked-in futures
entry (≈$97.10), thus demonstrating the hedge “locks in” a price band regardless of
direction.
(g)
The objective of the recommended hedge is to eliminate or greatly reduce the price ‐risk on
the future oil purchase. By hedging, the manufacturer “fixes” a budgeted cost and smooths
cash‐flows instead of speculating on oil’s direction. However, the figure below demonstrates
reasons of which an imperfect hedge arises.
Question 4:
(a)
To insure a $10 million cryptocurrency portfolio against falling below $7.5 million over the
next five months, we purchase 338 protective Bitcoin puts with a $35,000 strike. Since the
portfolio’s Bitcoin beta is 1.4, a 17.86% drop in BTC from today’s $41,408 spot price will
produce a 25% portfolio loss, equivalent to $2.5 million, exactly our downside limit. The
puts, exercisable at $35,000, will appreciate in value if BTC falls below that level, which will
offset any shortfall and effectively guaranteeing the $7.5 million floor that is exclusive of the
option premium. Moreover, because each contract covers one BTC, 338 contracts reflect the
requisite $14 million of beta-adjusted exposure that is calculated by 1.4 × $10 million /
41,408 ≈ 338. If Bitcoin rallies instead, the puts expire worthless and the portfolio fully
participates in gains, then preserves an upside. By contrast, hedging with Bitcoin futures will
lock in a sale price to eliminate both downside and upside and obligate margin calls on
interim price swings that introduces a liquidity risk. Only options deliver the asymmetric
payoff the client needs: capped losses without sacrificing profit potential.
Additionally, by selecting a five-month expiration horizon, the options align precisely with
the client’s investment timeline and market outlook. Moreover, the budget planning is
simplified because the up-front premium represents a known and fixed cost instead of an
open-ended obligation. Additionally, liquid options markets ensure tight bid-ask spreads and
a reliable execution while the absence of margin calls safeguards against forced deleveraging
during temporary volatility spikes. Finally, the counterparty risk is minimal given
standardized exchange clearing.
List of references:
EIA 2014, “EIA projects record natural gas storage injection in 2014 to boost stocks from 11-
year low - U.S. Energy Information Administration (EIA),” EIA, viewed
<https://www.eia.gov/todayinenergy/detail.php?id=15391>.
EIA 2020, “Low liquidity and limited available storage pushed WTI crude oil futures prices
below zero,” EIA, viewed <https://www.eia.gov/todayinenergy/detail.php?
id=43495#:~:text=The%20positive%20pricing%20of%20other,Texas%20Intermediate)%2C
%20COVID%2D19>.
Razek, N., Galvani, V., Rajan, S. & McQuinn, B. 2023, “Can U.S. strategic petroleum reserves
calm a tight market exacerbated by the Russia–Ukraine conflict?,” Resources Policy, vol. 86,
p. 104062.
Wahab, M.A.A., Mohamad, A. & Sifat, I. 2019, “On contango, backwardation, and seasonality
in index futures,” The Journal of Private Equity, vol. 22, no. 2, pp. 69–82.
