5.1

Front 1

Open Interest

Back 1

Open interest in the futures market is the number of outstanding contracts. A long position and a short position on the same futures contract are counted as one contract toward open interest. Only about 1% of all futures contract positions involve the delivery of the underlying commodity.

Front 2

Rolling contracts

Back 2

Using futures contracts presents a challenge for an investor who wants to maintain long-term exposure to commodities without taking delivery of the underlying commodity. Most futures contracts have an expiration date of only a few months. In order to maintain commodity exposure, the investor will have to repeatedly close out the existing futures position and establish a new position in a new futures contract with a longer maturity.

Front 3

Cost of Carry Model

Back 3

Cost of Carry is a measure of the financial difference between holding a position in the spot market and holding a position in the forward market. Cost of carry models involve two strategies with identical economic results but different current prices (and therefore returns) that reflect the cost of carrying each strategy. Buying an asset now or in the future through a forward contract both result in ownership of the asset and equivalent exposure to price risk. Thus, any difference between the spot and forward price is due to the cost of carry, which causes the term structure of forward prices to have a slope or curve. For commodities, the cost of carry relationship is

F(T) = S + carrying costs
* S = spot price
* F(T) = current forward price of a contract expiring at time T

Front 4

Financed positions

Back 4

Financed positions allow an investor to obtain economic ownership of an asset without forfeiting the cash value of the position. Forward contracts only require posting of a small amount of collateral which earns a market interest rate, meaning we can ignore the collaterla nd classify forwards as financed positions with zero investment. It is similar to buying the asset and selling short a bond (i.e., borrowing funds). Unlike direct ownership of an asset, however, forward contracts do not entitled the holder to dividends or coupons paid by the underlying asset. Arbitrage free models account for the financed position and lack of dividends/coupons in pricing forward contracts.

Front 5

Normal backwardation

Back 5

current forward price is less than the expected future spot price

Front 6

normal contago

Back 6

the current forward price is greater than the expected future spot price

Front 7

backwardation

Back 7

the current forward price is less than the current spot price

Front 8

contango

Back 8

the current forward price is greater than the current spot price

Front 9

Calendar spread

Back 9

A calendar spread strategy combines a long forward position and a short forward position on the same underlying asset but with different expiration dates. The strategy is an implicit bet on the shape of the forward term structure.

Front 10

Discuss the potential of futures and forward contracts as sources of ex ante alph

Back 10

An investor may utilize forward or futures contracts as a alpha driver. Investors look for violations of the law of one price and engage in arbitrage transactions. The arbitrageur will purchase the undervalued asset and sell the overvalued asset to earn a riskless return. Investors generally look for relative mispricing among different futures contracts.

Alpha-based strategies frequently involve speculation on the changes in the shape of the forward term structure based on the belief that the shape of the term structure is informationally inefficient.

Front 11

Discuss the potential of futures and forward contracts as source of ex ante beta

Back 11

An investor may utilize forward or futures contracts as a beta driver. Investors attempt to gain the risk and return exposure of the underlying asset while minimizing costs. The investor will determine the appropriate investment time horizon and analyze the trading costs of holding a single position or rolling over multiple positions over the time horizon.

Front 12

Basis in terms of a forward contract

Back 12

Basis in terms of a forward contract is the difference between the spot price and the price of the forward contract.

Basis = S - F(T)

Front 13

What are two key points regarding the term structure of forward prices.

Back 13

Two key points regarding the term structure of forward prices are:
1. The slope and shape of the term structure are driven by differences in the cost of carry.
2. The slope and shape of the term structure are not related to returns earned on forward contracts.