Commodity Derivatives Quiz Exam Quiz 31

To determine the most suitable hedging strategy, we need to calculate the potential profit or loss from each option considering the storage costs and then assess which strategy offers the best risk mitigation. First, let’s calculate the net price received under each strategy. * **Strategy A (Short Hedge with Futures):** The farmer sells December wheat futures at £200/tonne. When the wheat is harvested and sold in December, the spot price is £190/tonne, and the futures price is £192/tonne. The farmer loses £10/tonne in the spot market (£190 – £200) but gains £8/tonne in the futures market (£200 – £192). The net price received is £200 (initial futures price) – £10 (spot loss) + £8 (futures gain) = £198/tonne. Subtracting storage costs of £5/tonne, the net price is £193/tonne. * **Strategy B (Long Hedge with Futures):** This strategy is not suitable for a farmer looking to hedge against a price decrease. A long hedge protects against price increases, which is the opposite of what the farmer needs. * **Strategy C (Short Hedge with Options):** The farmer buys a put option with a strike price of £195/tonne at a premium of £3/tonne. When the spot price falls to £190/tonne, the farmer exercises the put option, receiving £195/tonne. The net price received is £195 (strike price) – £3 (premium) = £192/tonne. Subtracting storage costs of £5/tonne, the net price is £187/tonne. * **Strategy D (No Hedge):** The farmer sells the wheat at the spot price of £190/tonne in December. Subtracting storage costs of £5/tonne, the net price is £185/tonne. Comparing the net prices received under each strategy: * Strategy A: £193/tonne * Strategy B: Not suitable * Strategy C: £187/tonne * Strategy D: £185/tonne Therefore, the short hedge with futures (Strategy A) provides the highest net price and the best protection against price decreases, making it the most suitable strategy. The key to this problem lies in understanding how hedging strategies work in conjunction with storage costs. While a put option provides a price floor, the premium paid reduces the net revenue. A short futures hedge locks in a price but requires understanding the basis risk (the difference between spot and futures prices). The farmer needs to consider the interplay of these factors to make the most informed decision. The farmer is also affected by the laws and regulations regarding to trading, such as Market Abuse Regulation and MiFID II.

The core of this question revolves around understanding how a clearing house mitigates risk in commodity derivative markets, specifically concerning a default scenario. The key concept is that the clearing house acts as a central counterparty (CCP), stepping in between the buyer and seller in a transaction. This significantly reduces counterparty risk. Margin requirements are crucial; they are designed to cover potential losses if a member defaults. Variation margin is paid daily to reflect changes in the market value of the contract, while initial margin is a buffer to cover potential losses beyond a single day. In a default, the clearing house first uses the defaulting member’s margin to cover the losses. If the margin is insufficient, the clearing house can use its own resources, including a default fund contributed to by all members. The question also touches on the regulatory framework, particularly the role of EMIR (European Market Infrastructure Regulation) in ensuring the stability of clearing houses and the commodity derivatives market. The question assesses understanding of default waterfalls and loss allocation in a CCP context. To illustrate the concept of a default waterfall, consider a scenario involving three hypothetical clearing members: Alpha, Beta, and Gamma. Alpha defaults on its obligations. The clearing house first utilizes Alpha’s initial margin of £5 million and variation margin of £2 million, totaling £7 million. However, Alpha’s losses amount to £10 million. The clearing house then draws upon its default fund, which contains contributions from all members. Let’s say Beta and Gamma each contributed £1 million to the default fund. Therefore, the clearing house can access an additional £2 million. This covers £9 million of the £10 million loss. To cover the remaining £1 million, the clearing house might utilize other resources, such as assessments on non-defaulting members, or its own capital. This example highlights the layered approach to risk management employed by clearing houses.

To determine the most suitable hedging strategy, we need to calculate the potential profit/loss from each option and compare it with the expected profit/loss from the unhedged position. **Unhedged Scenario:** The farmer expects to sell 100 tonnes of wheat at £200/tonne, anticipating a revenue of £20,000. If the price drops to £180/tonne, the revenue becomes £18,000, resulting in a loss of £2,000. **Futures Hedge:** Selling 10 wheat futures contracts (each for 10 tonnes) at £200/tonne locks in a price. If the spot price drops to £180/tonne, the futures price will also likely drop. Let’s assume the futures price drops to £182/tonne. The farmer loses £20/tonne on the physical wheat but gains £18/tonne on the futures contracts. The net loss is £2/tonne or £200 across the 100 tonnes. **Put Option Hedge:** Buying 10 put options at a strike price of £190/tonne costs £5/tonne in premium. If the spot price drops to £180/tonne, the put options become in-the-money. The payoff per tonne is £190 – £180 = £10. After deducting the premium of £5/tonne, the net gain is £5/tonne. The net loss is £2000 – £500 = £1500. **Call Option Hedge:** Buying 10 call options is not a hedging strategy to protect against price decreases, so it is not suitable for this scenario. Comparing the three scenarios, the futures hedge results in the smallest loss (£200), making it the most suitable strategy in this case. The put option hedge results in a loss of £1500, while the unhedged position results in a loss of £2000. In this specific scenario, the futures hedge is the most effective because the basis risk (the difference between the spot price and the futures price) is assumed to be small and predictable. The put option hedge provides downside protection but at the cost of the premium, which reduces the overall effectiveness of the hedge when the price decline is relatively small. The unhedged position exposes the farmer to the full risk of the price decline.

The core of this question revolves around understanding the interplay between storage costs, convenience yield, and the resulting impact on forward prices in commodity markets, particularly within the context of UK regulatory frameworks affecting market participants. The formula for calculating the forward price \(F\) is: \[F = S \cdot e^{(r + u – c)T}\] Where: \(S\) = Spot price, \(r\) = Risk-free interest rate, \(u\) = Storage costs, \(c\) = Convenience yield, and \(T\) = Time to maturity. The storage costs directly increase the forward price, reflecting the expenses incurred in holding the physical commodity. The convenience yield, on the other hand, decreases the forward price, representing the benefit of holding the physical commodity for immediate use or unexpected demand. The risk-free rate accounts for the time value of money. The impact of regulatory changes, such as those imposed by the FCA, can significantly affect storage costs and convenience yields. For instance, stricter warehousing regulations might increase storage costs, while policies promoting renewable energy could decrease the convenience yield of fossil fuels. In this scenario, we need to calculate the forward price of Brent Crude oil, considering the given spot price, risk-free rate, storage costs, convenience yield, and time to maturity. We then analyze how a hypothetical regulatory change, increasing storage costs, would affect the forward price. First, calculate the initial forward price: \(F_1 = 80 \cdot e^{(0.05 + 0.02 – 0.03) \cdot 0.5} = 80 \cdot e^{0.02 \cdot 0.5} = 80 \cdot e^{0.01} \approx 80 \cdot 1.01005 \approx 80.80\). Next, calculate the forward price after the regulatory change: \(F_2 = 80 \cdot e^{(0.05 + 0.03 – 0.03) \cdot 0.5} = 80 \cdot e^{0.05 \cdot 0.5} = 80 \cdot e^{0.025} \approx 80 \cdot 1.02532 \approx 82.03\). Finally, calculate the difference in forward prices: \(F_2 – F_1 = 82.03 – 80.80 = 1.23\). The key takeaway is that understanding the relationship between these factors is crucial for accurately pricing commodity derivatives and assessing the impact of regulatory changes on market dynamics. This requires not just memorizing the formula, but also grasping the economic rationale behind each component and how they interact within the framework of UK commodity market regulations.

The core of this question revolves around understanding how basis risk arises in hedging strategies using commodity derivatives, particularly when the commodity underlying the derivative contract is not perfectly correlated with the physical commodity being hedged. Basis risk is the risk that the price of the derivative (e.g., futures contract) will not move in a perfectly correlated manner with the spot price of the commodity being hedged. This can lead to the hedge being less effective than intended. In this scenario, the refinery is hedging jet fuel production using crude oil futures. Jet fuel and crude oil prices are generally correlated, but the correlation is not perfect due to factors such as refining margins, regional supply and demand imbalances, and differences in the specific grades of crude oil used to produce jet fuel. This imperfect correlation creates basis risk. To determine the potential range of outcomes, we need to consider the best-case and worst-case scenarios for the refinery. The best-case scenario occurs when the basis narrows unexpectedly, meaning the price difference between jet fuel and crude oil decreases. The worst-case scenario occurs when the basis widens unexpectedly, meaning the price difference between jet fuel and crude oil increases. Initial hedge: The refinery hedges 100,000 barrels of jet fuel by selling 100 NYMEX crude oil futures contracts (each contract representing 1,000 barrels) at $80/barrel. This locks in a revenue of $8,000,000 before considering basis risk. Scenario 1: Jet fuel price increases to $95/barrel, and crude oil futures increase to $92/barrel. The refinery sells jet fuel for $9,500,000. The futures contracts are bought back at $92/barrel, resulting in a profit of ($80 – $92) * 100,000 = -$1,200,000. Net revenue: $9,500,000 – $1,200,000 = $8,300,000. Scenario 2: Jet fuel price decreases to $70/barrel, and crude oil futures decrease to $65/barrel. The refinery sells jet fuel for $7,000,000. The futures contracts are bought back at $65/barrel, resulting in a profit of ($80 – $65) * 100,000 = $1,500,000. Net revenue: $7,000,000 + $1,500,000 = $8,500,000. Scenario 3: Jet fuel price increases to $95/barrel, and crude oil futures increase to $88/barrel. The refinery sells jet fuel for $9,500,000. The futures contracts are bought back at $88/barrel, resulting in a profit of ($80 – $88) * 100,000 = -$800,000. Net revenue: $9,500,000 – $800,000 = $8,700,000. Scenario 4: Jet fuel price decreases to $70/barrel, and crude oil futures decrease to $75/barrel. The refinery sells jet fuel for $7,000,000. The futures contracts are bought back at $75/barrel, resulting in a profit of ($80 – $75) * 100,000 = $500,000. Net revenue: $7,000,000 + $500,000 = $7,500,000. The range of possible outcomes is therefore $7,500,000 to $8,700,000. This range illustrates the impact of basis risk on the hedging strategy. Even though the refinery hedged its exposure, the final revenue is not fixed at $8,000,000 due to the imperfect correlation between jet fuel and crude oil prices.

To determine the theoretical forward price, we need to understand the cost of carry model. This model essentially calculates the future value of holding the underlying asset (in this case, Brent Crude oil) until the delivery date, considering all costs and benefits associated with holding the asset. The costs typically include storage, insurance, and financing, while the benefits may include lease rates or convenience yields. Since no specific storage, insurance, or lease rate information is provided, we’ll focus on the financing cost, which is derived from the risk-free interest rate. The formula for the theoretical forward price (F) is: \( F = S * e^{(r*T)} \) Where: S = Spot price of the commodity r = Risk-free interest rate T = Time to maturity (in years) e = Euler’s number (approximately 2.71828) In this scenario: S = $85 per barrel r = 5% or 0.05 T = 6 months or 0.5 years Plugging the values into the formula: \( F = 85 * e^{(0.05 * 0.5)} \) \( F = 85 * e^{0.025} \) \( F = 85 * 1.025315 \) \( F = 87.151775 \) Rounding to two decimal places, the theoretical forward price is $87.15. The key here is understanding the exponential growth represented by \(e^{(r*T)}\). This isn’t simple interest; it’s continuously compounded interest, reflecting the cost of tying up capital to hold the asset. A crucial assumption is the efficiency of the market. If the actual forward price deviates significantly from this theoretical price, arbitrage opportunities may arise. For instance, if the actual forward price is higher than $87.15, an arbitrageur could buy the oil at the spot price, store it (hypothetically), and simultaneously sell a forward contract to lock in a profit. Conversely, if the actual forward price is lower, an arbitrageur could short the oil and buy a forward contract. However, real-world arbitrage is rarely perfect due to transaction costs, storage limitations, and other market frictions. Furthermore, this calculation doesn’t account for convenience yield, which is the benefit of holding the physical commodity (e.g., the ability to continue production or meet immediate demand). If a convenience yield exists, it would reduce the theoretical forward price.

The core of this question revolves around understanding how margin calls function in commodity futures contracts, particularly within the framework of UK regulatory oversight. The Financial Conduct Authority (FCA) mandates specific risk management protocols for firms dealing in commodity derivatives, including stringent margin requirements. The initial margin is the amount required to open a futures position, acting as a security deposit. The maintenance margin is the level at which the account must be maintained; if the account balance falls below this, a margin call is triggered. Variation margin is the amount needed to bring the account back to the initial margin level. The calculation proceeds as follows: 1. **Initial Margin:** The initial margin for each contract is £5,000, and Amelia buys 10 contracts, so the total initial margin is \(10 \times £5,000 = £50,000\). 2. **Maintenance Margin:** The maintenance margin is £4,000 per contract, so the total maintenance margin is \(10 \times £4,000 = £40,000\). 3. **Price Drop:** The price drops by £120 per tonne, and each contract represents 10 tonnes, so the loss per contract is \(£120 \times 10 = £1,200\). Across 10 contracts, the total loss is \(10 \times £1,200 = £12,000\). 4. **Account Balance After Loss:** Amelia’s account starts with £50,000 and loses £12,000, leaving a balance of \(£50,000 – £12,000 = £38,000\). 5. **Margin Call Trigger:** Since the account balance of £38,000 is below the total maintenance margin of £40,000, a margin call is triggered. 6. **Margin Call Amount:** The margin call requires Amelia to bring the account balance back to the initial margin level of £50,000. Therefore, she needs to deposit \(£50,000 – £38,000 = £12,000\). The FCA’s oversight ensures that firms like Amelia’s broker adhere to these margin requirements to mitigate counterparty risk. The initial margin acts as a buffer against potential losses, while the maintenance margin and subsequent margin calls prevent losses from escalating beyond a manageable level. Failing to meet a margin call can lead to the forced liquidation of the position, further highlighting the importance of understanding and managing margin requirements in commodity derivatives trading. The FCA also mandates daily mark-to-market valuations, meaning that the futures contracts are revalued daily to reflect the current market price, and gains or losses are credited or debited to the trader’s account accordingly. This daily settlement process, known as variation margin, ensures that profits and losses are realized promptly, reducing the accumulation of large, unmanaged exposures.

Let’s consider a scenario where a UK-based artisanal chocolate maker, “Cocoa Dreams,” sources cocoa beans from Ghana. They use commodity derivatives to manage price risk. Cocoa Dreams anticipates needing 50 tonnes of cocoa beans in six months. Futures contracts are traded in lots of 10 tonnes. Cocoa futures are currently trading at £2,000 per tonne for delivery in six months. Cocoa Dreams decides to hedge their purchase by buying 5 cocoa futures contracts (5 contracts * 10 tonnes/contract = 50 tonnes). Now, imagine that over the next six months, unforeseen weather events in West Africa cause a significant cocoa bean shortage. The spot price of cocoa rises to £2,500 per tonne. Simultaneously, the futures price converges with the spot price, also rising to £2,500 per tonne. Cocoa Dreams closes out their futures contracts by selling them at £2,500 per tonne. Their profit on the futures contracts is (£2,500 – £2,000) * 50 tonnes = £25,000. However, they still need to purchase the 50 tonnes of cocoa beans in the spot market at the higher price of £2,500 per tonne. The cost is £2,500 * 50 tonnes = £125,000. Without hedging, Cocoa Dreams would have paid £125,000. With hedging, they paid £125,000 in the spot market, but made £25,000 on the futures market, effectively reducing their net cost to £100,000. This demonstrates how hedging can protect against adverse price movements. Now, let’s say Cocoa Dreams entered into a swap agreement instead of futures. They agree to pay a fixed price of £2,000 per tonne for 50 tonnes of cocoa in six months. At the end of the six months, the spot price is £2,500. In this scenario, the swap counterparty would pay Cocoa Dreams the difference between the spot price and the fixed price for the 50 tonnes. This would be (£2,500 – £2,000) * 50 tonnes = £25,000. Cocoa Dreams then buys the cocoa at the spot price of £2,500 per tonne. The net cost is £125,000 – £25,000 = £100,000, identical to the futures outcome. Finally, consider Cocoa Dreams using a cocoa call option. They buy 50 call options, each representing 1 tonne of cocoa, with a strike price of £2,000 per tonne and a premium of £100 per tonne. If the spot price rises to £2,500, they exercise the options, buying cocoa at £2,000 per tonne. Their profit is (£2,500 – £2,000) * 50 tonnes = £25,000, less the premium cost of £100 * 50 tonnes = £5,000, resulting in a net profit of £20,000. Their total cost is the strike price (£2,000 * 50) plus premium (£5,000) = £105,000. If the spot price remained below £2,000, they would let the options expire worthless, losing only the premium.

The core of this question revolves around understanding how basis risk arises in hedging strategies using commodity derivatives, particularly when the commodity underlying the derivative doesn’t perfectly match the commodity being hedged. Basis is the difference between the spot price of an asset and the price of a related futures contract. Basis risk is the risk that this difference will change over time, making a hedge less effective. The scenario involves a bespoke biodiesel producer in rural Scotland. They need to hedge their feedstock costs, specifically used cooking oil (UCO). However, there isn’t a futures contract specifically for UCO. Instead, they consider hedging with a Brent Crude oil futures contract, which is a liquid and widely traded commodity derivative. This introduces basis risk. To calculate the expected profit/loss, we need to consider the change in both the UCO price and the Brent Crude price, and how these changes impact the hedge. 1. **Calculate the change in UCO cost:** The UCO price increases from £750/tonne to £780/tonne, resulting in an increased cost of £30/tonne. For 500 tonnes, this is a total increased cost of £30/tonne * 500 tonnes = £15,000. 2. **Calculate the profit/loss on the Brent Crude futures:** The Brent Crude price increases from $80/barrel to $82/barrel, a change of $2/barrel. Each contract represents 1,000 barrels, so each contract gains $2,000. With 10 contracts, the total gain is $20,000. We need to convert this to GBP using the exchange rate. 3. **Convert USD gain to GBP:** The exchange rate is $1.25/£. Therefore, the $20,000 gain is equivalent to £20,000 / 1.25 = £16,000. 4. **Calculate the net profit/loss:** The increased cost of UCO is £15,000, and the gain on the futures contracts is £16,000. Therefore, the net profit is £16,000 – £15,000 = £1,000. This example highlights that even with a hedge, the biodiesel producer isn’t perfectly protected due to basis risk. The Brent Crude price didn’t move exactly in line with the UCO price. The question tests the understanding of basis risk, hedging mechanics, and the importance of considering the correlation between the underlying asset and the hedging instrument. It also introduces a practical, real-world scenario relevant to the commodity derivatives market.

The core of this question lies in understanding the implications of contango in commodity markets and how different hedging strategies perform under such conditions. A key concept is that in contango, futures prices are higher than spot prices, and this difference represents the cost of carry (storage, insurance, financing). A producer hedging in a contango market will generally lock in a price that is higher than the current spot price, but they face the risk that the futures price converges towards the spot price as the contract nears expiration, potentially eroding their profit. Let’s analyze the potential outcomes for each hedging strategy: * **Selling Futures Contracts:** This is the classic hedging approach for producers. In contango, they initially benefit from the higher futures price. However, as the contract approaches expiration, the futures price will likely decrease towards the spot price, resulting in a loss on the futures contract. This loss offsets some of the revenue from selling the physical commodity at the spot price, but the initial higher futures price provides some protection. * **Buying Call Options on Futures:** This strategy provides price protection above a certain strike price while allowing the producer to benefit if prices rise significantly. However, in a contango market, the call options are likely to be more expensive due to the higher futures prices. If the spot price remains stable or decreases, the call options may expire worthless, resulting in a loss of the premium paid. * **Buying Put Options on Futures:** This strategy provides downside protection by setting a floor on the selling price. In contango, the put options might be cheaper since the futures prices are already elevated. If the spot price falls below the strike price at expiration, the put option will be exercised, offsetting the loss from selling the physical commodity at the lower spot price. * **Entering into a Forward Contract:** A forward contract is a customized agreement to sell the commodity at a specified price and date in the future. In contango, the forward price will reflect the higher futures prices. However, unlike futures contracts, forward contracts are not marked-to-market daily. This means the producer does not experience the daily fluctuations in price. The producer locks in a known price at the outset, providing certainty about future revenue. In this scenario, the forward contract provides the most predictable outcome in a contango market. While the initial futures price is attractive, the convergence risk makes the forward contract a safer choice for hedging, providing price certainty without the daily volatility.

To solve this problem, we need to understand how storage costs and convenience yield affect the relationship between spot prices and futures prices. The convenience yield represents the benefit of holding the physical commodity rather than a futures contract, such as the ability to profit from temporary local shortages or to continue production without interruption. Storage costs directly increase the cost of holding the physical commodity. The futures price \(F\) is related to the spot price \(S\) by the following formula: \[ F = S e^{(r + u – c)T} \] Where: – \(r\) is the risk-free interest rate – \(u\) is the storage cost per unit time – \(c\) is the convenience yield per unit time – \(T\) is the time to maturity of the futures contract Given: – Spot price \(S = £500\) per tonne – Risk-free interest rate \(r = 5\%\) per annum – Storage costs \(u = 3\%\) per annum – Convenience yield \(c = 2\%\) per annum – Time to maturity \(T = 6\) months = 0.5 years Plugging the values into the formula: \[ F = 500 \times e^{(0.05 + 0.03 – 0.02) \times 0.5} \] \[ F = 500 \times e^{(0.06 \times 0.5)} \] \[ F = 500 \times e^{0.03} \] \[ F = 500 \times 1.03045453 \] \[ F = 515.23 \] Therefore, the theoretical futures price is approximately £515.23. The convenience yield reflects the market’s expectation of future supply tightness. A higher convenience yield implies that market participants place a greater value on having the physical commodity readily available, which can occur when there are concerns about supply disruptions or strong immediate demand. The storage costs directly impact the futures price by increasing the cost of carry. If storage costs were significantly higher, the futures price would be higher relative to the spot price, reflecting the increased expense of holding the physical commodity. Conversely, if the convenience yield were higher, it would reduce the futures price relative to the spot price, as the benefit of holding the physical commodity would offset some of the cost of carry. The interplay between these factors determines the shape of the futures curve (contango or backwardation) and influences hedging and speculation strategies in commodity markets. The risk-free interest rate also plays a role, as it represents the opportunity cost of tying up capital in the commodity.

The core of this question lies in understanding how a contango market structure interacts with storage costs and the decision-making process of a commodity trader. A contango market, where future prices are higher than spot prices, incentivizes storage, but this incentive is offset by the costs associated with that storage. The trader needs to evaluate if the future price adequately compensates for these storage costs, including financing, insurance, and physical storage. First, we calculate the total storage cost per tonne over the 6-month period. This includes the financing cost, which is the spot price multiplied by the interest rate and the time period: \(1000 \times 0.05 \times 0.5 = 25\). Then we add the insurance cost of \(5\) and the physical storage cost of \(15\), giving a total storage cost of \(25 + 5 + 15 = 45\). Next, we determine the implied future price based on the spot price and storage costs. This is simply the spot price plus the total storage cost: \(1000 + 45 = 1045\). Finally, we compare the actual future price (\(1060\)) with the implied future price (\(1045\)). Since the actual future price is higher than the implied future price, the trader can lock in a profit by buying the commodity in the spot market, storing it, and selling it in the futures market. The profit per tonne is the difference between the actual future price and the implied future price: \(1060 – 1045 = 15\). A crucial element is recognizing that the trader is essentially arbitraging the difference between the spot and futures markets, capitalizing on the contango structure and storage economics. The trader is not merely speculating on price movements but rather exploiting a temporary mispricing between the spot and futures contracts. This arbitrage opportunity exists because the market price of the futures contract is higher than the cost of carrying the physical commodity to the future delivery date. Ignoring any of the storage costs would lead to an incorrect assessment of the profitability of this strategy. Understanding the impact of regulation, like position limits or margin requirements, is crucial in real-world application.

The core of this question lies in understanding how basis risk arises in hedging strategies, particularly when the commodity underlying the futures contract differs from the commodity being hedged. Basis risk is the risk that the price of the asset being hedged and the price of the hedging instrument (in this case, a futures contract) do not move perfectly in tandem. This imperfect correlation can arise due to differences in location, quality, or timing. The formula to calculate the effective price received after hedging is: Effective Price = Spot Price at Liquidation + (Initial Futures Price – Futures Price at Liquidation). The basis is the difference between the spot price and the futures price. In this scenario, the coffee farmer is hedging Arabica coffee beans using Robusta coffee futures. The initial basis is £350/tonne (Spot Arabica – Futures Robusta = £4,350 – £4,000). When the hedge is lifted, the basis has narrowed to £200/tonne (Spot Arabica – Futures Robusta = £4,500 – £4,300). This narrowing of the basis means the futures contract has gained relative to the spot price. The farmer initially locked in a futures price of £4,000/tonne. However, because the basis narrowed, the farmer effectively received more than just the initial futures price. The gain from the futures contract is the difference between the initial futures price and the final futures price: £4,300 – £4,000 = £300/tonne. This gain is added to the final spot price to determine the effective price received: £4,500 + £300 = £4,800/tonne. Therefore, the narrowing basis improved the farmer’s hedging outcome. A key concept here is understanding that a *narrowing* basis is beneficial to a short hedger (like the coffee farmer), while a *widening* basis would be detrimental. The farmer sold futures contracts to hedge, so they benefit when the futures price increases more than the spot price (or decreases less than the spot price).

The core of this question revolves around understanding the impact of contango and backwardation on hedging strategies involving commodity futures, particularly within the context of a rolling hedge. The scenario describes a situation where a UK-based energy firm, subject to specific regulatory requirements (Ofgem’s oversight), seeks to manage its exposure to natural gas price volatility. The firm’s rolling hedge strategy involves continuously replacing expiring futures contracts with new ones further out in the future. In a contango market (where futures prices are higher than the expected spot price), the firm will consistently sell expiring contracts at a lower price and buy new contracts at a higher price. This results in a negative roll yield, which erodes the hedge’s effectiveness. Conversely, in a backwardation market (where futures prices are lower than the expected spot price), the firm benefits from a positive roll yield. The question challenges the candidate to assess how the market structure (contango or backwardation) and the rolling strategy impact the firm’s overall hedging outcome. Furthermore, it introduces a regulatory angle, requiring consideration of how Ofgem might view the firm’s hedging activities in light of potential cost increases passed on to consumers. To solve this, we need to understand that in contango, each roll incurs a loss. With 100,000 MMBtu hedged and a £0.05/MMBtu loss per roll over 12 months, the total loss is 100,000 MMBtu * £0.05/MMBtu * 12 = £60,000. Therefore, the expected outcome is a £60,000 loss due to the rolling hedge in a contango market. Ofgem would likely scrutinize this, especially if these increased costs are passed on to consumers.

The question assesses the understanding of the impact of contango and backwardation on hedging strategies using commodity futures, specifically within the context of a UK-based energy company navigating regulatory requirements and market dynamics. The scenario involves analyzing the implications of different market conditions (contango vs. backwardation) on the hedging effectiveness and overall cost for the energy company. The correct answer requires understanding that in a contango market, the futures price is higher than the expected spot price at delivery. This means the company will likely pay more for the futures contract than the eventual spot price, resulting in a hedging cost. In backwardation, the opposite is true, and the company could potentially profit from the hedge. The question also touches upon the regulatory pressures in the UK market that may push companies towards hedging, even if it incurs costs. The incorrect options present common misconceptions. One incorrect option suggests that hedging always guarantees profits, which is untrue, especially in contango markets. Another suggests that the company should avoid hedging altogether in contango, which ignores the regulatory drivers and risk management benefits of hedging, even if costly. The final incorrect option focuses on storage costs, which are relevant to physical commodities but less so to the direct impact of contango/backwardation on the hedge itself.

The question explores the impact of contango and backwardation on hedging strategies using commodity futures. A refinery aiming to lock in future crude oil prices faces different hedging outcomes depending on the market structure. Contango occurs when futures prices are higher than the expected spot price at delivery. This means the refinery will initially pay a higher price than the current spot price for the futures contract. However, as the contract nears expiration, the futures price converges towards the spot price. If the spot price rises less than the initial contango premium, the hedge is profitable. Conversely, if the spot price rises more than the initial contango premium, the hedge underperforms compared to simply buying on the spot market. Backwardation occurs when futures prices are lower than the expected spot price at delivery. The refinery benefits initially by paying a lower price for the futures contract. As the contract nears expiration, the futures price converges towards the spot price. If the spot price rises more than the initial backwardation discount, the hedge is profitable. If the spot price rises less than the initial backwardation discount, the hedge underperforms compared to simply buying on the spot market. The refinery’s hedging strategy’s effectiveness hinges on whether the spot price increase exceeds or falls short of the contango premium or backwardation discount. This is a critical factor in assessing the overall hedging outcome. In this specific scenario, the contango premium is \( \$5 \) per barrel. The refinery locks in a price of \( \$85 \) per barrel. If the spot price at delivery is \( \$88 \) per barrel, the refinery effectively paid \( \$85 \) per barrel instead of \( \$88 \) per barrel, saving \( \$3 \) per barrel. However, the contango premium was \( \$5 \) per barrel, meaning the hedge underperformed compared to an ideal scenario where the futures price perfectly predicted the spot price. The underperformance is \( \$5 – \$3 = \$2 \) per barrel.

Let’s consider a scenario where a UK-based artisanal chocolate maker, “Cocoa Dreams Ltd,” relies heavily on cocoa butter sourced from Ghana. Cocoa butter prices are notoriously volatile due to weather patterns and political instability in the region. Cocoa Dreams wants to protect its profit margins. They are considering using commodity derivatives to hedge against potential price increases. They are looking at futures contracts, options on futures, swaps, and forwards. Futures contracts are standardized agreements traded on exchanges, obligating Cocoa Dreams to buy cocoa butter at a predetermined price and date. Options on futures give Cocoa Dreams the *right*, but not the *obligation*, to buy (call option) or sell (put option) cocoa butter futures at a specific price (strike price) before a certain date (expiration). Swaps involve exchanging one stream of cash flows for another; in this case, Cocoa Dreams might exchange a floating cocoa butter price for a fixed price. Forwards are similar to futures but are customized, over-the-counter (OTC) agreements between Cocoa Dreams and a counterparty, like a bank. The key difference lies in the standardization, exchange trading, and margining requirements. Futures are standardized and exchange-traded, providing liquidity and transparency, but require daily margin calls. Options on futures offer flexibility but involve paying a premium. Swaps are customized and OTC, exposing Cocoa Dreams to counterparty risk. Forwards are also customized and OTC, carrying counterparty risk and potentially less liquidity. Now, consider Cocoa Dreams’ specific situation. They need a flexible solution because their production volume fluctuates seasonally. Futures might be too rigid, forcing them to buy a fixed quantity even if demand is low. Options provide flexibility but add the cost of the premium. A swap locks in a price but might not be easily unwound if Cocoa Dreams’ needs change. A forward can be tailored to their exact volume needs but carries the risk that the counterparty defaults. The crucial factor is understanding the trade-offs between standardization, flexibility, cost, and risk. The choice depends on Cocoa Dreams’ risk tolerance, financial resources, and specific hedging objectives. If they prioritize cost and are willing to accept some price risk, they might use futures. If they prioritize flexibility, they might use options, even with the premium. If they need a guaranteed price and are comfortable with counterparty risk, they might use a swap or a forward.

To determine the most suitable hedging strategy, we need to analyze the company’s exposure and the available derivative instruments. The company faces the risk of rising copper prices, impacting its profitability. Futures contracts and options on futures are potential hedging tools. Futures contracts lock in a price for future delivery, while options on futures provide the right, but not the obligation, to buy or sell futures contracts at a specific price. In this scenario, the company wants to protect against significant price increases but also wants to benefit from potential price decreases. A suitable strategy would be to purchase call options on copper futures. This gives the company the right to buy copper futures at the strike price, protecting it from prices rising above that level. If copper prices fall below the strike price, the company can let the option expire and purchase copper at the lower spot market price. The cost of the call option is the premium paid. The maximum loss is limited to the premium paid. The potential profit is unlimited if copper prices rise significantly. Let’s consider a specific example. Suppose the current copper futures price is £8,500 per tonne. The company purchases a call option on copper futures with a strike price of £8,750 per tonne, paying a premium of £250 per tonne. If, at expiration, the copper futures price is £9,000 per tonne, the company will exercise the option, buying copper futures at £8,750 per tonne. Its net profit per tonne will be (£9,000 – £8,750) – £250 = £0. If the copper futures price is £9,500 per tonne, the net profit per tonne will be (£9,500 – £8,750) – £250 = £500. If, at expiration, the copper futures price is £8,000 per tonne, the company will let the option expire. Its loss is limited to the premium paid, £250 per tonne. It can then purchase copper at the spot market price of £8,000 per tonne. Purchasing a copper futures contract would lock in a price but eliminate the benefit of potential price decreases. Selling a copper futures contract would expose the company to losses if prices rise. A put option would protect against price decreases, not increases. Therefore, buying call options on copper futures is the most suitable hedging strategy.

Let’s break down this complex scenario. First, we need to understand the impact of the unexpected geopolitical event on the oil market. A supply disruption of 1.5 million barrels per day (bpd) is significant. We can model this as a reduction in supply, leading to a price increase. The initial price increase to $95/barrel is a starting point. Next, we analyze the trader’s position. They are long 500 Brent Crude oil futures contracts, each representing 1,000 barrels. This means they effectively control 500,000 barrels of oil. They also hold 250 put options with a strike price of $90/barrel, each covering 1,000 barrels, protecting 250,000 barrels. The trader’s decision to close out 200 futures contracts at $95/barrel locks in a profit on those contracts. The initial purchase price was $88/barrel, so the profit per contract is $7/barrel, totaling $7 * 1,000 * 200 = $1,400,000. The remaining 300 futures contracts are subject to the margin call. A maintenance margin of $8,000/contract means the trader needs to maintain that amount in their account. The price drop from $95 to $92/barrel represents a loss of $3/barrel on those 300,000 barrels, totaling $3 * 300 * 1,000 = $900,000. If the initial margin was only slightly above the maintenance margin, this loss could trigger a margin call. However, the question states the broker requires additional funds of $1,000,000 to be deposited. This is a crucial piece of information. The put options provide downside protection. Since the price dropped to $92/barrel, the put options are in the money. The intrinsic value of each put option is $95 – $92 = $3/barrel, or $3,000 per contract. The total value of the put options is 250 * $3,000 = $750,000. However, these options were bought for $2,000 each, so the net profit from the options is $1,000 per contract, or $250,000. The trader’s overall position is complex. They have realized a profit of $1,400,000 on the closed futures, a potential margin call requiring $1,000,000, and a profit of $250,000 from the put options. The net impact depends on the initial margin and the broker’s specific requirements. The question asks about the most likely immediate action. Given the margin call, the trader’s primary concern is meeting that obligation. The profit from the closed futures and the put options helps, but the trader must act quickly to avoid forced liquidation.

The core of this question lies in understanding how basis risk arises in hedging strategies using commodity derivatives, particularly when the asset being hedged is not perfectly correlated with the underlying asset of the derivative. Basis risk is the risk that the price of the asset being hedged and the price of the hedging instrument (e.g., a futures contract) will not move in a perfectly correlated manner. This imperfect correlation can arise due to differences in location, quality, or timing. In this scenario, the UK-based distiller is hedging against price increases in barley, but is using a Chicago Board of Trade (CBOT) wheat futures contract. Wheat and barley prices are related, but not perfectly so, creating basis risk. To determine the impact of basis risk, we need to analyze the changes in both the spot price of barley and the futures price of wheat. The distiller bought the wheat futures contract at £200/tonne and sold it at £215/tonne, resulting in a gain of £15/tonne from the hedge. However, the price of barley increased from £180/tonne to £205/tonne, resulting in a loss of £25/tonne on the physical barley purchase. The net effect is the gain from the hedge (£15/tonne) minus the loss on the barley purchase (£25/tonne), which equals a net loss of £10/tonne. This loss is directly attributable to basis risk, as the hedge did not perfectly offset the change in the price of barley. Consider an analogy: imagine trying to heat a room with a blanket. The blanket will provide *some* insulation, but it won’t perfectly block all heat loss. The difference between the ideal temperature and the actual temperature achieved is analogous to basis risk. In our scenario, the wheat futures are the “blanket,” providing some protection against barley price increases, but not perfectly. Furthermore, the UK regulatory framework, particularly under MiFID II, emphasizes the importance of understanding and managing risks associated with commodity derivatives, including basis risk. Firms are required to assess the suitability of hedging strategies and ensure that clients understand the potential for basis risk to impact the effectiveness of the hedge. The FCA also monitors firms’ compliance with these requirements. The distiller’s hedging strategy, while seemingly logical given the correlation between wheat and barley prices, exposes them to basis risk. The example highlights the importance of carefully considering the correlation between the hedged asset and the underlying asset of the derivative, and understanding the potential impact of basis risk on the overall hedging outcome.

Let’s analyze the scenario where a junior trader at a UK-based investment firm, regulated under MiFID II, executes a series of commodity swap transactions without fully understanding the implications of position limits and reporting requirements under the Market Abuse Regulation (MAR). The trader, driven by short-term profit targets, enters into multiple Brent crude oil swaps referencing ICE Brent futures. The combined notional value of these swaps inadvertently exceeds the position limit set by the Financial Conduct Authority (FCA) for that specific commodity and delivery month. Furthermore, the trader fails to report these transactions to the FCA within the required timeframe, assuming that since the swaps are cleared through a central counterparty (CCP), the reporting is automatically handled. This assumption is incorrect, as the firm retains the responsibility for accurate and timely reporting, even with CCP clearing. The consequences involve potential fines from the FCA for exceeding position limits and failing to report transactions, reputational damage to the firm, and potential disciplinary action against the trader. The position limit violation occurs because the trader did not aggregate all positions in the same underlying commodity, including physically-settled contracts and other derivatives. The reporting failure stems from a misunderstanding of the firm’s obligations under MAR, specifically the requirement to report transactions that could potentially constitute market abuse, regardless of whether they are cleared. A key element here is understanding that while CCPs provide clearing services, the regulatory reporting responsibility rests with the trading firm. Moreover, the firm’s compliance department should have implemented controls and monitoring systems to detect such breaches and provide adequate training to traders on regulatory obligations. The trader’s focus on short-term profits at the expense of regulatory compliance highlights a failure of the firm’s risk culture. This scenario illustrates the importance of understanding position limits, reporting obligations, and the distinction between clearing and reporting responsibilities under UK regulations.

To determine the most suitable hedging strategy, we need to calculate the implied volatility of the options and compare them to the historical volatility. Implied volatility is derived from option prices, reflecting the market’s expectation of future price volatility. A higher implied volatility relative to historical volatility suggests that options are relatively expensive, favoring selling strategies. Conversely, lower implied volatility favors buying strategies. First, we need to understand the relationship between option prices, volatility, and time to expiration. Option prices increase with higher volatility and longer time horizons. The trader should calculate the implied volatility for both the near-term and deferred options using an option pricing model like Black-Scholes. The calculation involves inputting the option price, strike price, underlying asset price, time to expiration, and risk-free interest rate to solve for volatility. Let’s assume, after calculation using an option pricing model, the implied volatility for the near-term options (expiring in 1 month) is 25%, and for the deferred options (expiring in 6 months) is 35%. The historical volatility of the underlying copper contract over the past year is 28%. Comparing implied and historical volatilities, the near-term options are relatively undervalued (25% vs. 28%), while the deferred options are overvalued (35% vs. 28%). This scenario suggests a volatility skew, where longer-dated options are priced with a higher volatility premium. Given this volatility skew, the most appropriate hedging strategy is to sell the deferred options and buy the near-term options. This strategy, known as a calendar spread or time spread, aims to profit from the expected convergence of implied volatilities to historical volatility. As the deferred options’ implied volatility decreases and the near-term options’ implied volatility increases, the trader can close the positions at a profit. The trader should also consider the cost of carry, which includes storage costs, insurance, and financing costs. These costs can impact the profitability of the hedge, particularly for physical commodities like copper. The trader must ensure that the potential profit from the volatility spread outweighs the cost of carry. Finally, the trader should monitor the market conditions and adjust the hedge as needed. Unexpected events, such as supply disruptions or changes in demand, can significantly impact commodity prices and volatility.

The core of this question revolves around understanding the implications of basis risk in commodity hedging, particularly when using futures contracts. Basis risk arises because the price of the futures contract (for delivery at a specified future date) may not move in perfect lockstep with the spot price (the price for immediate delivery) of the commodity being hedged. This difference, the basis, can fluctuate due to factors like storage costs, transportation bottlenecks, and localized supply/demand imbalances. The calculation involves determining the effective price achieved after hedging, considering the initial basis, the change in the basis, and the final spot price. The formula is: Effective Price = Final Spot Price + (Initial Basis – Final Basis). The initial basis is the futures price minus the spot price at the time the hedge is initiated. The final basis is the futures price minus the spot price at the time the hedge is lifted. In this scenario, a positive initial basis (futures price higher than spot price) indicates a contango market. A narrowing basis (the difference between futures and spot prices decreases) means the futures price is decreasing relative to the spot price, or the spot price is increasing relative to the futures price. The effective price is calculated to assess the success of the hedge. If the effective price is higher than the price the company wanted to achieve, the hedge has been less effective than anticipated due to the adverse movement in the basis. Consider a farmer hedging their wheat crop. They want to lock in a price of £200/tonne. The December wheat futures are trading at £210/tonne, while the current spot price is £205/tonne (initial basis of £5). The farmer sells December futures. When they harvest and sell their wheat in December, the spot price is £220/tonne, and the December futures are trading at £222/tonne (final basis of £2). The effective price is £220 + (£5 – £2) = £223/tonne. While they made more than expected, the basis risk prevented them from perfectly locking in their target price. Another example: an airline hedges jet fuel. They want to lock in a price of $80/barrel. The nearby futures contract is at $85/barrel, spot is $82/barrel (initial basis of $3). As the hedge nears expiry, the spot is $90/barrel, and the nearby futures are $91/barrel (final basis of $1). Effective price is $90 + ($3 – $1) = $92/barrel. Again, the basis risk resulted in a higher-than-anticipated effective price.

To determine the profit or loss from the swap, we need to calculate the total payments made and received over the swap’s lifetime. The fixed payments are straightforward: the fixed rate multiplied by the notional principal for each payment period. The floating payments, however, depend on the spot prices at each reset date. We calculate each floating payment and then sum them up. Finally, we subtract the total fixed payments from the total floating payments to find the profit (if positive) or loss (if negative). The fixed payments are 5% of £1,000,000 annually, paid quarterly, so each quarterly payment is \((0.05 / 4) * £1,000,000 = £12,500\). Over two years (8 quarters), the total fixed payments are \(8 * £12,500 = £100,000\). The floating payments are based on the spot prices provided. Each payment is calculated as the difference between the spot price and the initial price (£250), multiplied by the contract size (10 tonnes), multiplied by the number of contracts (40). The floating payments for each quarter are: * Quarter 1: \((255 – 250) * 10 * 40 = £2,000\) * Quarter 2: \((248 – 250) * 10 * 40 = -£800\) * Quarter 3: \((252 – 250) * 10 * 40 = £800\) * Quarter 4: \((258 – 250) * 10 * 40 = £3,200\) * Quarter 5: \((260 – 250) * 10 * 40 = £4,000\) * Quarter 6: \((255 – 250) * 10 * 40 = £2,000\) * Quarter 7: \((245 – 250) * 10 * 40 = -£2,000\) * Quarter 8: \((253 – 250) * 10 * 40 = £1,200\) The total floating payments are \(£2,000 – £800 + £800 + £3,200 + £4,000 + £2,000 – £2,000 + £1,200 = £10,400\). The net profit/loss is the total floating payments minus the total fixed payments: \(£10,400 – £100,000 = -£89,600\). Therefore, the counterparty has incurred a loss of £89,600. Now, let’s consider a more nuanced scenario. Imagine a commodity producer in the UK using this swap to hedge against price volatility. The producer is selling their product in GBP and wants to lock in a certain price. If the spot price falls significantly below £250, the swap will generate losses, but these losses are offset by the increased revenue from selling their actual commodity at a higher locked-in price. Conversely, if the spot price rises significantly above £250, the swap will generate profits, but these profits are offset by the reduced revenue from selling their commodity at a lower locked-in price. This illustrates how commodity derivatives, like swaps, are used to manage risk and stabilize cash flows, not necessarily to generate pure profit. The Financial Conduct Authority (FCA) in the UK closely monitors such hedging activities to ensure they are genuine and not speculative, as excessive speculation can destabilize commodity markets.

The core of this question lies in understanding how basis risk manifests in cross-hedging scenarios and the potential for losses even when the overall commodity price movement is anticipated correctly. Basis risk arises because the commodity being hedged (in this case, jet fuel) is not perfectly correlated with the commodity used for the hedge (heating oil futures). The calculation determines the net profit or loss considering the initial hedge position, the changes in both the jet fuel and heating oil prices, and the impact of basis risk. First, we calculate the profit/loss on the futures contracts: Heating Oil Futures Profit/Loss = (Selling Price – Purchase Price) * Contract Size * Number of Contracts = (\(78 \)- \(75\)) * 42,000 gallons/contract * 5 contracts = \$630,000. Next, we calculate the loss on the physical jet fuel: Jet Fuel Loss = (Purchase Price – Selling Price) * Volume = (\(80\) – \(76\)) * 210,000 gallons = \$840,000. Finally, we calculate the net profit/loss: Net Profit/Loss = Heating Oil Futures Profit/Loss – Jet Fuel Loss = \$630,000 – \$840,000 = -\$210,000. The negative result indicates a net loss. The example demonstrates that even with a well-intentioned hedge, basis risk can lead to adverse outcomes. The critical takeaway is that the effectiveness of a cross-hedge is directly tied to the correlation between the underlying asset and the hedging instrument. A lower correlation increases basis risk and the potential for the hedge to underperform or even result in a loss. In this scenario, although the airline correctly anticipated a decline in jet fuel prices and implemented a hedge, the imperfect correlation with heating oil futures resulted in a net loss due to the basis widening more than expected. This highlights the importance of carefully selecting hedging instruments and continuously monitoring basis risk.

To determine the most suitable hedging strategy, we must calculate the potential profit or loss from each strategy under both scenarios (price increase and price decrease). The optimal strategy will be the one that minimizes the risk of loss while still allowing for potential profit. **Scenario 1: Price Increase** * **Unhedged:** Profit = £2,800 – £2,500 = £300 * **Short Hedge (Futures):** * Spot Market Profit: £300 * Futures Loss: (£2.80 – £2.60) * 1000 = -£200 * Net Profit: £300 – £200 = £100 * **Long Hedge (Options – Buying Calls):** * Spot Market Profit: £300 * Call Option Profit: (£2.80 – £2.60) * 1000 – £50 = £200 – £50 = £150 * Net Profit: £300 + £150 = £450 * **Short Hedge (Swaps):** * Spot Market Profit: £300 * Swap: £2,600 – £2,500 = £100 * Net Profit: £300 – £100 = £200 **Scenario 2: Price Decrease** * **Unhedged:** Loss = £2,300 – £2,500 = -£200 * **Short Hedge (Futures):** * Spot Market Loss: -£200 * Futures Profit: (£2.60 – £2.30) * 1000 = £300 * Net Profit: -£200 + £300 = £100 * **Long Hedge (Options – Buying Calls):** * Spot Market Loss: -£200 * Call Option Loss: Since £2.30 < £2.60, the option expires worthless. Loss = -£50 * Net Loss: -£200 – £50 = -£250 * **Short Hedge (Swaps):** * Spot Market Loss: -£200 * Swap: £2,600 – £2,500 = £100 * Net Loss: -£200 + £100 = -£100 Based on these calculations, the short hedge using futures provides a consistent profit of £100 regardless of the price movement. The unhedged position is the riskiest, with a potential loss of £200. The long hedge using call options provides the highest profit in a rising market but the largest loss in a falling market. The short hedge using swaps limits the losses the most. Therefore, the best strategy depends on the risk appetite. If the company wants to minimize risk and ensure a minimum profit, the short hedge using futures is best. If the company is comfortable with some risk and wants to maximize potential profit, the long hedge using call options may be preferred. If the company wants to minimize losses and has a risk-averse attitude, the short hedge using swaps may be preferred.

Let’s break down this complex scenario. The core issue revolves around the optimal hedging strategy for a UK-based chocolate manufacturer, “ChocoBliss,” facing volatile cocoa bean prices. ChocoBliss uses a combination of cocoa futures and options to manage price risk. However, recent market disruptions due to geopolitical instability in West Africa have caused both futures and options premiums to spike, making their existing hedging strategy prohibitively expensive. The question focuses on the concept of a “basis trade” using cocoa bean forwards and futures contracts. A basis trade exploits the difference between the spot price of a commodity and the price of a futures contract for the same commodity. The “basis” is simply the spot price minus the futures price. ChocoBliss is considering a basis trade to reduce hedging costs, anticipating that the inflated futures prices will converge with spot prices as supply chain disruptions ease. To determine the profit or loss, we need to understand how the basis changes over time. If ChocoBliss buys cocoa beans forward (locking in a future purchase price) and simultaneously sells cocoa futures, they profit if the basis *strengthens* (i.e., becomes less negative, or even positive). This happens when the spot price rises relative to the futures price, or when the futures price falls relative to the spot price. Conversely, they lose if the basis *weakens*. The initial basis is £2,600 (spot) – £2,850 (futures) = -£250. The final basis is £2,700 (spot) – £2,750 (futures) = -£50. The basis strengthened by £200 (£250 – £50). Since ChocoBliss sold futures, a strengthening basis results in a profit. The profit is £200 per tonne. Now, let’s address the options. Option (a) correctly identifies that the company has made a profit. The strengthening of the basis by £200 per tonne means the futures position generated more profit than the loss on the physical cocoa. Option (b) incorrectly states a loss, misinterpreting the impact of a strengthening basis when futures are sold. Option (c) confuses the direction of the basis movement, assuming a weakening basis resulted in a profit. Option (d) incorrectly calculates the profit, failing to account for the initial and final basis difference. This question tests understanding of basis trading, hedging strategies, and the impact of market volatility on commodity derivatives.

The question assesses the understanding of the impact of contango and backwardation on hedging strategies using commodity futures, especially considering storage costs and convenience yield. * **Contango:** A situation where the futures price of a commodity is higher than the expected spot price at delivery. This usually occurs when there are significant storage costs, as market participants are willing to pay more for future delivery to avoid these costs. * **Backwardation:** A situation where the futures price of a commodity is lower than the expected spot price at delivery. This often happens when there is a high convenience yield (the benefit of holding the physical commodity). The effectiveness of a hedging strategy depends on whether the market is in contango or backwardation. In a contango market, a hedger selling futures might face losses as the futures price converges to the lower spot price. In a backwardation market, a hedger selling futures might gain as the futures price converges to the higher spot price. **Calculation:** * **Scenario 1: Contango** * Initial Futures Price: £80/barrel * Expected Spot Price at Delivery: £75/barrel * Loss on Futures Contract: £80 – £75 = £5/barrel * Storage Cost Avoided: £3/barrel * Net Loss: £5 – £3 = £2/barrel * **Scenario 2: Backwardation** * Initial Futures Price: £70/barrel * Expected Spot Price at Delivery: £75/barrel * Gain on Futures Contract: £75 – £70 = £5/barrel * Storage Cost Avoided: £3/barrel * Net Gain: £5 + £3 = £8/barrel The key is to understand how storage costs influence the overall hedging outcome. Storage costs act as an offset to losses in contango and augment gains in backwardation. In contango, you lose on the contract but save on storage. In backwardation, you gain on the contract and save on storage. The question requires integrating knowledge of market conditions (contango/backwardation), storage costs, and hedging strategies to determine the net impact on the hedger’s position. It also requires the understanding that convenience yield will affect the price of future contracts.

Let’s consider a scenario involving a UK-based energy company, “GreenPower UK,” which relies heavily on natural gas for electricity generation. GreenPower UK wants to hedge against price volatility in the natural gas market using commodity derivatives. They decide to use a combination of futures contracts and options on futures. First, GreenPower UK enters into a natural gas futures contract to purchase 1,000,000 MMBtu of natural gas at £2.50/MMBtu for delivery in six months. This locks in a price for a portion of their future gas needs. To further protect themselves from potentially higher prices while still benefiting if prices fall, they also purchase call options on natural gas futures contracts. They buy 100 call options contracts, each covering 10,000 MMBtu, with a strike price of £2.60/MMBtu, and pay a premium of £0.05/MMBtu per option. In six months, the spot price of natural gas is £2.75/MMBtu. GreenPower UK will exercise their call options because the spot price is higher than the strike price. The profit from each call option contract is (£2.75 – £2.60) * 10,000 MMBtu = £1,500. The total profit from the 100 call option contracts is £1,500 * 100 = £150,000. However, we must subtract the premium paid for the options: £0.05/MMBtu * 10,000 MMBtu/contract * 100 contracts = £50,000. Therefore, the net profit from the options is £150,000 – £50,000 = £100,000. The futures contract obligates GreenPower UK to purchase 1,000,000 MMBtu at £2.50/MMBtu. Since the spot price is £2.75/MMBtu, they are saving £0.25/MMBtu compared to buying at the spot price. This results in a saving of £0.25/MMBtu * 1,000,000 MMBtu = £250,000. The total effective cost of the natural gas is the futures contract price plus the net cost/profit from the options. In this case, the futures contract cost is locked in, and the options generated a net profit of £100,000. The savings from the futures contract is £250,000. Therefore, the overall effective price GreenPower UK paid is influenced by both the futures and options strategies. Now consider a different scenario. Suppose the spot price of natural gas in six months is £2.40/MMBtu. In this case, GreenPower UK would not exercise their call options because the spot price is lower than the strike price of £2.60/MMBtu. The options would expire worthless, and GreenPower UK would lose the premium paid for the options, which is £50,000. However, they are still obligated to purchase 1,000,000 MMBtu at £2.50/MMBtu through the futures contract. This is £0.10/MMBtu higher than the spot price, resulting in a loss of £0.10/MMBtu * 1,000,000 MMBtu = £100,000 on the futures contract. The total cost is the loss on the futures plus the premium paid for the options, which is £100,000 + £50,000 = £150,000.

The core of this question revolves around understanding the profit/loss calculation for a commodity swap, specifically a fixed-for-floating swap, and how the settlement process works. The calculation involves determining the net payment based on the difference between the fixed swap rate and the average floating rate over the settlement period, then applying this difference to the notional principal. A crucial aspect is understanding that the party paying the fixed rate benefits when the average floating rate is higher than the fixed rate, and vice versa. The question also tests understanding of the FCA’s regulatory perimeter and whether the described swap falls under its jurisdiction based on the characteristics of the counterparties involved. To calculate the profit/loss, we first determine the average floating rate: (5.1% + 5.3% + 5.5%) / 3 = 5.3%. The difference between the average floating rate and the fixed rate is 5.3% – 5.0% = 0.3%. This difference is then applied to the notional principal: 0.3% * £10,000,000 = £30,000. Since ABC Ltd. is paying the fixed rate, they will receive this amount. Regarding the FCA’s jurisdiction, the key factor is whether both counterparties are MiFID investment firms. If they are, the swap is likely within the FCA’s regulatory perimeter. If not, the swap may fall outside, depending on other factors such as whether it is traded on a regulated market or MTF. The correct answer is a) because it accurately reflects the profit ABC Ltd. makes and correctly states that the swap is likely within the FCA’s perimeter because both parties are MiFID investment firms.