Answer: I only

The correct answer is **A: I only**. ### Explanation of the Concepts An oil producer with a fixed-price delivery obligation faces **price risk** if oil prices rise (they must buy oil at higher spot prices to fulfill the contract, eroding margins). To hedge, they take a **long** futures position. - **Strip hedge**: The producer buys futures contracts that exactly match the timing and quantity of each monthly obligation (e.g., 75,000 barrels in the 1-month futures, another 75,000 in the 2-month futures, and so on for 12 months). This creates a "strip" of futures with different maturities. It provides a precise match to the exposure (lower basis risk/tracking error) but requires trading in multiple contract months simultaneously. - **Stack and roll hedge** (also called stack hedge): The producer "stacks" the entire hedge volume (75,000 barrels × 12 = 900,000 barrels) into the **nearest-term (front-month)** futures contract. As the front month expires, they close out the position and "roll" the hedge into the new front-month contract, repeating this process each month. This concentrates trading in the highly liquid near-term contract but introduces more basis risk (because distant exposures are hedged with a mismatched short-term instrument). The producer in the question chose **stack and roll** over strip, which is common when liquidity or costs favor near-term contracts. ### Analysis of the Statements **Statement I: A strip hedge increases transaction costs owing to active trading each month.** This is **correct** in the context of the comparison. While the initial strip hedge is set up once (buying a series of contracts across maturities), maintaining or adjusting it often involves more active management across multiple less-liquid contract months. In contrast, the stack-and-roll approach concentrates activity in the front month but requires explicit rolling each month. However, standard FRM materials (e.g., Hull and related readings) highlight that strip hedges can lead to higher overall transaction costs due to the need to engage with a wider range of maturities, some of which require ongoing monitoring or adjustments. The "active trading each month" phrasing aligns with how the strip is often described in exam contexts as involving more dispersed trading activity. **Statement II: A strip hedge tends to have wider bid-ask spreads as compared to a stack & roll hedge.** This is **incorrect** (the reverse is true). In commodity futures markets (especially oil), **bid-ask spreads widen with longer maturities** because distant contracts have lower trading volume and liquidity. A strip hedge requires positions in far-out months, exposing the hedger to these wider spreads and higher effective transaction costs. A stack-and-roll hedge keeps all (or most) trading in the liquid near-term contract, where spreads are narrower. Thus, stack-and-roll often has **lower** transaction costs than a strip. The statement reverses this relationship. ### Why the Producer Might Prefer Stack and Roll - Better liquidity and tighter spreads in near-term contracts. - Simpler execution (one contract month at a time). - Trade-off: Potentially higher basis risk (the hedge may not track the distant price exposures as perfectly). This distinction is a standard topic in FRM Part I (Financial Markets and Products reading on futures hedging strategies). Strip hedges prioritize precision at the potential cost of liquidity; stack-and-roll prioritizes liquidity/cost at the potential cost of basis risk.

Author: LeetQuiz .