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Answer: If the forward curve unexpectedly shifts to backwardation (aka, inverted forward curve), the company's net cost will be less than $290,000; i.e., the company will be better off than it planned
## Correct answer: D This is a **long hedge** on a future purchase of copper. ### Key numbers - Planned purchase amount: 4 contracts × 25,000 pounds = **100,000 pounds** - March futures price: **$2.90** - Expected December spot/futures price: **$3.00** If the basis converges to zero as expected, the futures gain offsets the higher purchase price, so the **net cost** is: \[ 100{,}000 \times 2.90 = 290{,}000 \] ### Basis and long hedges For a **long hedge**: - **Weaker basis** means a lower final effective cost. - **Stronger basis** means a higher final effective cost. ### Evaluate the statements - **A**: True. A weaker basis reduces the net cost. - **B**: True. A stronger basis increases the net cost. - **C**: True. If basis goes to zero, the effective cost is locked in at the futures price. - **D**: False. A shift to **backwardation** implies a stronger basis relative to the initial contango situation, which would tend to **increase** the net cost, not reduce it. So the false statement is **D**.
Author: Manit Arora
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Q-710.3. It is currently March, and a company plans to purchase copper in December. The spot price of copper is $2.80 in March while the December futures contract price is $2.90; i.e., the forward curve is "in contango" with a -$0.10 basis. A company employs a long hedge on the assumption that the futures price will converge to the spot price in December when the contract matures. The company's future "net cost" will include the cost to purchase copper at the future prevailing spot price plus (or minus) the gain (or loss) on the futures position. The company anticipates the spot/futures price will be $3.00 in December. The company goes long four contracts, each for 25,000 pounds of copper.
http://www.cmegroup.com/trading/metals/base/copper_contract_specifications.html
Under these assumptions, each of the following statements is true EXCEPT, which is false?
A
If the basis unexpectedly weakens, the company's net cost will be less than $290,000; i.e., the company will be better off than it planned
B
If the basis unexpectedly strengthens, the company's net cost will be more than $290,000; i.e., the company will be worse off than it planned
C
If the basis converges to zero as expected, the company's net cost will be $290,000 regardless of whether the spot price increases or decreases
D
If the forward curve unexpectedly shifts to backwardation (aka, inverted forward curve), the company's net cost will be less than $290,000; i.e., the company will be better off than it planned
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