6. Risk of Rolling Over (17 points total) In this problem, you will work through a very sim- ple example showing the risk with using short-dated futures contracts. You want to hedge against the price movements for 1,000 barrels of crude oil in one year (September next year). You decide to go long one seven month contract (April) with the in- tention to close out the position in six months (March), and roll over into a new seven month contract (October next year) at that time. Suppose the April contracts currently trade for $55 per barrel, and suppose there are four possible outcomes in March. The four outcomes in March are listed below (with all prices ex- pressed per barrel): 1A "widget" is a placeholder name for a manufactured item. It is used broadly in economics when we do not want to specify an actual product that exists. 2 October Contract Outcome 1 Outcome 2 Outcome 3 Outcome 4 Spot Price (in March) April Contract $54 $54 $54 $55 $55 $56 $56 $56 $53 $55 $58 $56 For simplicity, assume that when you close out the October contract next September, the forward price of the contract equals the spot price at the time. Also, for this problem, ignore any effects from discount rates, and only track total gains and losses over the lifetime of each contract. (a) (6 points) For each possible outcome, write down the total amount paid using the hedging strategy. Make sure you include rolling over the contract, closing out the second contract, and buying 1,000 barrels of oil. Let S denote the spot price of oil next September. Hint: S should not show up in your answer! That's the point of hedging. (b) (6 points) From your analysis above, what pattern of prices is costly to you? Explain why in a few sentences. (C) (5 points) Is there any other risk in this strategy? Hint: think about margin calls. 6. Risk of Rolling Over (17 points total) In this problem, you will work through a very sim- ple example showing the risk with using short-dated futures contracts. You want to hedge against the price movements for 1,000 barrels of crude oil in one year (September next year). You decide to go long one seven month contract (April) with the in- tention to close out the position in six months (March), and roll over into a new seven month contract (October next year) at that time. Suppose the April contracts currently trade for $55 per barrel, and suppose there are four possible outcomes in March. The four outcomes in March are listed below (with all prices ex- pressed per barrel): 1A "widget" is a placeholder name for a manufactured item. It is used broadly in economics when we do not want to specify an actual product that exists. 2 October Contract Outcome 1 Outcome 2 Outcome 3 Outcome 4 Spot Price (in March) April Contract $54 $54 $54 $55 $55 $56 $56 $56 $53 $55 $58 $56 For simplicity, assume that when you close out the October contract next September, the forward price of the contract equals the spot price at the time. Also, for this problem, ignore any effects from discount rates, and only track total gains and losses over the lifetime of each contract. (a) (6 points) For each possible outcome, write down the total amount paid using the hedging strategy. Make sure you include rolling over the contract, closing out the second contract, and buying 1,000 barrels of oil. Let S denote the spot price of oil next September. Hint: S should not show up in your answer! That's the point of hedging. (b) (6 points) From your analysis above, what pattern of prices is costly to you? Explain why in a few sentences. (C) (5 points) Is there any other risk in this strategy? Hint: think about margin calls
