Consider the example of an oil refiner that contacts a bank asking for the price for the purchase of oil in, say, 12 months. The price quoted by the bank is not a forecast of where it thinks the price of oil will trade at the time of delivery. The bank will quote a price which depends on the cost of hedging the bank's own exposure. This is another example of the application of cash flow engineering to derivatives products. The cost of the product will be a function of the cost of the hedge. To avoid the risk of a rise in the price of oil, the bank would enter a series of transactions on the trade date to hedge its risk. Since the bank is agreeing to sell a fixed amount of oil in the future, it must first fund the purchase of oil in the spot market now and store the oil until delivery. Oil is traded in US dollars. The spot oil purchase could be financed by borrowing in US dollars at LIBOR from another bank. The bank buys the agreed amount of oil in the spot market from another institution, say another investment bank or an oil producer. The bank also incurs storage and insurance costs to store the oil until delivery. The above example is framed in the context of a bilateral OTC forward contract, but the same principle also applies to an oil futures contract.

• Apply contractual equation to create synthetic commodities for this example. (10 Points)
• Show the implied cash flows associated with a long futures and a synthetic long futures position (ignoring margin payments). ( 10 Points)
• Use your answer for A to create the synthetic spot: ( 10 Points)