Question 1: Which one has the basis risk: 1) commodity swap with long-term contract. 2) commodity swap with near term contract (It is actually a question in the Schewesr notes, the one right after SS 11, the answer should be near term. I do not know why? Could anyone help to explain?) Question 2: Non- storable commodities like agriculture are negatively correlated with inflation. (Why? I am now seeing the inflation and agriculture price both booming.)
Joey to the rescue…
If I read your question correctly, the near term futures contract may have to be rolled. This would create basis risk if the maturities don’t line up. In answer to your ag commodity question, there is a difference between unexpected inflation and shifts in the demand curve putting semi-permanent pressure on prices. There are a number of theories out there on ag inflation, but there seems to have been a clear shift upwards in the demand curve.
Doesn’t basis risk occur only if you terminate the contract before maturity? If you hold on till maturity there should be no basis risk.
Basis risk occurs if (1) if hedge is unwound before the contract maturity, or (2) if the commodity is being hedged by something that is only imperfectly correlated (proxy hedge). I feel there is not enough information given in the question you posted. As to the second question - I think the key word here is non-storable: if you cannot store it , e.g. bananas, you have to sell it at whatever cost within reasonable time. This pressure on disposal should create a downward pressure on price. This is my common sense answer, which may be at odds with the economic theory.
Basis risk is higher for a near-term contract b/c I believe the volatility of the contact is higher the closer to expiration. The Longter-term contract is less volatile…
What’s the question here? Is the question something comparing a commodity swap with a long-term futures contract vs rolling a short-term futures contract? With just this much information, it’s tough to say. A commodity swap has lots of differences with a futures contract. In particular, a huge number of commodity swaps are based on average price instead of end of the period price. Commodity swaps are based off spot price indexes and futures contracts are based on, uh, futures prices.
Oh and the negative correlation between non-storable commodities and inflation - where did you get that from? I don’t think it’s true.
JoeyDVivre Wrote: ------------------------------------------------------- > Oh and the negative correlation between > non-storable commodities and inflation - where did > you get that from? I don’t think it’s true. From Schweser’s notes: LOS 34. o Book 4 page 30, it mentioned livestock, wheat and corn are negatively correlated with inflation.
I think it’s just not true. In particular, I would say Live Cattle has a really high positive correlation to inflation (like 0.5 or something). Wheat and corn I would say have low positive correlations. Not that I have actually calculated it anytime recently…
I agree. Well, I will ignore this question, as I can not find it in the CFAI book.
I think non storable where referring to Corn and wheat and such vs. Gold etc.
Vulture Wrote: ------------------------------------------------------- > If I read your question correctly, the near term > futures contract may have to be rolled. This > would create basis risk if the maturities don’t > line up. Agree but will the long term one not have similar problem? The long-term one needs to be unwound before expirary, which I thought also means basis risks? I thought I understand basis risk after CFAAtlanta’s explanation but … >.< - sticky
I would also like to quote the full question from Schweser (p.71, book 4). Which of the following is NOT an example of basis risk? Purchasing: A. an oil contract with delivery in a different geographical region. B. a commodity with a desired distant delivery with near term contracts. C. a Eurodollar contract, due to lack of commodity futures D. a commodity with a desired distant delivery with long-term contracts Answer, as mentioned above, is D. Now if I go through each of these choices … (A) has basis risk, because there is risk that the oil is delivered in an undesirable physical location which, say, is too costly to reach. © has basis risk, because the relative value between Eurodollar and the commodity can change. How about (B) and (D)? Why is there no basis risk with (D) but (B)? - sticky
Well, I’m not going to defend the “no basis risk” part of D but B surely has basis risk because they are simply different commodities. For example, suppose I am hedging September corn with May contracts. I’m hedging corn growing in the fields with corn in grain storage facilities. Lots of basis there
D is the BEST (not perfect) answer with some possibility of no basis risk. In other cases, there is basis risk.
Thanks, JoeyDVivre and CFAAtlanta!! - sticky
2 Points here. #1 is how close the contract is to the asset as a hedge, if you are using it as a proxy you certainly have basis risk and it’s high, for instance, Oil for Jet fuel, close but not perfect and there will potentially be separate sets of idiosyncratic factors affecting both. If you use more distant futures contracts to hedge and asset and have to say terminate the hedge as you decide to sell a commodity you are faced with basis risk as supply and demand factor could have created a backwardian situation, which is certainly a negative. Also factors such as like storage costs or the risk free rate could have came in and the lease rate could have increase (while your not leasing out your commodity), also having a negative effect, if the hedge was planned to be a longer term one.