Table of Contents
CFA Level 3 – Alternative Investment, Session 13 – Reading 33
(Notes, Practice Questions, Sample Questions)
1. Which of the following commodities is very difficult to store and transport?
A)Oil.
B)Corn.
C)Natural gas
Explanation — C — Natural gas is expensive to store and demand in the United States peaks during high periods of use in the winter months. In addition, the price of natural gas is different for various regions due to high international transportation costs
2. Which of the following commodities is an example of constant production and seasonal demand?
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A)Natural gas.
B)Corn.
C)Oil
Explanation — A — Natural gas is an example of a commodity with constant production, but seasonal demand
3. Patsy Cain works in the alternative investment division for a global investment bank. This morning she received a questionnaire from Michael Garland, a computer-industry executive looking for someone to handle a portion of his investment portfolio. Cain had sent him the questionnaire a week ago in an effort to determine whether he was a good candidate for money management.
When asked about his investment experience, Garland responded that he has been actively investing in a variety of asset classes for more than 30 years, with considerable success overall. Tax issues are a concern, as Garland receives a large amount of dividend income from the company he owns and he also operates several charitable foundations funded by both himself as well as outside donors.
Garland also wrote that he does not like gambling or tobacco companies and can afford to tie up his money for no more than five years because he intends to retire at that time.
After Cain returns the questionnaire, Garland calls for an appointment. When he meets with Cain, he explains that another manager has done a fine job with his stocks and bonds, but he is not happy with the performance of his alternative investments and wants her to manage them. Cain still is not sure what kind of investments would be best for Garland, so she asks him to rank his investment goals in order of importance. They are:
Returns.
Diversification.
Ease of tracking.
Garland is very interested in commodities. He owns a chemical company that makes food additives and flavorings, and he uses a lot of corn and other grains in his products. Rather than buy grains at market prices, Garland would like to purchase quantities of grain for his own use, store it in his own warehouse, and sell any excess. Alternatively, he could use futures contracts to guarantee prices for purchases at a future date.
Cain decides that Garland is a likely candidate for commodity investments. When she suggests futures to him, Garland explains that he got burned on a natural-gas investment once and is nervous about commodities because of their price volatility. Cain advises him to stick with oil futures rather than natural-gas futures, offering four reasons for the advice:
“Oil prices are similar worldwide, while natural-gas prices differ by region.”
“Seasonal trends in oil prices are well documented.”
“Forward prices for oil tend to be less volatile than prices for natural gas.”
“Oil is easier to transport than natural gas.”
Garland is also interested in hedge funds, though he is concerned about their potential volatility. Cain makes a mental note to assemble a list of hedge funds with high Sharpe ratios. Hedge funds appeal to Garland mostly because of their willingness to take both long and short positions. He postulates that a hedge fund that takes only long positions might as well be a mutual fund. Which of the following statements about oil and natural-gas futures is least accurate?
A)”Forward prices for oil tend to be less volatile than prices for natural gas.”
B)”Oil prices are similar worldwide, while natural-gas prices differ by region.”
C)”Seasonal trends in oil prices are well documented.”
Explanation — C — Oil prices do not follow seasonal trends, though natural-gas prices do. Both remaining statements are true
4. Based only on Garland’s three stated investment goals, his best option is:
A)publicly traded real-estate equity units.
B)oil futures.
C)a market-neutral hedge fund.
Explanation — A — Real estate, private equity, and hedge funds can all boost returns, though commodities are more often used as a diversification tool. Real estate and hedge funds offer substantial diversification benefits, but private equity investments tend to move with the stock market. Hedge fund performance is difficult to track, but the changing value of a publicly traded real-estate fund is easy to track. While real estate investments are not the best return generators, they have performed well in recent years, and they are very good for diversification. As such, the real estate equity units represent the best option
5. In selecting hedge funds for Garland, Cain should avoid:
A)hedged-equity funds.
B)emerging-market funds.
C)merger-arbitrage funds
Explanation — B — Most emerging markets do not permit short positions, and Garland only wants hedge funds that take short positions. Both remaining fund strategies generally involve long-short combinations
6. With regard to measuring the volatility of hedge funds, which of the following is least likely to be a limitation of the Sharpe ratio?
A)funds with large private-equity positions will appear less volatile than they actually are.
B)its time-dependency makes volatility appear higher over long periods.
C)it is not effective for selecting good hedge-fund investments
Explanation — B — The Sharpe ratio is time-dependent, but the ratio rises when calculated using longer time periods, suggesting that volatility appears lower, not higher. Both remaining statements reflect limitations of the Sharpe ratio
7. Based on Garland’s response to the questionnaire, the issue most likely to cause Cain NOT to take him on as a client is:
A)suitability.
B)decision risk.
C)tax complexities
Explanation — B — Garland’s responses suggest he is sophisticated and wealthy, quite suitable for alternative-asset investments. His private-equity ownership and complex tax situation are issues Cain must address, but they are not uncommon, and certainly no reason not to take him on as a client. That leaves decision risk. Garland’s answers gave no hint about whether he is loss-averse or likely to make quick and emotional decisions. Since both remaining answers are not reasons for concern, the biggest worry must be the information he did not provide relating to decision risk
8. Regarding Garland’s plan to purchase grain for his company’s use, Cain should begin by advising him about:
A)convenience yield.
B)lease rates.
C)storage costs.
Explanation — A — Garland is interested in selling the excess grain, not lending it, so lease rates are not relevant. Storage costs may be an issue, though in some cases the company could have no measurable storage costs. However, the company is likely to know its own costs, and there is probably little reason for Cain to advise Garland on this topic. The convenience yield reflects the value of a commodity held by an investor for nonmonetary return, and affects the price an investor should pay for a commodity.
9. It is currently August and the spot price of soybeans is $6.02/bushel. Storage costs for soybeans on a continuously compounded basis are $0.39/bushel annually. The appropriate continuously compounded interest rate is 8%. If a soybean farmer has just finished harvesting his crop but would like to sell half of the crop in November and half in February by going short futures contracts, which of the following statements is most accurate? The farmer should store his crop only if the November futures contract price is at least:
A)$6.77/bushel and the February futures contract price is at least $6.27/bushel.
B)$6.14/bushel and the February futures contract price is at least $6.27/bushel.
C)$6.24/bushel and the February futures contract price is at least $6.47/bushel.
Explanation — C — Calculate the price of the November (3-month) and February (6-month) forward prices using the following pricing formula which accounts for storage costs:
Storage costs (λ) = .39/6.02 = 6.48% Forward prices (FO,T) = SOe(RF+λ)T FO,0.25 = 6.02e(0.08 + 0.0648)(.25) = $6.24 FO,0.50 = 6.02e(0.08 + 0.0648)(.50) = $6.47
The soybean farmer would only be willing to store half the crop until November if the November futures contract price is at least $6.24/bushel. Similarly, the soybean farmer would only be willing to store the other half of the crop until February if the February futures contract price is at least $6.47/bushel
10. Which of the following statements regarding lease rates is least accurate? The lease rate is:
A)earned whether or not the underlying commodity is actually loaned.
B)the amount of interest a lender of a commodity requires.
C)the amount of return the investor requires who has bought and then lent a commodity
Explanation — A — The lease rate can only be earned by actually lending the underlying commodity
11. A producer of soybean meal and soybean oil wishes to hedge with soybean contracts. The convenience yields and storage costs for soybean meal and soybean oil are significantly different from that of soybeans. Which of these differences, if any, could be a source of basis risk?
A)Both convenience yields and storage costs.
B)Convenience yields only.
C)Neither convenience yields nor storage costs
Explanation — A — Basis risk is the result of imperfect hedges. Differences in both convenience yields and storage costs would result in increased basis risk
12. Soybeans have seasonal production but constant demand throughout the year. Soybean forward contracts currently have an upward sloping forward curve. Under these conditions, we would expect the forward curve to:
A)decrease until harvest time and then drop more sharply at harvest time.
B)increase until harvest time and then drop sharply at harvest time.
C)decrease until harvest time and then increase sharply at harvest time
Explanation — B — Soybeans are produced in the fall of every year, but they are consumed throughout the year. In order to meet consumption needs, soybeans must be stored. Thus, interest and storage costs need to be considered. Soybean prices will fall as it is being harvested and then rise to reflect the cost of storage over the next 12 months until it is harvested again. Thus the forward curve is increasing until harvest time and then it drops sharply and slopes upward again after harvest time is over
13. Jill Mahoney, CFA, has noticed that the forward prices for a given commodity have exhibited contango. Regulatory changes concerning the storage of the underlying commodity have recently increased the storage costs. This will most likely lead to:
A)a steeper forward curve and continued contango.
B)a flatter forward curve but contango will still exist.
C)a flatter forward curve and possibly normal backwardation
Explanation — A — Storage costs can produce contango, which means the distant delivery prices for futures exceed spot prices in the commodity market. An increase in the storage costs will increase the futures prices and the slope of the forward curve
14. Which of the following statements regarding the convenience yield is least accurate?
A)The forward price may appear higher at times, when the convenience yield is not considered.
B)The convenience yield can be earned by the average investor who does not have a business reason for holding the commodity.
C)The commodity borrower is willing to pay the value of the convenience yield less the cost of storage
Explanation — B — The convenience yield cannot be earned by the average investor who does not have a business reason for holding the commodity
15. Which of the following statements regarding commodity spreads is least accurate?
A)A trader creates a crush spread by holding a long position in soybeans and a short position in soybean meal and soybean oil.
B)The difference in prices of crude oil, heating oil, and gasoline is known as a crush spread.
C)A commodity spread results from a commodity that is an input in the production process of other commodities
Explanation — B — The difference in prices of crude oil, heating oil, and gasoline is known as a crack spread
16.1 Granite Investment Bank provides investment and risk management advice to large investors. Granite also advises corporations on the issuance of securities. Jill Carr is a senior portfolio manager for the firm.
One of Granite’s corporate clients, Argyle Inc., is planning to issue a USD10 million, 5-year, floating-rate bond. The firm has an AA credit rating and expects to pay a 125 bp premium to comparable maturity Treasuries (which currently have a 4.2% yield to maturity). Argyle’s CFO, Tom Davis, is concerned about increases in interest rate volatility and a possible increase in interest rates, but believes the spread to Treasuries will remain constant.
Granite also has an investor who would like to hedge the credit risk of a bond using either a binary credit put option or credit spread call option. The semi-annual bonds were issued at par by the Stedman Corporation with a 5.5% coupon and an original 5-year maturity.
The strike price on the put option is 200 bp to comparable maturity Treasuries. The credit spread call option has a strike spread of 190 bp, a notional principal of USD10 million, and specifies the benchmark rate as the 4-year Treasury rate with a risk factor of 3.2.
After one year has passed, the bond’s rating has decreased to BBB, the yield to maturity (YTM) on 4-year Treasuries has fallen to 3.9%, and the Stedman bonds are trading with a YTM of 6.2%.
During a presentation to investors, Carr discusses commodity derivative contracts as investments and risk reduction devices. Discussing her presentation, Carr describes a strategy where an investor can take one position in crude oil and an opposite position in gasoline and heating oil. She illustrates this hedge with the following example. Suppose crude oil was overpriced relative to gasoline and heating oil. Furthermore, 7 gallons of crude oil produces 4 gallons of gasoline and 3 gallons of heating oil. The investor would go short 7 crude oil futures contracts and long 4 gasoline futures contracts and long 3 heating oil futures contracts. Carr states that this is known as a crack spread and is a perfect hedge.
Later in the afternoon, Carr discusses the pricing of commodity futures contracts with Tonya Dugans, her assistant. Carr states that the futures price will incorporate the spot price, the risk-free rate, the convenience yield, and storage costs. Dugans states that the futures price will be higher when the convenience yield and storage costs are higher.
Carr points out that positions in storable commodities can be a good hedge against inflation. She states, however, that non-storable commodities, such as agricultural commodities, do not provide as good an inflation hedge as do storable commodities, such as oil. In order to most effectively protect Argyle from the expected change in interest rates on their anticipated borrowing costs, Davis should:
A)buy bond futures.
B)buy an interest rate cap.
C)enter into a swap as the fixed payer.
Explanation — B — The borrowing costs for Argyle will be higher if rates rise, so an effective hedge will generate profits when rates rise. If interest rates rise, the interest rate cap, which is a series of interest rate calls, will provide a payoff. To fully hedge the floating interest payments on the bond, Argyle would buy an interest rate cap with a maturity of five years. The other responses will not provide an effective hedge for Argyle. Bond futures will decrease in value when interest rates rise. Since interest rate volatility is expected to increase this means interest rates are likely to fall as well as increase. Being the fixed rate payer in an interest rate swap will experience losses in the event interest rates fall. This is not a position the firm will want to undertake.
16.2 What is the value of the binary credit put option to an owner of USD10 million of Stedman bonds one year after bond issuance?
A)USD104,000.
B)USD246,700.
C)USD102,500.
Explanation — A — The strike price is the PV of the bond (5.5% coupon, 4 years to maturity) at a 5.9% YTM (= 3.9% + 2.0%), which is 98.593 (% of par). On your TI-BAII Plus, the inputs are: 5.9/2=I/Y; 27.50=PMT; 1000=FV; 8=N; CPT PV= 985.93.
The current bond value is the PV with a yield to maturity of 6.2%, which is 97.553 (% of par). On your TI-BAII Plus, the inputs are: 6.2/2=I/Y; 27.50=PMT; 1000=FV; 8=N; CPT PV= 975.53. The option is in the money by (0.98593 − 0.97553) × 10,000,000 = $104,000.
16.3 What is the value of the credit spread call option to an owner of USD10 million of Stedman bonds one year after bond issuance?
A)0, they are out-of-the-money.
B)USD128,000.
C)USD64,000.
Explanation — B — Given the relevant yield of 6.2% relative to the Treasury yield of 3.9%, the spread on the bonds is 2.3% (= 6.2% − 3.9%). This is greater than the strike spread of 1.9%, so the option is in the money.
The option value is Max (0, 0.023 − 0.019)(3.2)(10,000,000) = $128,000.
16.4 Regarding her statements about commodity contracts, Carr is:
A)correct.
B)incorrect because this will not be a perfect hedge.
C)incorrect because her example is not representative of a commodity contract strategy.
Explanation — B — Carr is incorrect. This crack spread will not create a perfect hedge because crude oil can be used for other outputs such as jet fuel. This strategy is also known as a commodity spread.
16.5 Regarding her statements about pricing commodity contracts, Dugans is:
A)incorrect because the futures price will be higher when the convenience yield is lower.
B)correct.
C)incorrect because the futures price will be higher when storage costs are lower.
Explanation — A — Dugans is incorrect because the futures price will be higher when the convenience yield is lower. In other words, when an asset does not have value for its convenience yield, holding the spot asset will not be as advantageous and the futures contract will be more attractive. Dugans is correct, though, that higher storage costs for the spot asset will make the futures contract more attractive.
16.6 Regarding her statements about commodities as inflation hedges, Carr is:
A)correct.
B)incorrect because non-storable commodities provide an inflation hedge.
C)incorrect because storable commodities do not provide an inflation hedge.
Explanation — A — Carr is correct. Positions in storable commodities are a hedge against inflation. Non-storable commodities do not provide as good a hedge as they tend to have a negative correlation with inflation.
17. A trader in soybean futures contracts has discovered an arbitrage opportunity involving soybean futures and futures on soybean meal and soybean oil. Of the following, this most likely can occur with a:
A)crack spread by holding a long position in soybeans and a long position in soybean meal and short position in soybean oil.
B)crack spread by holding a long position in soybeans and a long position in soybean meal and soybean oil.
C)crush spread by holding a short position in soybeans and a long position in soybean meal and soybean oil
Explanation — C — The only possible answer is a position in the input (e.g., short) and the opposite position (long in this case) in both of the outputs. This is called a crush spread
18. In order to minimize basis risk, it is ideal to find a futures contract:
A)that is highly correlated with the price of the hedged asset.
B)that is uncorrelated with the price of the hedged asset.
C)that is highly correlated with the size of the hedged asset
Explanation — A — In order to minimize basis risk, it is ideal to find a futures contract that is highly correlated with the price of the hedged asset
19. Which of the following hedged positions is least likely to be subject to basis risk?
A)A jewelry maker is expecting to make large monthly purchases of gold in each of the next nine months but is afraid the price will rise. The company enters into a long strip hedge using gold futures.
B)A grain company must deliver 1 million bushels of corn in six, nine, and twelve months. The company enters into a short stack hedge using 3-month futures contracts on corn.
C)A jet-fuel wholesaler expects the price of jet fuel to fall in one year. The wholesaler therefore establishes a short position in a one-year crude oil contract to offset price declines.
Explanation — A — Basis risk occurs when a derivatives instrument used to hedge a position does not exactly correspond to the position being hedged. Hedging jet-fuel with oil futures and hedging Spanish natural gas futures for delivery in Louisiana are not perfect hedges and are therefore subject to basis risk. Basis risk can also occur when the maturity of the underlying position and the maturity of the derivative used to hedge are significantly different. Stack hedges, in which multiple future liabilities are hedged with a single near-term futures contract, are subject to basis risk. Strip hedges match the dates of the underlying position and the derivatives positions and, assuming the commodity in the futures contract matched the commodity to be hedged, are not subject to basis risk.
20. Commodity futures may tend to have more basis risk than financial futures because:
A)of timing.
B)there can be more than one risk-free rate.
C)commodity futures contracts can have different geographical points of delivery.
Explanation — C — Imperfect hedges cause basis risk in commodity futures. For commodities, this can be caused by hedging an oil contract with delivery on the East Coast with a NYMEX oil contract that calls for delivery in the South. Such geographic considerations are less important for financial futures
21. Basis risk will arise in both commodity and financial futures due to:
A)grade.
B)timing.
C)storage costs
Explanation — B — Basis risk will arise in both commodity and financial futures due to timing. Basis risk arising from storage costs, grade, and/or transportation costs is exclusive to commodity futures
22. Hedging a transaction to take place in five years with one-year futures contracts would produce basis risk in:
A)both commodity futures and financial futures.
B)financial futures but not commodity futures.
C)commodity futures but not financial futures.
Explanation — A — In order to minimize basis risk, it is ideal to find a futures contract that is highly correlated with the price of the hedged asset. In addition, the timing of the delivery should match the expiration of the hedge in both financial and commodity futures. Basis risk can result in both commodity futures and financial futures from an imperfect hedge caused by a desired distant delivery but hedged with near term contracts
23. One common source of basis risk shared by commodity futures and financial futures is:
A)transportation costs.
B)nothing, because they share no common sources of basis risk.
C)the difference in the timing of the transaction and the maturity of the contract.
Explanation — C — All futures contracts can have basis risk because of differences in the timing of the transaction being hedged and the maturity of the contract. Transportation costs are a factor with commodity futures but not with financial futures
