David..

I have a fundamental doubt. In your spreadsheet on basis risk, when you say at time zero say May,09 spot rate is $ 2.00 you say futures is at say 2.05. In sep09 suppose spot goes up to 2.05 and futures at 2.05.
My question fundamental is in May 09 whenyou say futures is 2.05, what do you mean. Are you saying if we buy say 3 months futures in May’09 , the futures is bought at 2.05, what do you mean by saying in sep09 futures at 2.05? I can understand spot rate in sep09 the month/day of maturity to arrive at the basis risk but why and what are we talking about futiresrate at time of maturity or n between?

Hope I have put qn stright.
venkat

Hi venkat,

The futures price is changing over time, as the spot price is. Say,
T0 = May 2009
T1 = June
T4 = Sep 2009 (actually, changing daily, etc, but you get the point)

T0 = S0 = spot (May) & F0 = forward price for delivery price for commodity to be bought/sold on Sept 2009. Forward/future has 4 month maturity
T1 = S0 = spot (June) & new F0 for forward price for commodity to be bought/sold on Sept 2009. Forward/future has 3 month maturity.

Relates to common confusion on value of forward: value (f) = (F0 - K)*EXP[-rT]

once the forward is entered into, the delivery (K) price does not change; however, each day, the maturity on the dd/mm/yy contract (e.g., Dec 2009) is shortening and there is a new forward price. So, hopefully, you can agree that with each “new day” there is a “repricing” of the same Dec 2009 contract - if for no other reason that its maturity changes

In the XLS, maybe you are thinking, at maturity, there is no time left, per Hull, the Forward price must equal the spot price. Theoretically, you are correct, they should converge as the contract reaches expiration. But only in theory, there is convergence “zone” and basis risk includes the risk they do not converge (which has been the case recently in some commodity markets).

David

...another way to tackle this is from the MG case. Recall their original strategy was to take profits from the backwardation. This is the “roll return” earned in backwardation. If you think about an inverted forward curve in May (say spot = 2.00, Nov forward = $1.60, dec forward = $1.50; i.e., backwardation). Now go forward one month and make the simplifying assumption that the forward curve does not shift!

Now in June, spot = $2.00 but December forward price is now $1.60!
see how the forward price must go up to 1.60 here if curve does not shift: it went from a 7 month to a 6 month contract, and backwardation means the 6 month must have a higher forward price. So, the forward can be exited now for a $0.10. So we say, backwardation implies profit on the roll return. Was working for MG until shift to contango, then roll return goes negative. David

David..
. Too good answer first part. But second part , hmm reading again and again. Please elaoborate"Assumption of forward curve shift”.

Backardation implies profit on roll return. Fine. Kindly eloborate situation in Contango. My small brain acts too slow to grasp.
venkat

Venkat,

I copied a recent oil futures curve (from our XLS), as of mid-June:

This is contango (btw, per cost of carry, this implies that cost of financing + storage cost of oil exceeds the convenience yield of ownership). Let’s just assume the start of one of the red arrows is the 1-year future price of oil:  the June 2010 futures price. So say the spot (June) = $65 and in June 2009, the June 2010 future price (+ 1 year maturity as of June 2009) = $80. Now, like MG, you enter a long position in the June 2010 oil futures

Now go forward in time, say three months. But also, let’s just assume this forward curve does not shift; i.e., in Sept 2009 (+ 3 months), the spot price of oil is $65 and there is the same contango forward curve (i.e., the spot price has not moved and the shape of the forward curve is exactly the same). What is the situation with your forward contract? It is now 9 months to maturity (12 - 3 months elapsed). You still are long June 2010 oil, but down from 12 months to 9 months.

If the curve is in the same exact contango, notice that your futures price must be lower; e.g., maybe $75. Notice this is necessary due to the basis convergence between forward and spot. So, we say, in contango, the roll return (i.e., if you close out this position, you will lose $80 - $75 = loss of $5) is negative.

....and, this is similar to the problem confronted by Metallgesellschaft: because the long, short-term futures were marked-to-market (key difference between futures and forward), the loss was immediately booked, but the gains on short-position, long-term forwards were not booked, so big paper losses in short run caused funding liquidity crisis…hope this helps - David