I think I got the MG question right in the 2008 FRM exam, but I confuse myself when thinking about why positions lose value in contango or backwardation.

For the short position in long-term forward contracts during backwardation, these gain value because it locks in a higher price in the future for the seller? During backwardation, the forward price will be lower compared to the agreed price in the forward contract, creating profits?

For the long position in short-term futures contracts during contango, these lose value because it locks in a higher price in the future for the buyer? Each rolling hedge will require MG to buy at a higher price?

From my point of view, your analysis and conclusion are correct.
Rgds
Stefan

Dennis,

I too agree with your analysis. I would add:

In regard to long-term short forwards during backwardation: IMO, these are the simpler case. These are MG’s contracts with customers. I don’t think contango/backwardation is the essence here; rather, these short forwards gain when spot prices declines and lose when the spot increases (i.e., for this leg, MG is just like a commodity hedger - as you say, locking in a sales price - but, because MG needs to buy the deliverables, they profit on the short when the price goes down). The backwardation enters here because: this historical backwardation had tended to associate with stable or declining spot prices, but not increasing spot prices. But I say backwardation is not essential here: in MG’s case the spot price declined yet the backwardation shifted to contango (i.e., the forward declined more) and these forward-contracts-with-customers are still okay (temporarily). The role of backwardation here is that it tends to signal that spot prices are steady or declining. So, okay, this is the simpler case: shorting is profitable when the spot is going down.

The other leg, IMO, is more difficult. These are the short-term long futures that are “the hedging instruments.” Here the key perspective, arguably, is that we expect spot and futures to converge. So, under backwardation, for example, if spot is $100, forward one month = $90, forward two months = $80 (i.e., backwardation). Now, assume stable spot price at $100, and further assume forward must converge to spot. Now, I go long the 2-month forward @ $80 today. Now go forward in time one month. Spot is $100 again, my forward contract price has increased +$10 to $90 because it is converging with the spot. This is my “rollover” profit that i am virtually assured if (i) backwardation persists and (ii) the future converges to the spot (zero basis at maturity).

In MG’s case, the shift to contango involved: forward prices falling (with stable spot, notice this by itself implies backwardation) but spot prices falling even more. In this way, the forward curve shift from inverted to “normal” while generally drifting down. Now this is is a bad deal. The rollover above is losing; the forward is converging but it is converging to a spot that is dropping. It may help to think of the forward as “chasing the spot” over time. In MG’s contango, the forward started to chase the spot down - so the forward price is dropping.

The terrible irony in MG’s case is that contango did not hurt the underlying contracts. The underlying contracts were winning (these forward just could not be booked). The hedges broke MG. Ironically, without the hedges they were fine !!??

What i’ve said IMO is still consistent with (not in opposition to) what you’ve said.

David