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Problems in GARP's 2020 FRM material


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FRM 1, Foundations, Chapter 2, Question No. 2.14: MGRM was exposed to a shift in the price curve from backwardation to contango, which meant that the program generated huge margin calls that became a severe and unexpected cash drain.
A. True
B. False

As per Section 2.7 (What can go wrong in Corporate Hedging?), it should be 'True'. The 'Answers' section, however, states: 'False because the curve moved from backwardation to contango'.

David Harper CFA FRM

David Harper CFA FRM
Staff member
Thread starter #22
@vishno We've already captured FRM-1 (i.e., foundtations) 2.14 here at https://www.bionicturtle.com/forum/threads/problems-in-garps-2020-frm-material.23011/post-81062 but it's deeper than true/false actually
Thank you @GarryB good catch. This Q&A apparently wants to be "True" but there is an important caveat: it is a lazy, imprecise question. The MGRM case has been assigned since the start of the FRM so it has been extensively covered by several authors. Let us make a note of something: the shift in the forward curve (aka, futures price curve ... it is lazy to call it a "price curve") from contango to backwardation does not itself generate huge margin calls.

Consider (eg) a spot price of $40.00 and a long futures contract (ie., MGRM's hedge) under oil backwardation (the initial state) so that say the futures price is $32.00. Imagine a shift to contango without any change in the spot price; e.g., say futures price leaps up to $45.00 (i.e., contango). That's dramatic to illustrate, but this sort of futures price increase which would not itself create a margin call. Quite the opposite for a long, it would generate excess margin! The shift to contango per se did not create the margin calls.

Rather, in MGRM what created huge margin calls was the unexpected drop in oil spot prices (the shift to contango actually mitigates the margin calls) because this drove the drop in near-month futures contract prices (source: Allen Case Studies, previous FRM assignment).

The shift from backwardation to contango (as our members well know) implies a loss in the roll yield (aka, roll over return) for the long futures position. Losses due to roll over are different than margin calls! Of course, there was a third factor (accounting) such that:
  1. Unanticipated drop in stop price drove drop in (highly correlated) near month futures prices (this was stack and roll, so they were short term contract) which caused huge margin calls
  2. Shift from backwardation to contango created roll return losses
  3. Accounting: MGRM would have been okay in the US because they could have shown net profits by booking unrealized forward contract gains (ie, forward sales to customers which which the underlying exposure that they where hedging). But under German rules, they long position short-term future contracts losses could not be (accountin-gwise) offset by the short position long-term forward contract gains. Many authors consider this the actual death knew because it was the huge reported losses that led to confidence run on MGRM. I hope that's interesting!
In summary, the following are TRUE statements::
  • MGRM was exposed to a shift in the forward curve from backwardation to contango (aka, curve risk), the realization of which created roll return losses
  • MGRM was also exposed to a drop in the spot price (and correlated near-month future prices) risk), the realization of which created margin calls.
So it does appear to be a typo, but when the typo is corrected, it masks a deeper flaw.

(If the question does intends to be false because the shift-to-contango did not per se cause margin calls, then it is still a poorly written question because it doesn't properly parse the cause and effect.)


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@David Harper CFA FRM
Sorry for bringing it up again; I swear I went through the entire page but skimmed the last bit too quickly. And thanks for linking the detailed response. I'm still pretty new to the jargon, should take some more re-reads to get it down. I found the bit in GARP's book to be overly simplified, thereby, adding to the confusion regarding this one.
Dear all,

Glad to make your acquaintance . I was not really sure where to post this, therefore free to move it as you wish.

In the aforementioned question, it states that "a company decides to hedge the purchase of 100,000 bushels of corn on February 15 of Year 2."

However, the answer starts by : "The company should short 20 May contracts on January 15 of Year 1 and"

I am sorry for not providing full details as I am not sure if am restricted from copyright.

My question, is, clearly should the initial position being LONG and then rolling forward as required?

With thanks.

David Harper CFA FRM

David Harper CFA FRM
Staff member
Thread starter #25
Hi @christoforou.n I moved to the error thread for the new GARP material. I agree with you: this should be stack/rolling LONG positions in futures contracts. The company is hedging a future purchase of corn, therefore wants a LONG hedge. This can be tested by substituting price increases into the exhibit: if we simulate price increases, then the stack/roll hedge needs to produce a net gain to hedge. Specifically, here is the given scenario in 8.20 such that the short stack/roll produced a gain (and the long produces a loss) of 0.15:

But below is an alternative scenario of rising corn prices. In order to hedge the purchase at higher prices, we need the LONG position stack/roll (lower panel) because we need a net profit--in this case $1.80--to offset the higher prices. (of course, a difference scenario would be prices dropping and the long stack/roll would produces losses, appropriate to the hedge). Thank you!