Explain why commodity futures markets need to be liquid to function effectively and how speculators can help increase the degree of liquidity

Question 1
(a) For any one specific commodity market which has a related futures market, explain briefly:
i. What factors have influenced commodity prices in recent years?
ii. How the pattern of futures prices relate to spot prices (eg contango or backwardation), giving reasons for this pattern.

(b) Outline a trade that a producer, consumer or speculator in this market may wish to engage in, constructing a numerical example using realistic quantities and prices. Using your own suggested figures for price changes, calculate the net outcome of this trade.

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Question 2

(a) Explain why commodity futures markets need to be liquid to function effectively and how speculators can help increase the degree of liquidity.
(b) How does the open interest measure attempt to serve as an indicator of a commodity futures market’s liquidity?
(c) If there are only four traders (A, B, C and D) in a commodity futures market and A sold 14 lots to B, C sold 6 lots to B, and D sold 7 lots to A, what would the open interest measure be?
(d) Briefly outline how these factors regarding liquidity apply to any recently opened commodity futures market, or a market that has closed due to insufficient liquidity.

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Question 3

(a) In the context of commodity futures markets, explain briefly what the functions of the following are:
(i) Clearing House.
(ii) Initial margins.
(iii) The mark to market process and calculation of variation margins
(b) If the initial margin required on the LIFFE commodity exchange for a 50 tonne standard contract in White sugar is $600 and a trader buys one December futures standard contract on day 1 at a price of $240.00 a tonne, what is the value of the initial margin (i) per tonne of sugar, and (ii) as a percentage of the full standard contract price?
(c) Calculate the variation margin for days 2, 3 and 4, if the December futures price per tonne changes to:
(i) $237.60 at end of day 2
(ii) $241.20 at end of day 3
(iii) $242.40 at end of day 4
(d) If the trader squares out at the end of day 4, calculate their rate of return on the initial margin and explain why this is different to the 1% rise in the futures price.

 

Question 4

A manufacturer of ready-made vegetarian meals for supermarket uses a lot of soya beans. Assume that in May this company is planning its November production, when it estimates that it will need to buy 5,000 bushels of soya beans. At the current spot price of $9.225 per bushel, it can budget for a satisfactory profit. November soya bean futures are selling at $9.895 a bushel. The manufacturer wishes to hedge against a possible soya bean price rise but also thinks there is a reasonable chance that soya bean prices may fall by November.

(a) Explain, constructing examples with appropriate values, why hedging using soya bean futures may mean the company loses out on any potential windfall gain from a soya bean price fall, but hedging using options on soya bean futures would allow them to benefit from a soya bean price fall, using the data below to work out the company’s net price per bushel paid under scenarios (i) a price rise, and (ii) a price fall.
Date Spot Price Nov Futures
May $9.225 $9.895
(i) Nov $12.415 $12.415
(ii) Nov $7.400 $7.400
Note: The November date is assumed to be the November futures expiry date. Assume that, in May, options on November soya bean futures with a strike price of $9.895 have a premium of $0.245 for call options and $0.0205 for put options.

 

Explain why commodity futures markets need to be liquid to function effectively and how speculators can help increase the degree of liquidity