Jorion's Practice Questions

[ahnnecabiles]

Hi David,

I have a few questions on the FRM Handbook practice questions:

1. A question on Chapter 9 (page 233):

The spot price of the corn on April 10 is 207 cents/bushels. The futures price of the September contract is 241.5 cents/bushels. If hedgers are net short, which of the following statements is most accurate concerning the expected spot price of corn in September:

a. E(ST) is higher than 207
b. E(ST) is lower than 207
c. E(ST) is higher than 241.5
d. E(ST) is lower than 241.5

The answer is c. Why? Isn't it that since the hedgers are net short, they are expecting that the expected spot price of the corn will be lower than 241.5, which is letter d?

2. A question on Chapter 10 (page 261)

(this requires some knowledge of markets) Which of the following products has the least liquidity?

a. US on the run treasury
b. US off the run treasury
c. floating rate notes
d. high grade corporate bond

the answer is c because . But, I think the answer will be depending on the position and expectations of the market. If most are holding a floating rate bond and they are expecting that interest rate will rise in the future, isn't it that this type of bond will be more liquid?

Thanks for your time david.

 

[David Harper CFA FRM]

Chinquee,

1. (d) is tempting because the hedgers, being net short, will lose money with (c) and profit with (d). That is, say the corn farmer sells forard at say, $3 per, and the expected spot is $4. Then if the expected spot is realized, the long speculators profit +1 and the short hedge farmers lose $1. (I've written a lot on this, here is a post that might help).

This scenario is the "theory of normal backwardation;" i.e., that long speculators insist on a profit so they will only pay a futures price that is lower than the expected spot. Conversely, the hedger is not trying to profit from the forward contract itself, unlike the speculator. The hedger, the corn farmer, is "paying" to eliminate downside risk. In this case, the farmer is okay to assume an expected loss of $1 because his "payoff" is: if corn drops to $2, he will not lose; he's hedged his downside and the price is the expected modest loss.

2. Yikes, I would have gotten this wrong. I don't understand this question, sorry. I don't see the FRN as exclusive of a high grade corporate bond. I agree with your premise, supply/demand impacts liquidity. I would be struggling frankly between (b), (c) and (d)!

David