Series 3 Exam

GtraderG

Newbie
3 0
Hello
I am studying for my series 3 exam and I hope to come here to get some help with questions that I have.

Here is one question that I would like to get clarity on:

Hedging:
Feb cotton is at $.60 and May cotton is at $.65. If the Feb contract goes to $.63 and the May contract goes to $.66, a profitable spread would have resulted in:

Answer: a profit of $.02/lb

Fair enough. I got the answer correct in the study material, but I do not know why it is correct - I just got it right through process of elimination. The answer key says

"Because the May contract is overpriced relative to the other futures, the spreader would want to go long Feb cotton and short May cotton...."

What in the original question gave away that the May contract was overpriced? Of course it was higher than the nearer month contract, but that is just due to carrying costs, right?

Thanks for your help. I think that this thread could be a great resource for many people with series 3 questions.
 

wackypete2

Legendary member
10,229 2,053
Right answer but you're reading into the question wrong. If the question was what would an unprofitable spread result in...the answer would be -$0.02/lb. The difference in spread is the same. You can't tell from the first sentence if May is overpriced or not but the spread is originally $0.05/lb. The spread then decreases to $0.03/lb. Since Feb is nearest to spot price then assume for a minute it is the spot price. It increased by 3 cents while the more forward contract only increased by 1 cent. Therefore the assumption is the May contract was overpriced relative to the Feb price at the time the spread was put on since it didn't increase by the same amount.

Peter
 

wackypete2

Legendary member
10,229 2,053
For clarification, the test problem isn't asking you how you would know that the May contract was overpriced in advance. It is asking that IF you had a profitable spread then what is the profit.

Good Luck on your exam!

Peter
 

GtraderG

Newbie
3 0
Thank you. I really appreciate your help and that was a great answer. I will undoubtedly have more questions that I will post here. :)
 
 
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