if the oil future price for november 2016 delivery is $42/barrel. The backwardat

Question

if the oil future price for november 2016 delivery is $42/barrel. The backwardation between november-december 2016 contract is $1.50/barrel. If a hedge fund manager beleives november-december pair would turn to $0.25/barrel contango. She sells 50 of november 2016 contract and simultaneously buys 50 lots of the december 2016 contract. Each lot of futures contract is 1000 barrel of crud oil. what is the profit generated by this strategy if the fund manager view of market comes true accurately by august 2016 and she unwinds her trades.

Explanation / Answer

Backwardation - A phenomenon where Future's price is below the expected future spot price (as we approach maturity on a contract).

Contango - A phenomenon where Future's price is above the expected future spot price (as we approach maturity on a contract).

HERE At Dec, Let future spot price be $X, by backwardation, Future price = X+1.5 and by Contango, Future price = X-0.5.

Hedge manager sells 50 November 2016 and buys 50 December contracts. (1 contract = 1000 barrels)

Profit = 50*1000*(X+1.5-(X-0.25))= 50,000*$1.75 = $87,500

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