Problem 2.31. Suppose that there are no storage costs for crude oil and the inte

Question

Problem 2.31. Suppose that there are no storage costs for crude oil and the interest rate for borrowing or lending is 5% per annum. How could you make money if the June and December futures contracts for a particular year trade at $50 and $56?You could go long one June oil contract and short one December contract. In June you take delivery of the oil borrowing $80 per barrel at 5% to meet cash outflows. The interest accumulated over six months is about 50×0.05×1/2 or $1.25. In December the oil is sold for $56 per barrel which is more than the $51.25 that has to be repaid on the loan. The strategy, therefore, leads to a profit. Note that this profit is independent of the actual price of oil in June and December. It will be slightly affected by the daily settlement procedures.

Explanation / Answer

You could go long one June oil contract and short one December contract. In June you take delivery of the oil borrowing $50 per barrel at 5% to meet cash outflows. The interest accumulated in six months is about 50×0.05×0.5 or $1.25. In December the oil is sold for $56 per barrel and $51.25 is repaid on the loan. The strategy therefore leads to a profit of $4.75. Note that this profit is independent of the actual price of oil in June or December. It will be slightly affected by the daily settlement procedures.

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