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CFA Institute Exam CFA-Level-II Topic 1 Question 90 Discussion

Actual exam question for CFA Institute's CFA-Level-II exam
Question #: 90
Topic #: 1
[All CFA-Level-II Questions]

Michelle Norris, CFA, manages assets for individual investors in the United States as well as in other countries. Norris limits the scope of her practice to equity securities traded on U .S . stock exchanges. Her partner, John Witkowski, handles any requests for international securities. Recently, one of Norris's wealthiest clients suffered a substantial decline in the value of his international portfolio. Worried that his U .S . allocation might suffer the same fate, he has asked Norris to implement a hedge on his portfolio. Norris has agreed to her client's request and is currently in the process of evaluating several futures contracts. Her primary interest is in a futures contract on a broad equity index that will expire 240 days from today. The closing price as of yesterday, January 17, for the equity index was 1,050. The expected dividends from the index yield 2% (continuously compounded annual rate). The effective annual risk-free rate is 4.0811%, and the term structure is flat. Norris decides that this equity index futures contract is the appropriate hedge for her client's portfolio and enters into the contract.

Upon entering into the contract, Norris makes the following comment to her client:

"You should note that since we have taken a short position in the futures contract, the price we will receive for selling the equity index in 240 days will be reduced by the convenience yield associated with having a long position in the underlying asset. If there were no cash flows associated with the underlying asset, the price would be higher. Additionally, you should note that if we had entered into a forward contract with the same terms, the contract price would most likely have been lower but we would have increased the credit risk exposure of the portfolio."

Sixty days after entering into the futures contract, the equity index reached a level of 1,015. The futures contract that Norris purchased is now trading on the Chicago Mercantile Exchange for a price of 1,035. Interest rates have not changed. After performing some calculations, Norris calls her client to let him know of an arbitrage opportunity related to his futures position. Over the phone, Norris makes the following comments to her client:

"We have an excellent opportunity to earn a riskless profit by engaging in arbitrage using the equity index, risk-free assets, and futures contracts. My recommended strategy is as follows: We should sell the equity index short, buy the futures contract, and pay any dividends occurring over the life of the contract. By pursuing this strategy, we can generate profits for your portfolio without incurring any risk."

Which of the following types of futures markets best characterizes the observed market for the 240-day equity index futures contract?

Show Suggested Answer Hide Answer
Suggested Answer: C

Contango markets arc characterized by futures prices that are higher than the spot price. Since the futures price calculated in the previous question is higher than the spot price, the market can be characterized as a contango market. (Study Session 16, LOS 59.e)


Contribute your Thoughts:

Julian
1 months ago
I'll hedge my bets on C) Contango. Although, if this was a futures contract on avocados, I'd bet on guacamole instead.
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Carman
8 days ago
C) Contango.
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Abel
9 days ago
B) Backwardation.
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Valda
14 days ago
A) Inverted.
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Johnna
1 months ago
Exactly, Corinne. It's interesting how Norris identified the arbitrage opportunity to earn a riskless profit for her client's portfolio.
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Corinne
1 months ago
I agree with you, Johnna. The convenience yield associated with the long position in the underlying asset is causing the futures price to be higher.
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Ryan
1 months ago
C) Contango, no doubt about it. The futures contract is trading at a premium to the spot price.
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Deandrea
2 months ago
This seems straightforward. The answer has to be C) Contango. The question clearly states the futures price is higher than the spot price.
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Renea
9 days ago
Yes, Contango is the correct answer here, given the relationship between futures and spot prices.
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Jamika
11 days ago
It's definitely Contango, since the futures price is higher than the spot price.
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Lonny
24 days ago
Contango is when the futures price is higher than the spot price, so that makes sense.
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Beth
1 months ago
I agree, the futures price being higher than the spot price indicates Contango.
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Josue
2 months ago
Definitely C) Contango. The futures price is trading above the spot price, and that's the definition of a contango market.
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Sommer
28 days ago
Contango markets can offer unique opportunities for investors to profit from price differences.
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Izetta
1 months ago
It's interesting how we can take advantage of arbitrage opportunities in this type of futures market.
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Rusty
1 months ago
I agree, the futures price being higher than the spot price indicates a contango market.
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Vallie
2 months ago
Hmm, I think the answer is C) Contango. The futures price is higher than the spot price, which indicates a contango market.
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Tresa
1 months ago
Contango is indeed the correct answer, as the futures price is higher than the spot price in this case.
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India
1 months ago
That's right, a contango market is characterized by the futures price being higher than the spot price.
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Delsie
1 months ago
I agree, a contango market is when the futures price is higher than the spot price.
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Joanna
2 months ago
Yes, you are correct. The futures price being higher than the spot price indicates a contango market.
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Johnna
2 months ago
I think the futures market for the 240-day equity index contract is in Contango.
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