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Question 1a [1 mark]
Open interest tends to be low when a contract with a new expiration is first listed for trading, and it tends to be small after the contract has traded for a long time. Explain.
Question 1b [1 mark]
Explain why the futures price converges to the spot price and discuss what would happen if this convergence failed.
Question 2 [2 marks]
A cocoa merchant holds a current inventory of goods worth $10 million at present prices of $1,250 per metric ton. The standard deviation of returns for the inventory is 0.22. She is considering a risk-minimisation hedge of her inventory using the cocoa contract of the Coffee, Cocoa and Sugar Exchange. The contract size is 10 metric tons. The volatility of the futures is 0.44. For the particular grade of cocoa in her inventory, the correlation between futures and spot cocoa is 0.88. Compute the risk-minimisation hedge ratio and determine how many contracts she should trade.
Hint:
2
