RIT - Case Brief - F2 - Cost-of-Carry (Contango)

RIT Case Brief – F2
Build 1.01
Futures 2
As a recent university grad, you’ve decided to put some of the theory that you’ve learned in the
classroom into practice. Specifically, you’re analyzing the differences between spot and futures
contracts. In your textbook, you observe the following relationship:
𝐹0 = 𝑆0 𝑒 (𝑐−𝑦)𝑇
𝑊ℎ𝑒𝑟𝑒; 𝐹0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐𝑒; 𝑆0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒;

𝑐 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠𝑙𝑦 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑟𝑟𝑦 𝑟𝑎𝑡𝑒;
𝑦 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠𝑙𝑦 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑐𝑜𝑛𝑣𝑒𝑛𝑖𝑒𝑛𝑐𝑒 𝑦𝑖𝑒𝑙𝑑;
𝑎𝑛𝑑 𝑇 𝑖𝑠 𝑡ℎ𝑒 𝑡𝑖𝑚𝑒 𝑡𝑜 𝑠𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑟𝑒𝑠𝑠𝑒𝑑 𝑎𝑠 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
Being the resourceful person that you are, you’ve made some inquiries into the cost of storage for
crude oil and have been quoted a price of $0.10 per day per barrel. In addition, the market is
currently exhibiting historically low interest rates of zero percent. Therefore, our trading scenario is
simplified with three assumptions: 1) there are no financing or interest costs 2) convenience yield is
zero, and 3) time is discretized into single days since you must pay for your storage on a daily basis.
Expressing the time scale as days instead of years, the arbitrage-free pricing equation for this trading
case is:
𝐹0 = 𝑆0 + 𝐶𝑇
𝑊ℎ𝑒𝑟𝑒; 𝐹0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐𝑒; 𝑆0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒;

𝐶 = 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑡𝑜𝑟𝑎𝑔𝑒 𝑝𝑒𝑟 𝑏𝑎𝑟𝑟𝑒𝑙 𝑜𝑓 𝑐𝑟𝑢𝑑𝑒;
𝑎𝑛𝑑 𝑇 𝑖𝑠 𝑛𝑜𝑤 𝑡ℎ𝑒 𝑡𝑖𝑚𝑒 𝑡𝑜 𝑠𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑟𝑒𝑠𝑠𝑒𝑑 𝑎𝑠 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠.
You believe that by using this pricing relationship, you can generate arbitrage profits by trading the
basis spread between the futures and the physical market. Since you have observed that the cost of
storing a barrel of crude oil is 10 cents per day, the futures contract should trade at premium of
($0.10 * # of days to settlement) over the spot market price. If it doesn’t, you can generate profits
by selling the futures contract (committing to delivery of physical at a specified price) and buying
the spot crude oil.
Your goal is to observe the market and determine whether arbitrage opportunities exist. If the
opportunities present themselves, you should arrange necessary storage and execute the required
trades in order to generate arbitrage profits.
Kevin Mak* and Tom McCurdy** prepared this case for the RIT market simulation platform, http://rit.rotman.utoronto.ca/.
*Manager of the Financial Research and Trading Lab, Rotman School of Management;
**Professor of Finance and Founding Director of the FRTL, Rotman School of Management, University of Toronto.
Copyright © 2014, Rotman School of Management. No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any means – electronic, mechanical, photocopying, recording
or otherwise – without the permission of Rotman School of Management.
As you’re working at your computer and calculating the appropriate prices, you get a suggestion
from a peer that you can build a real-time-linked Excel spreadsheet to calculate the arbitrage
relationship in real time. To do so, you are advised to drag & drop fields of data from the Portfolio
window directly into an open Excel sheet.
Futures Contango Trading Simulation #2 – F2
In this trading simulation, you can purchase or sell futures contracts on crude oil (CL-1F). You can
also trade physical crude (spot crude). The futures contract is a commitment to take or make
delivery at the end of the 1-month trading period. At the end of the month, the contract will settle
and if you are long (short), you will need to take (make) delivery of crude. Each contract represents
1000 barrels of crude oil.
The spot market for crude (CL) trades as individual barrels which means purchasing 1 unit of CL
will result in owning 1 barrel of crude oil. Storage tanks are available to be leased at any time. These
containers each hold a maximum of 10,000 barrels of crude oil. The cost for leasing a storage tank is
$1000 per day. Each participant can lease up to 20 storage tanks at the same time.
The case represents 1 month (20 trading days) of time, and that month is simulated over 10
minutes (=600seconds) of trading time. Therefore, 1 trading day is simulated over 30 seconds
(=600seconds/20 trading days).
Each student will be subject to gross and net trading limits. The gross trading limit reflects the sum
of the absolute values of the long and short positions across both the futures and the spot contracts;
while the net trading limit reflects the sum of long and short positions such that short positions
negate any long positions.
Net Trading Limit 1,000,000 units of the underlying

Gross Trading Limit 10,000,000 units of the underlying
For example, if you short 1 contract of CL-1F and buy 1,000 barrels of CL spot, your Net Trading
Limit will be zero while your Gross Trading Limit will be 2,000. There are no transaction costs.
Discussion Questions and Follow Up:
(1) What are the correct optimization ratios to make a complete arbitrage profit (i.e. how many
barrels, futures and storage do you use at once?)
(2) What should you do if the observed spread is larger than predicted by your pricing
equation?
(3) What should you do if the observed spread is smaller than predicted by your pricing
equation?
(4) Why would it be ideal to close out your trades if the arbitrage spread returns to zero?
Copyright © 2014, Rotman School of Management. 2

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RIT Case Brief – F2

𝑊ℎ𝑒𝑟𝑒; 𝐹0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐𝑒; 𝑆0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒;

𝑊ℎ𝑒𝑟𝑒; 𝐹0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐𝑒; 𝑆0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒;

Futures Contango Trading Simulation #2 – F2

Net Trading Limit 1,000,000 units of the underlying

Discussion Questions and Follow Up:

Copyright © 2014, Rotman School of Management. 2

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