Smith is the portfolio manager of U.S.-based PM Hedge Fund (PM), which focuses on precious metals, fixed income, and derivatives. Smith has a strategy of rolling forward a long position in short-dated platinum futures traded on NYMEX. Smith’s expectations are as follows:
• Electricity supply disruptions in South Africa, the world’s dominant platinum producer, will cause platinum supply to fall and spot prices to rise.
• Interest rates will rise.
• The convenience yield on platinum will increase.
Smith observes that his expectations are not yet reflected in platinum futures prices.
What happens to the roll yield if the Smith’s market expectations are correct?
My answer was “Roll Yield = Change in Futures Price – Change in Spot. The Spot prices will increase as per Smith’s expectations due decrease in supply. However the Roll yield may increase or decrease or not change, depending on the change of futures’ price. If the future prices fall, the Roll yield increases if the futures price increases more than the Spot prices. If the change in future price offsets the change in spot prices, the Roll yield will not change.
CFAI answer is “This is the return that arises from rolling long platinum futures contracts over time. Smith expects convenience yields will rise, increasing roll return as a result of increased backwardation. Also, he expects interest rates will rise, thus decreasing roll return. In the cost-of-carry model, these two factors have opposite effects. If these effects are assumed to offset each other, then there will be net change in the roll return. Conversely, if the rise in convenience yield is more than the rise in interest rates, roll return will increase.”
MY QUESTION:
• Electricity supply disruptions in South Africa, the world’s dominant platinum producer, will cause platinum supply to fall and spot prices to rise.
• Interest rates will rise.
• The convenience yield on platinum will increase.
Smith observes that his expectations are not yet reflected in platinum futures prices.
What happens to the roll yield if the Smith’s market expectations are correct?
My answer was “Roll Yield = Change in Futures Price – Change in Spot. The Spot prices will increase as per Smith’s expectations due decrease in supply. However the Roll yield may increase or decrease or not change, depending on the change of futures’ price. If the future prices fall, the Roll yield increases if the futures price increases more than the Spot prices. If the change in future price offsets the change in spot prices, the Roll yield will not change.
CFAI answer is “This is the return that arises from rolling long platinum futures contracts over time. Smith expects convenience yields will rise, increasing roll return as a result of increased backwardation. Also, he expects interest rates will rise, thus decreasing roll return. In the cost-of-carry model, these two factors have opposite effects. If these effects are assumed to offset each other, then there will be net change in the roll return. Conversely, if the rise in convenience yield is more than the rise in interest rates, roll return will increase.”
MY QUESTION:
- I don’t understand CFAI solution above. Could some smart guy explain it in simple terms
- Is my answer wrong??? If so, how would you have answered using the formula for Roll Yields.