Prepare for NISM-Series-XVI by treating commodity futures as a pricing and settlement machine: fair value is spot plus carry minus convenience yield, a hedger's outcome is the opening futures price plus the closing basis, gains and losses settle daily against margin, and bought options trade fixed outcomes for premium-paid flexibility.
Why Basis, Not Price Direction, Decides Hedging Answers
Basis is the spot price minus the futures price at a point in time. Hedge questions reward tracking how that gap changes, because a hedger's final outcome equals the opening futures price adjusted by the closing basis.
Define basis precisely as spot minus futures, and note that the two converge as delivery approaches: any persistent gap lets a cash-and-carry trader profit by buying physical, selling futures, and delivering. Basis risk is the uncertainty in that gap at the moment a hedge is closed. Unlike tightly arbitraged index futures, commodity basis can be wide and unstable because of grade and quality differences, delivery location, storage constraints, and seasonal demand for physical stock.
The practical habit is to write down four numbers for every hedge problem: spot and futures at the start, spot and futures at the close. Hedging items give you the values you need; your job is to use all four rather than only two. Judged on the futures leg alone, a hedge can look like a clear profit or loss while the combined spot-plus-futures position says the opposite. Train yourself to never evaluate a hedge without the closing spot.
Separating Cost of Carry from Convenience Yield
Fair futures value equals spot plus storage, insurance, and financing costs, minus convenience yield — the hidden benefit of holding physical stock. Mixing these components up produces wrong conclusions about contango, backwardation, and arbitrage.
Each carry component has a distinct source. Storage is what it costs to keep the commodity deliverable; insurance protects the warehouse position; financing is the interest on capital tied up in physical inventory. Cash-and-carry arbitrage keeps the futures price roughly within these bounds: if futures trade far above spot plus carry, buying physical and selling futures earns the gap, which pulls the two together. Positive net carry is the normal reason futures sit above spot, a shape called contango.
Convenience yield works in the opposite direction: it is the value of having the physical commodity on hand — keeping a processing plant running, meeting sudden customer demand, avoiding supply disruption. A futures holder gets none of it. When that benefit is large, the market can sustain futures below spot, called backwardation. So backwardation is a clue that physical availability is valuable, not automatic evidence of mispricing. In questions, identify which component the numbers emphasise before choosing an answer.
- Storage cost: expense of keeping the commodity deliverable until futures expiry
- Financing cost: interest on the money locked in the physical position
- Insurance: cost of protecting stored inventory
- Convenience yield: non-cash benefit of owning the physical commodity, deducted from carry
Contango and Backwardation: Read the Curve, Then Act on the Position
Contango means futures trade above spot; backwardation means below. The shape tells you what a rolling hedge should experience — apply it to the specific position, do not stop at labelling the curve.
Rolling matters for hedges that must extend beyond the near contract, and convergence sets the direction of the roll. In a persistent backwardation, the near contract sits below spot and converges upward toward spot over its life; a long hedger who closes the expiring position and re-buys a later contract therefore tends to pay progressively less for each new far contract than the price at which the old one finished — a favourable roll for the long side, often described as positive roll yield for longs in backwardation. The mirror image holds in persistent contango: the near contract converges downward toward spot, so a short hedger who re-sells a later contract tends to sell each new position at progressively higher prices relative to where the old one settled — positive roll yield for shorts in contango.
A common reasoning error is treating contango as proof of overpricing and backwardation as proof of underpricing, and a second is assigning the roll benefit to the wrong side. The curve shape reflects carry costs and convenience yield, so a steep contango can be fully justified by high storage and financing, and a backwardation can persist while physical supply is tight. Before judging any curve-based question, ask what the position is: who is rolling, in which direction, and what convergence does to their contract over the remaining life — longs benefit from backwardation, shorts from contango.
Worked Scenario: A Long Hedge Judged by Basis, Not Futures Profit
A consumer hedging a future purchase must measure the net effective cost: spot paid at close minus the futures gain. Judging the hedge on the futures leg alone reverses the correct answer.
Setup: a metal fabricator needs copper in three months and fears a price rise, so it buys a futures lot at 815 while spot stands at 800, giving an opening basis of minus 15 (spot minus futures). At the close, spot is 850 and futures is 858. The futures position shows a gain of 43 per unit. The tempting first reaction is to say the hedge simply made money and stop there — but the fabricator still has to buy physical at 850, so the futures profit and the physical cost must be combined before concluding anything.
The better decision is to compute the effective purchase price: 850 minus 43 equals 807, which equals the opening futures price plus the closing basis (815 plus minus 8). This is why it matters: the hedge locked in roughly the opening futures level, and the residual exposure was basis movement, not price level. When a question offers 807, 850, and 815 as candidate outcomes, writing the answer as opening futures price plus closing basis identifies the correct choice immediately, and shows the hedge did its job even though prices rose.
Daily Mark-to-Market and Margin Calls: Trace the Ledger
Futures gains and losses are settled in cash each day against posted margin. Track the running balance after every move, and trigger a top-up only when the balance breaches the maintenance level.
Setup: a trader sells a commodity futures lot, posting an initial margin of 1,00,000 with a maintenance level of 75,000. Day 1: the price rises, which is adverse for a seller, generating a 20,000 mark-to-market debit; the balance falls to 80,000. Day 2: another adverse 10,000 move leaves 70,000. The frequent slip here is assuming a call was due on Day 1 because the balance dropped below the initial margin. In the standard framework, the trigger is the maintenance level, not the initial level, so no call arose on Day 1.
On Day 2 the balance is below maintenance, so the trader must top up to the initial margin of 1,00,000 — a 30,000 variation payment — not merely restore the balance to 75,000. This daily settlement is precisely what separates futures from forwards, where the whole difference changes hands at maturity. Practise by drawing a two-column ledger (price move, running balance) for multi-day problems in which the price moves against the position on some days and with it on others, and state explicitly whether each day produces a call.
Futures Hedge or Bought Option: Match the Payoff the Question Describes
A futures hedge fixes an outcome; a bought option buys protection while keeping the favourable side open. Choose the tool from what the question says about upside retention and upfront premium, not from habit.
A bought put behaves like insurance for a producer: the premium is sunk cost, and the strike sets a floor below which losses stop, while gains above the strike continue. Consider a farmer holding an unharvested crop: selling futures locks today's price but surrenders any benefit if prices rally before harvest. If the question says the farmer wants protection yet also wants to gain from a rally, the bought put is the matching answer, and the cost is the premium. A bought call does the mirror-image job for a consumer who wants a ceiling on purchase cost without giving up a price fall.
Compute payoffs at expiry for two or three price levels rather than memorising shapes, and include the premium in the breakeven. Distinguish bought positions from written positions: a written option collects premium but carries potentially unlimited exposure, which is generally inconsistent with a hedging motive in textbook questions. The decision that matters is what the question optimises for — certainty, cost, or retained upside.
| Situation described in the question | Tool that matches | Payoff logic to state in your answer |
|---|---|---|
| Producer wants a price floor but will pay for flexibility | Buy a put | Losses stop at the strike; upside retained; premium is a sunk cost |
| Consumer wants a cost ceiling but no obligation | Buy a call | Purchase cost capped at the strike; benefit of falling prices kept |
| Hedger wants a locked price with no upfront premium | Futures hedge | Outcome fixed near opening futures price plus closing basis; margin calls possible |
| Directional view with strictly limited downside | Long option rather than futures | Loss limited to premium; futures carries full price exposure |
References and further reading
Use these references to explore the concepts and check the latest information from the relevant organizations.