Back To School Quiz #1

1.

In grain merchandising, basis…

A.

Is more predictable than flat prices
B.

Consists partly of transportation costs and local supply and demand
C.

Is the link between cash and futures prices at some specific location
D.

All of the above

Correct Answer
D. All of the above

Explanation
Basis is an important concept in grain marketing. It is the difference between cash and futures prices. Mathematically speaking; basis = cash price – futures price (and not the other way around!). Basis in most parts of the cornbelt, particularly the northern half, is usually a negative number, i.e., cash prices are less than futures prices. Occasionally I meet a confused producer who tells me that he had a bad day because his basis “increased” from 50 to 60 cents. I can’t help but point out that his basis actually decreased, from -50 cents to -60 cents (50 cents under to 60 cents under). This is the type of small, irritating correction that rarely earns me a thank you.

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2.

When a put option is exercised, the seller of a put…

A.

Is long a put
B.

Is short a call
C.

Is long the underlying futures contract
D.

Is short the underlying futures contract
E.

Pays the premium

Correct Answer
C. Is long the underlying futures contract

Explanation
The buyer of a put option has bought the right to sell futures. If the buyer exercises the right to sell, who will take the other side (the long side) of the futures contract? That would be the seller of a put option.

By the way, the buyer of the future is not necessarily the same individual who originally sold the exercised put. The trader obligated to buy the futures contract will be the oldest seller of the particular put in question. The process of assigning the other side of an exercised option is similar to the delivery process in grains. In delivery, however, it is the seller of futures who has the right to choose to deliver grain, and the “lucky” buyer is determined by the oldest long in the market.

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3.

The option premium and option strike price are (respectively)…

A.

Set by the exchange and determined at expiration
B.

Set at expiration and determined when exercised
C.

Negotiated by open outcry and determined by the exchange

Correct Answer
C. Negotiated by open outcry and determined by the exchange

Explanation
While most futures trades and prices are now executed electronically, it is still accurate to say that options premiums are negotiated the old-fashioned way; open outcry in a trading pit. Strike prices, also known as exercise prices, are determined by the exchanges. Strike prices for soybean options are established in 20 cent increments (e.g., 900, 920, 940 calls). Corn option strike prices are in 10 cent increments.

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4.

U.S. corn demand is made up of three broad categories. Which of these three is projected to be the largest part of total corn demand in the 2009/2010 crop year?

A.

Feed demand
B.

Food, seed and industrial demand
C.

Export demand

Correct Answer
B. Food, seed and industrial demand

Explanation
According to the June WASDE report, food, seed and industrial demand for corn in 2009/2010 is projected to reach 5.4 billion bushels, larger than 5.1 billion bushels of feed demand. Corn exports are projected to be a little less than 2 billion bushels. High industrial demand for corn is driven by growth in ethanol production; 4.1 billion bushels in 2009/10 and more than 3 times higher than just 5 years ago. By the way, this will mark the first time that feed demand is not be the largest part of total corn demand.

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5.

Options buyers pay a premium to purchase “rights” – calls and puts. What are the primary components of the premium?

A.

Intrinsic value and the strike price
B.

Time value and the futures price
C.

Intrinsic value and time value

Correct Answer
C. Intrinsic value and time value

Explanation
Intrinsic value and time value are the two primary components of an option premium. Intrinsic value refers to how much an option is “in-the-money.” A call option is in the money if the strike price is less than the underlying futures prices (e.g., a $9 November soybean call would be 50 cents in-the-money if November futures are trading at $9.50 – there is 50 cents of intrinsic value). A put option is in the money if the strike price is greater than the underlying futures prices. Intrinsic value can only be a positive number or 0. There is no negative intrinsic value.

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6.

Let’s assume that November soybean futures are trading at $9.75. You pay a premium of 90 cents per bushel for a $10 November soybean call. What is the time value of this option?

A.

25 cents per bushel
B.

90 cents per bushel
C.

There is no time value

Correct Answer
C. There is no time value

Explanation
An option premium is made up of two components; intrinsic value (if any) and time value. In this case, when the futures price ($9.75) is trading less than the strike price of the call ($10), there is no intrinsic value – the option is trading 25 cents “out-of-the-money.” If there is no intrinsic value, then the entire premium of 90 cents per bushel can be viewed as time value.

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