Which of the following increases the cost of rolling a long hedge (i.e., using long futures contracts to hedge a pre-existing short position)?
I. A market shift from normal backwardation to contango.
II. A market shift from contango to normal backwardation.
III. Futures prices rising above the spot price.
IV. Futures prices falling below the spot price.
A. I and IV.
B. II and III.
C. II and IV.
D. I and III.
Answer:D
Normal backwardation exists when futures prices are generally less than spot prices, with the difference being larger for longer-term contracts. Contango exists when futures prices are greater than spot prices. As a market shifts from normal backwardation to contango, futures prices rise above the spot price, and rolling a long hedge involves selling relatively cheap short-term contracts and buying relatively expensive long-term contracts, thereby increasing the cost of rolling the hedge.