Consider the scenario where the current price of crude oil is $100 per barrel, with the three-month forward price at $105. There are now concerns among some market participants about a potential conflict in the Middle East, leading to speculation that oil prices could surge in the next three months. Assuming the current price of oil remains unchanged at $100 and the markets permits no arbitrage opportunities, how would the three-month forward price change?

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BlackTom AI · Accepted Answer

The problem asks us to assess how the three-month forward price would change given new concerns about a potential Middle East conflict and the expectation that oil prices could surge, while the current spot price remains at $100 and no arbitrage opportunities exist.
Option 1: 'Lower than $105.' This would imply the market expects the future spot price to be lower or that holding costs or carry are negative enough to push the forward below 105. Given the scenario describes a potential price surge due to a conflict, a downward move in the forward price is inconsistent with the information about expected higher future prices, making this option implausible.
Option 2: 'Higher than $105.' If participants anticipate a future spike in oil prices because of geopolitical risk, the forward contract prices would incorporate that expected rise. Under no-arbitrage, the forward price reflects the market’s expectation of the future spot price plus the cost of carry. With an elevated expected future price and the spot still at 100, the forward price should rise above the current forward of 105 to prevent arbitrage profits from trading today against the forward, aligning with the idea of risk premia and expectations of higher prices.
Option 3: 'Not enough information.' While one might wonder if more details (like interest rates, storage costs, convenience yield) are needed, the problem explicitly includes the no-arbitrage condition and cites a plausible external shock that would push expected future prices upward. This information is typically sufficient to infer that the forward should increase when the expected future spot rises.
Option 4: 'Same as $105.' Maintaining the forward at exactly 105 despite expectations of higher future prices would create arbitrage pressure: traders could borrow at the cost of carry, buy spot at 100, and lock in selling forward at 105, profiting if the future price ends up higher. The presence of a credible catalyst for higher prices makes this equality unlikely under no-arbitrage.
Overall, the reasoning anchored in no-arbitrage and the introduction of a credible risk that future price will be higher leads to the conclusion that the three-month forward price would move above 105.

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