A futures contract is used for hedging. Explain why the daily settlement of the contract

Under what circumstances are (a) a short hedge and (b) a long hedge appropriate?

Explain what is meant by basis risk when futures contracts are used for hedging.

Explain what is meant by a perfect hedge. Does a perfect hedge always lead to a better outcome than an imperfect hedge? Explain your answer.

Under what circumstances does a minimum variance hedge portfolio lead to no hedging at all?

Give three reasons why the treasurer of a company might not hedge the companys exposure to a particular risk.

Suppose that the standard deviation of quarterly changes in the prices of a commodity is $0.65, the standard deviation of quarterly changes in a futures price on the commodity is $0.81, and the coefficient of correlation between the two changes is 0.8. What is the optimal hedge ratio for a 3-month contract? What does it mean?

A company has a $20 million portfolio with a beta of 1.2. It would like to use futures contracts on a stock index to hedge its risk. The index futures price is currently standing at 1080, and each contract is for delivery of $250 times the index. What is the hedge that minimizes risk? What should the company do if it wants to reduce the beta of the portfolio to 0.6?

In the corn futures contract traded on an exchange, the following delivery months areavailable: March, May, July, September, and December. Which of the available contracts should be used for hedging when the expiration of the hedge is in (a) June, (b) July, and (c) January.

Does a perfect hedge always succeed in locking in the current spot price of an asset for a future transaction? Explain your answer.

Explain why a short hedgers position improves when the basis strengthens unexpectedly and worsens when the basis weakens unexpectedly.

Imagine you are the treasurer of a Japanese company exporting electronic equipment to the United States. Discuss how you would design a foreign exchange hedging strategy and the arguments you would use to sell the strategy to your fellow executives.

Suppose that in Example 3.2 of Section 3.3 the company decides to use a hedge ratio of 0.8. How does the decision affect the way in which the hedge is implemented and the result?

If the minimum variance hedge ratio is calculated as 1.0, the hedge must be perfect. Is this statement true? Explain your answer.

If there is no basis risk, the minimum variance hedge ratio is always 1.0. Is this statement true? Explain your answer.

For an asset where futures prices are usually less than spot prices, long hedges are likely to be particularly attractive. Explain this statement.

The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound) 1.2. The standard deviation of monthly changes in the futures price of live cattle for the closest contract is 1.4. The correlation between the futures price changes and the spot price changes is 0.7. It is now October 15. A beef producer is committed to purchasing 200,000 pounds of live cattle on November 15. The producer wants to use the December live cattle futures contracts to hedge its risk. Each contract is for the delivery of 40,000 pounds of cattle. What strategy should the beef producer follow?

A corn farmer argues I do not use futures contracts for hedging. My real risk is not the price of corn. It is that my whole crop gets wiped out by the weather. Discuss this viewpoint. Should the farmer estimate his or her expected production of corn and hedge to try to lock in a price for expected production?

On July 1, an investor holds 50,000 shares of a certain stock. The market price is $30 per share. The investor is interested in hedging against movements in the market over the next month and decides to use the September Mini S&P 500 futures contract. The index futures price is currently 1,500 and one contract is for delivery of $50 times the index. The beta of the stock is 1.3. What strategy should the investor follow? Under what circumstances will it be profitable?

Suppose that in Table 3.5 the company decides to use a hedge ratio of 1.5. How does the decision affect the way the hedge is implemented and the result?

A futures contract is used for hedging. Explain why the daily settlement of the contract can give rise to cash-flow problems.

An airline executive has argued: There is no point in our using oil futures. There is just as much chance that the price of oil in the future will be less than the futures price as there is that it will be greater than this price. Discuss the executives viewpoint.

Suppose that the 1-year gold lease rate is 1.5% and the 1-year risk-free rate is 5.0%. Both rates are compounded annually. Use the discussion in Business Snapshot 3.1 to calculate the maximum 1-year gold forward price Goldman Sachs should quote to the gold-mining company when the spot price is $1,200.

The expected return on the S&P 500 is 12% and the risk-free rate is 5%. What is the expected return on an investment with a beta of (a) 0.2, (b) 0.5, and (c) 1.4?

It is now June. A company knows that it will sell 5,000 barrels of crude oil in September. It uses the October CME Group futures contract to hedge the price it will receive. Each contract is on 1,000 barrels of light sweet crude. What position should it take? What price risks is it still exposed to after taking the position?

Sixty futures contracts are used to hedge an exposure to the price of silver. Each futures contract is on 5,000 ounces of silver. At the time the hedge is closed out, the basis is $0.20 per ounce. What is the effect of the basis on the hedgers financial position if (a) the trader is hedging the purchase of silver and (b) the trader is hedging the sale of silver?

A trader owns 55,000 units of a particular asset and decides to hedge the value of her position with futures contracts on another related asset. Each futures contract is on 5,000 units. The spot price of the asset that is owned is $28 and the standard deviation of the change in this price over the life of the hedge is estimated to be $0.43. The futures price of the related asset is $27 and the standard deviation of the change in this over the life of the hedge is $0.40. The coefficient of correlation between the spot price change and futures price change is 0.95. (a) What is the minimum variance hedge ratio? (b) Should the hedger take a long or short futures position? (c) What is the optimal number of futures contracts with no tailing of the hedge? (d) What is the optimal number of futures contracts with tailing of the hedge?

A company wishes to hedge its exposure to a new fuel whose price changes have a 0.6 correlation with gasoline futures price changes. The company will lose $1 million for each 1 cent increase in the price per gallon of the new fuel over the next three months. The new fuels price changes have a standard deviation that is 50% greater than price changes in gasoline futures prices. If gasoline futures are used to hedge the exposure, what should the hedge ratio be? What is the companys exposure measured in gallons of the new fuel? What position, measured in gallons, should the company take in gasoline futures? How many gasoline futures contracts should be traded? Each contract is on 42,000 gallons.

A portfolio manager has maintained an actively managed portfolio with a beta of 0.2. During the last year, the risk-free rate was 5% and equities performed very badly providing a return of 30%. The portfolio manager produced a return of 10% and claims that in the circumstances it was a good performance. Discuss this claim.

The following table gives data on monthly changes in the spot price and the futures price for a certain commodity. Use the data to calculate a minimum variance hedge ratio. Spot price change 0.50 0.61 0.22 0.35 0.79 Futures price change 0.56 0.63 0.12 0.44 0.60 Spot price change 0.04 0.15 0.70 0.51 0.41 Futures price change 0.06 0.01 0.80 0.56 0.46 3.30. I

It is July 16. A company has a portfolio of stocks worth $100 million. The beta of the portfolio is 1.2. The company would like to use the December futures contract on a stock index to change the beta of the portfolio to 0.5 during the period July 16 to November 16. The index futures price is currently 1,000 and each contract is on $250 times the index. (a) What position should the company take? (b) Suppose that the company changes its mind and decides to increase the beta of the portfolio from 1.2 to 1.5. What position in futures contracts should it take?

A fund manager has a portfolio worth $50 million with a beta of 0.87. The manager is concerned about the performance of the market over the next 2 months and plans to use 3-month futures contracts on the S&P 500 to hedge the risk. The current level of the index is 1,250, one contract is on 250 times the index, the risk-free rate is 6% per annum, and the dividend yield on the index is 3% per annum. The current 3-month futures price is 1,259. (a) What position should the fund manager take to hedge all exposure to the market over the next 2 months? (b) Calculate the effect of your strategy on the fund managers returns if the index in 2 months is 1,000, 1,100, 1,200, 1,300, and 1,400. Assume that the 1-month futures price is 0.25% higher than the index level at this time.

It is now October 2014. A company anticipates that it will purchase 1 million pounds of copper in each of February 2015, August 2015, February 2016, and August 2016. The company has decided to use the futures contracts traded in the COMEX division of the CME Group to hedge its risk. One contract is for the delivery of 25,000 pounds of copper. The initial margin is $2,000 per contract and the maintenance margin is $1,500 per contract. The companys policy is to hedge 80% of its exposure. Contracts with maturities up to 13 months into the future are considered to have sufficient liquidity to meet the companys needs. Devise a hedging strategy for the company. (Do not make the tailing adjustment described in Section 3.4.) Assume the market prices (in cents per pound) today and at future dates are as in the following table. What is the impact of the strategy you propose on the price the company pays for copper? What is the initial margin requirement in October 2014? Is the company subject to any margin calls?