9 - Hedging with Futures

Question 1

why do investors hedge?

Answer 1

to reduce risk or alter risk exposure

• ie control import/export prices, tax potential, smooth earnings

Question 2

why is hedging not always a good idea?

Answer 2

• can give misleading impression of risk reduction
• hedging eliminates the opportunity to take advantage of favourable markets
• hedging is just speculation

Question 3

what does a short hedge imply?

Answer 3

you take up a short position in futures contracts

usually done when you own the spot price

Question 4

what does a long hedge imply?

Answer 4

you take up a long position in futures contracts

usually done when you have short sold the spot price

Question 5

what is basis risk?

Answer 5

the difference between the spot price and the futures price

basis= spot - futures

Question 6

what is the profit formula for a short hedge? for a long hedge?

what if held to expiry?

Answer 6

cap pi = (St-So) - (ft-fo)
cap pi = -(St-So) + (ft-fo)

note this is if position is closed before expiry
cap pi = (St) - (ft)
cap pi = -(St) + (ft)

because prices merge at expiry

Question 7

what’s the basis at expiration?

Answer 7

0

Question 8

whats the basis risk at time 0?

Answer 8

bo= So - fo

Question 9

whats the basis risk at any time during between 0 and expiry?

Answer 9

bt= St - ft

Question 10

what are two problems/risks with hedging?

Answer 10

• spot and futures occasionally move in opposite directions - need them to move in tandem for the hedge to be successful.
• quality risk

Question 11

what determines contract choice (which commodity to choose)?

Answer 11

• cross hedging
• which is most correlated with the spot
• pricing of contract
• margin requirements (low margins are desired, but must have enough cash to pay margin calls)

Question 12

what is a hedge ratio?

Answer 12

the number of futures contracts to hedge a particular exposure

Question 13

what is the minimal variance ratio?

Answer 13

the optimal varian minimising ratio

tis it the beta from a regression of spot price change on future price change

Question 14

how is the effectiveness of a hedge ratio determined?

Answer 14

e= (risk of unhedged position - risk of hedged position) / risk of unhedged position

it the r squared - how well is your independent variable explained by your dependent variable

Question 15

what are tailing the market hedge, stock index futures hedge, stock portfolio hedge, anticipatory hedge for a takeover, speculating on unsystematic risk, stock market timing with futures, stock index arbitrage all examples of?

Answer 15

stock index futures hedges

Question 16

what is the important adjustment that must be made for tailing the market hedge? when do you maintain/kill the hedge?

Answer 16

must account for the effect of interest on marking to market.

maintain hedge when interest decreases
kill hedge when interest high enough to cover transaction costs

Question 17

stock index futures hedge just accounts for which factor? what does it do?

Answer 17

the contract multiplier

one to one hedge

Question 18

what does anticipatory hedge for a takeover aim to do?

Answer 18

hedge against stock price increasing

Question 19

when you are trying to protect against stock price increasing, should you buy or sell futures contracts?

Answer 19

ALWAYS buy - even if the formula gives you a negative sign,

because if stock increases so will futures price, meaning when you buy futures back at a higher price you make a loss reducing the over all stock increase

Question 20

when hedging for speculating on unsystematic risk, what is the hedge designed to do?

Answer 20

eliminate systematic risk so as to capture unsystematic return of a stock that is believed to be underpriced
ie hedge against market fluctuations

Question 21

if you are expecting the prices to drop and you want to hedge against the drop what should you do with the futures contracts?

Answer 21

sell initially - more gain

buy later- at a lower price

Question 22

if you are expecting the prices to increase and you want to hedge against the increase what should you do with the futures contracts?

Answer 22

buy initially - costs more

sell later - receive less money

Question 23

to reach a target beta on a portfolio of stock how does the Nf = Beta (S/f) formula change?

Answer 23

Nf = B target - B current (S / f )

Question 24

when is the market in contango? are there arbitrage possibilities?

Answer 24

when the futures price > spot price

sell futures buy spot

Question 25

when is the market in backwardation? are there arbitrage possibilities?

Answer 25

when the futures price < spot price

buy futures sell spot

Question 26

what does index arbitrage involve?

Answer 26

simultaneous trades in futures and many different stocks