9 - Hedging with Futures Flashcards
why do investors hedge?
to reduce risk or alter risk exposure
- ie control import/export prices, tax potential, smooth earnings
why is hedging not always a good idea?
- can give misleading impression of risk reduction
- hedging eliminates the opportunity to take advantage of favourable markets
- hedging is just speculation
what does a short hedge imply?
you take up a short position in futures contracts
usually done when you own the spot price
what does a long hedge imply?
you take up a long position in futures contracts
usually done when you have short sold the spot price
what is basis risk?
the difference between the spot price and the futures price
basis= spot - futures
what is the profit formula for a short hedge? for a long hedge?
what if held to expiry?
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
what’s the basis at expiration?
0
whats the basis risk at time 0?
bo= So - fo
whats the basis risk at any time during between 0 and expiry?
bt= St - ft
what are two problems/risks with hedging?
- spot and futures occasionally move in opposite directions - need them to move in tandem for the hedge to be successful.
- quality risk
what determines contract choice (which commodity to choose)?
- 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)
what is a hedge ratio?
the number of futures contracts to hedge a particular exposure
what is the minimal variance ratio?
the optimal varian minimising ratio
tis it the beta from a regression of spot price change on future price change
how is the effectiveness of a hedge ratio determined?
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
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?
stock index futures hedges
what is the important adjustment that must be made for tailing the market hedge? when do you maintain/kill the hedge?
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
stock index futures hedge just accounts for which factor? what does it do?
the contract multiplier
one to one hedge
what does anticipatory hedge for a takeover aim to do?
hedge against stock price increasing
when you are trying to protect against stock price increasing, should you buy or sell futures contracts?
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
when hedging for speculating on unsystematic risk, what is the hedge designed to do?
eliminate systematic risk so as to capture unsystematic return of a stock that is believed to be underpriced
ie hedge against market fluctuations
if you are expecting the prices to drop and you want to hedge against the drop what should you do with the futures contracts?
sell initially - more gain
buy later- at a lower price
if you are expecting the prices to increase and you want to hedge against the increase what should you do with the futures contracts?
buy initially - costs more
sell later - receive less money
to reach a target beta on a portfolio of stock how does the Nf = Beta (S/f) formula change?
Nf = B target - B current (S / f )
when is the market in contango? are there arbitrage possibilities?
when the futures price > spot price
sell futures buy spot
when is the market in backwardation? are there arbitrage possibilities?
when the futures price < spot price
buy futures sell spot
what does index arbitrage involve?
simultaneous trades in futures and many different stocks
