Chapter 3 - Hedging Strategies Using Futures

Question 1

Describe when a LONG futures hedge is appropriate

Answer 1

A long futures hedge is appropriate when
you know you will purchase an asset in
the future and want to lock in the price (buy now to lock in price)

Question 2

Describe when a SHORTfutures hedge is appropriate

Answer 2

A short futures hedge is appropriate
when you know you will sell an asset in
the future and want to lock in the price (sell now and lock in price)

Question 3

What is the main goal of using futures as hedge instruments

Answer 3

The goal is to reduce exposure to price changes in the underlying asset

Question 4

What is the main argument in FAVOR of hedging

Answer 4

Companies should focus on the main
business they are in and take steps to
minimize risks arising from interest rates,
exchange rates, and other market variables

Question 5

What is the main argument AGAINST hedging

Answer 5

Shareholders are usually well diversified and
can make their own hedging decisions. It may increase risk to hedge when competitors do not. Explaining a situation where there is a loss on
the hedge and a gain on the underlying can
be difficult.

Question 6

What is “basis risk”

Answer 6

Basis is usually defined as the spot price minus the futures price. It Basis risk arises because of the
uncertainty about the basis when the hedge is closed out

Question 7

What month/when should be selected for delivery?

Answer 7

Choose a delivery month that is as close as
possible to, but later than, the end of the life
of the hedge

Question 8

What is cross hedging?

Answer 8

When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. This is known as cross

Question 9

What is the optimal hedge ratio (minimum variance hedge ratio)?

Answer 9

h = rho (sigma S / sigma F) = correlation coefficient between S and F x (standard deviation of the change in spot price during the hedge period / standard deviation of the change in future price during the hedge period)

Question 10

What is the optimal number of CONTRACTS formula based on the optimal hedging ratio?

Answer 10

h x (total units/units per contract)

Question 11

What is the hedging formula for INDEX FUTURES

Answer 11

N* = Beta (VA/VF) V A is the value of the portfolio, b is

its beta, and V F is the value of one futures contract