Exam: CH 3 hedging strats with futures

Question 1

What is a perfect hedge?

Answer 1

• A perfect hedge is one that completely removes risk - rare.
• Instead we consider strategies that do not need to be adjusted

Question 2

What does a short hedge involve?

Answer 2

• involves a short position in future contracts

Question 3

When is a short hedge useful?

Answer 3

• Useful if the hedger already owns the asset

- Useful if the hedge plans to own the asset in the near future
example in lec notes

Question 4

What does a long hedge involve?

Answer 4

• involves a long position in future contract

Question 5

When is a long hedge useful?

Answer 5

• It is used when a company knows it will need to purchase a certain asset in the future and wants to lock in a price now

Question 6

Define basis

Answer 6

= Spot price of the asset to be hedged − Futures price of contract used

• At time zero, basis, b0 = S0 - F0

Question 7

the basis should be zero at the expiration of the futures contract if?

Answer 7

If the asset being hedged is the same as the the asset underlying the futures contract

Question 8

What is strengthening of the basis?

Answer 8

When the spot price increases by more than the futures prices, the basis increases

Question 9

What isweakening of the basis?

Answer 9

When the futures price increases by more than the spot price, the basis declines

Question 10

Consider a long hedge

What happens when the basis weakens?

Answer 10

• the hedge position improves - since

Spot Price < Future Price

Question 11

Consider a long hedge

What happens when the basis strengthens?

Answer 11

• the hedge position worsens - since

Spot Price > Future Price

Question 12

If the asset being hedged is different than the asset underlying the futures
contract, then?

Answer 12

• the basis risk is usually higher

Question 13

Can Basis risk be affected by the choice of the futures contract to be hedge?

Answer 13

yes

Question 14

What are the two important factors that can affect basis risk in relation to the choice of the futures contract?

Answer 14

• The choice of the asset underlying the futures contract

* The choice of the delivery month

Question 15

is it better to have a time difference between futures prices and delivery month?

Answer 15

yes because Futures prices during delivery month can be erratic due to possibility of delivery

Question 16

what is the rule of thumb when it comes to delivery month and futures prices?

Answer 16

• choose a delivery month that is as close as possible to,

but later than, the expiration of the hedge

Question 17

When do you use cross hedging?

Answer 17

• When the asset being hedged is different from the asset underlying the futures contract.

Question 18

What is the hedge ratio?

Answer 18

It is the ratio of the size of the position in futures contracts to the size of the exposure

Question 19

What is the hedge ratio when the asset is the same as the futures contract?

Answer 19

• it is 1.0

Question 20

Is it always optimal to choose the hedge ratio to be 1.0?

Answer 20

No not always optimal

Question 21

What formula is used to adjust for the impact of daily settlement?

Answer 21

N=(hVA)/VF

Where:

VA = dollar value of the position being hedged
VF = dollar value of one futures contract

Question 22

What does a stock index do?

Answer 22

tracks changes in the value of - a hypothetical portfolio of stocks

Question 23

If one stock in the index rises (_____) sharply, then the stock is given ____ (____) weight.

Answer 23

• If one stock in the index rises (drops) sharply, then the stock is given more (less) weight

Question 24

When should a Stock index future be used?

Answer 24

• useful for hedging a well-diversified stock portfolio

Question 25

When should we have to use β to determine the appropriate hedge ratio?

Answer 25

If the portfolio does not exactly mirror the index

Question 26

What does it mean if β = 3?

Answer 26

- then the return on the portfolio is three times the return on the stock index; hence, it is three times more sensitive to market movements than a portfolio with β = 1.0

Question 27

What causes an investor to roll the hedge?

Answer 27

- If the hedge expiration happens after the delivery date of the futures contract

Question 28

How do you accomplish rolling the hedge forward?

Answer 28

- Accomplished by closing out the futures contract and taking the same futures contract with a later delivery date