Exam: CH 3 hedging strats with futures Flashcards
What is a perfect hedge?
- A perfect hedge is one that completely removes risk - rare.
- Instead we consider strategies that do not need to be adjusted
What does a short hedge involve?
- involves a short position in future contracts
When is a short hedge useful?
- 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
What does a long hedge involve?
- involves a long position in future contract
When is a long hedge useful?
- 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
Define basis
= Spot price of the asset to be hedged − Futures price of contract used
- At time zero, basis, b0 = S0 - F0
the basis should be zero at the expiration of the futures contract if?
If the asset being hedged is the same as the the asset underlying the futures contract
What is strengthening of the basis?
When the spot price increases by more than the futures prices, the basis increases
What isweakening of the basis?
When the futures price increases by more than the spot price, the basis declines
Consider a long hedge
What happens when the basis weakens?
- the hedge position improves - since
Spot Price < Future Price
Consider a long hedge
What happens when the basis strengthens?
- the hedge position worsens - since
Spot Price > Future Price
If the asset being hedged is different than the asset underlying the futures
contract, then?
- the basis risk is usually higher
Can Basis risk be affected by the choice of the futures contract to be hedge?
yes
What are the two important factors that can affect basis risk in relation to the choice of the futures contract?
- The choice of the asset underlying the futures contract
* The choice of the delivery month
is it better to have a time difference between futures prices and delivery month?
yes because Futures prices during delivery month can be erratic due to possibility of delivery
what is the rule of thumb when it comes to delivery month and futures prices?
- choose a delivery month that is as close as possible to,
but later than, the expiration of the hedge
When do you use cross hedging?
- When the asset being hedged is different from the asset underlying the futures contract.
What is the hedge ratio?
It is the ratio of the size of the position in futures contracts to the size of the exposure
What is the hedge ratio when the asset is the same as the futures contract?
- it is 1.0
Is it always optimal to choose the hedge ratio to be 1.0?
No not always optimal
What formula is used to adjust for the impact of daily settlement?
N=(hVA)/VF
Where:
VA = dollar value of the position being hedged
VF = dollar value of one futures contract
What does a stock index do?
tracks changes in the value of - a hypothetical portfolio of stocks
If one stock in the index rises (_____) sharply, then the stock is given ____ (____) weight.
• If one stock in the index rises (drops) sharply, then the stock is given more (less) weight
When should a Stock index future be used?
- useful for hedging a well-diversified stock portfolio
When should we have to use β to determine the appropriate hedge ratio?
If the portfolio does not exactly mirror the index
What does it mean if β = 3?
- 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
What causes an investor to roll the hedge?
- If the hedge expiration happens after the delivery date of the futures contract
How do you accomplish rolling the hedge forward?
- Accomplished by closing out the futures contract and taking the same futures contract with a later delivery date
