Hedging and Futures

Question 1

What is a derivative

Answer 1

A derivative is a financial instrument whose value is based on, or derived from, the value of another asset

E.G. e futures, forwards, options, and swaps

Question 2

Why are derivatives important

Answer 2

Large market size
to transfer risk
Many financial transactions, such as loans or bonds, often contain hidden derivative elements that impact their value and risk profile

Question 3

Main uses of derivatives

Answer 3

Hedging risk: Reducing exposure to price movements in assets.
Speculation: Taking on risk to profit from market movements.
Arbitrage: Exploiting price differences between markets for profit

Question 4

Features of the exchange traded market

Answer 4

Trade standardised contracts with terms (e.g., contract size, expiration) set by the exchange
E.G: Chicago Board Options Exchange (CBOE)
Advantage: Lower credit risk, as contracts are cleared through a central clearing house

Question 5

Features of Over-the-Counter (OTC) Markets

Answer 5

Customised contracts: Traders negotiate directly with each other to create contracts tailored to their specific needs.
Larger market
Disadvantages:
Credit risk is higher when contracts are cleared bilaterally (without an intermediary).
Uncollateralised trades pose an even greater risk of default

Question 6

Forward contract definition

Answer 6

A forward contract is an agreement between two parties to buy or sell an asset at a fixed future date (maturity, T) for a pre-agreed price (delivery price, K).

Question 7

Key Features of Forward contracts

Answer 7

Set for a future date
Typically traded OTC rather than through the exchange
No initial payments

Question 8

Advantages of hedging

Answer 8

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
Bankruptcy is costly! Bankruptcy cost is a deadweight loss to society created by market inefficiency

Question 9

Disadvantages of hedging

Answer 9

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

Question 10

Define a basis

Answer 10

Basis is the difference between the spot & the futures price

Question 11

Explain the difference between hedging, speculation and arbitrage

Answer 11

Hedging aims to reduce risk.
Speculation seeks to profit from risk-taking.
Arbitrage exploits price differences across markets.

Question 12

If the minimum variance hedge ratio is calculated as 1.0, the hedge must be perfect. Is this statement true? Explain your answer

Answer 12

The statement is not necessarily true

Question 13

Examples of Market failures due to derivatives

Answer 13

2007-2008 Global Financial Crisis (Subprime Mortgage Crisis)
Enron Scandal (2001):
$74 billion share price collapse involving energy derivatives
Long-Term Capital Management (LTCM) Collapse (1998)

Question 14

Spot contract definition

Answer 14

An agreement to buy or sell an asset immediately at
the current market price

Question 15

Forwards vs Futures

Answer 15

OTC traded vs Exchange traded
Customised terms vs Standardised terms
Tailored delivery date vs Several choices of delivery dates
Usually low liquidity vs Usually high liquidity
Signifcant counterparty risk (if uncollateralised) vs Negligible counterparty risk
Collateralised or Not MtM vs Marked-to-market (MtM)
Delivery or cash settlement vs Contracts usually closed out
at expiry prior to maturity

Question 16

What is a Clearing House?

Answer 16

A clearing house is a financial institution that facilitates the
settlement of payments, securities, or derivatives transactions.
It acts as an intermediary between two clearing firms to reduce the risk of either party failing to fulfil their trade obligations

Question 17

A long forward/futures hedge is appropriate when

Answer 17

you know you will purchase an asset in the future and want to lock in the price.
Go short when you know you will want to sell

Question 18

why does Basis Risk arise

Answer 18

Mismatch of asset to be hedged (S) & asset underlying the futures contract (F)
Mismatch of date when the asset to be hedged is bought/sold (ST ) and delivery month of the futures (Ft,T∗ ).
Uncertainty on the date when the asset to be hedged is bought/sold

Question 19

what is cross hedging

Answer 19

Cross hedging occurs when the asset underlying the futures contract
is different from the asset whose price is being hedge.
Example: Jet fuel being hedged using heating oil futures

The regression approach above is valid only if the relationship
between ∆S and ∆F is linear

Question 20

Investment assets

Answer 20

Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver, stocks, bonds).
The benefit of holding investment asset often represented by the income or dividend yield

Question 21

Consumption assets

Answer 21

Consumption assets are assets held primarily for consumption
(Examples: copper, oil).
The benefit of holding consumption asset is called convenience yield, which is not obtained by owners of long future contracts

Question 22

when is continuous dividend yield used vs discrete

Answer 22

The continuous dividend yield is often used when stock index is involved, whereas the known discrete dividend income method is often used in the case of individual stocks

Question 23

Out of futures and forwards, which usually have the longer term date

Answer 23

Forwards

Question 24

Where are futures traded

Answer 24

Futures contracts are traded on exchanges

Question 25

Where are forwards traded

Answer 25

OTC

Question 26

Compare the sizes of the OTC and the exchange market

Answer 26

The over-the-counter market is ten times as big as the exchange-traded market.

Question 27

Which entity in the United States takes primary responsibility for regulating futures market

Answer 27

Commodities Futures Trading Commission (CFTC)

Question 28

The frequency with which futures margin accounts are adjusted for gains and losses is

Answer 28

Daily

Question 29

the phrase 'haircut' refers to market value or face value

Answer 29

market value

Question 30

When a firm has hedged heavily, how can they run into liquidity problems

Answer 30

liable to experience liquidity problems if the prices rise dramatically

Question 31

describe an optimal hedge ratio in a futures hedge graphically

Answer 31

The optimal hedge ratio is the slope of the best fit line when the change in the spot price (y-axis) is regressed against the change in the futures price (x-axis).

Question 32

When can hedging be a risky choice for a company

Answer 32

If all companies in an industry do not hedge, a company may increase its risk by choosing to hedge.

Question 33

Describe the stack and roll technique in hedging

Answer 33

It creates long-term hedges by repeatedly using short-term futures contracts.

Question 34

If the spot price of an asset is positively correlated with the market, how would you expect the forward price to differ from the futures price

Answer 34

The forward price is less than the expected future spot price. Because we expect a greater rate of return than the risk free from the asset

Question 35

Describe the pricing limits for a consumption commodity

Answer 35

For a consumption commodity, there is an upper limit to the futures price because if the futures price becomes too high, arbitrage is possible. However there is no lower limit as consumption assets are not easily shorted

Question 36

How is the forward price of a foreign currency typically quoted

Answer 36

Some forward prices are quoted as the number of U.S. dollars per unit of the foreign currency, and others are quoted in the reverse way.

Question 37

How is the futures price of a foreign currency quoted by the CME Group?

Answer 37

The number of U.S. dollars per unit of the foreign currency.

Question 38

How can OTC traded forwards credit risk vary

Answer 38

There are 3 possible arrangement for OTC traded forwards Contracts collateralised with the CCP (only standardised contracts) will have similar credit risk to futures The bilaterally collateralised OTC contracts still have some counterparty credit risk, but is substantially less than those that are uncollateralised

Question 39

How do 2 parties with varying credit scores compensate each other

Answer 39

For the uncollateralised OTC contracts, the weaker party has to compensate the stronger party through a CVA

Question 40

Speculation in futures markets is pure gambling. It is not in the public interest to allow speculators to buy seats on a futures exchange Discuss this view-point

Answer 40

speculators add liquidity to the market However, contracts must have some useful economic purpose. Regulators generally only approve contracts when they are likely to be of interest to hedgers as well as speculators.

Question 41

What factors must be considered when deciding whether to hedge currency exchange using forwards or futures

Answer 41

In total the gain or loss under a futures contract is equal to the gain or loss under the corresponding forward contract. However, the timing of the cash flow is different and one does not know in advance which will work out better unless the asset price and the interest rate are correlated

Question 42

When hedging using futures or forwards which has the better outcome when foreign currency falls then rises / rises then falls

Answer 42

falls then rises - forwards early cash flows are negative rises then falls - futures as we benefit from the early positive cash flows

Question 43

When hedging using futures or forwards which has the better outcome when foreign currency falls/rises

Answer 43

falls - forwards as the loss is realised at the end rises - futures the gains are realised day by day both are due to present value

Question 44

part with the short position often choses when/where to deliver the asset, how does this effect futures price

Answer 44

These options make the contract less attractive to the party with the long position and more attractive to the party with the short position

Question 45

Explain how collateral requirements increased in the OTC market in 2008

Answer 45

Regulations require most standard OTC transactions entered into between financial institutions to be cleared by CCPs. These have initial and variation margin requirements similar to exchanges. There is also a requirement that initial and variation margin be provided for most bilaterally cleared OTC transactions

Question 46

Explain what is meant by open interest

Answer 46

Open interest is the number of contract outstanding

Question 47

Meaning of the term, cost of carry

Answer 47

cost of carry is the interest cost, plus storage, less the income earned

Question 48

How would convenience yield and cost of carry impact a basis

Answer 48

convenience yield is the benefit from holding the physical asset so reduces the forward price cost of carry consists of all the costs incurred whilst holding the asset so increases the forward price

Question 49

What is the cost of carry for: (a) a non-dividend-paying stock (b) a stock index (c) a commodity with storage costs (d) a foreign currency.

Answer 49

a) The risk-free rate, b) the excess of the risk-free rate over the dividend yield, c) the risk- free rate plus the storage cost d) the excess of the domestic risk-free rate over the foreign risk-free rate.

Question 50

Explain why a foreign currency can be treated as an asset providing a known yield.

Answer 50

A foreign currency provides a known interest rate, using the conversion rate we can work out the the yield as a percentage of the domestic currency

Question 51

In the absence of default risk, would the forward price be higher or lower than the futures price if the firms stock price is positively correlated with interest rate

Answer 51

The long futures contract is a better deal than long forward contract when correlation with interest rate is positive. This is because the gain due to price increase will be invested in a higher interest rate while the loss due to price decrease will be funded at a lower cost

Question 52

Contango definition

Answer 52

Contango is a situation in which the futures price (or forward price) of a commodity is higher than the expected spot price of the contract at maturity.

Question 53

Backwardation definition

Answer 53

Backwardation is when the current price of an underlying asset is higher than prices trading in the futures market