Hedging and Futures Flashcards
What is a derivative
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
Why are derivatives important
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
Main uses of derivatives
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
Features of the exchange traded market
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
Features of Over-the-Counter (OTC) Markets
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
Forward contract definition
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).
Key Features of Forward contracts
Set for a future date
Typically traded OTC rather than through the exchange
No initial payments
Advantages of hedging
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
Disadvantages of hedging
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.
Define a basis
Basis is the difference between the spot & the futures price
Explain the difference between hedging, speculation and arbitrage
Hedging aims to reduce risk.
Speculation seeks to profit from risk-taking.
Arbitrage exploits price differences across markets.
If the minimum variance hedge ratio is calculated as 1.0, the hedge must be perfect. Is this statement true? Explain your answer
The statement is not necessarily true
Examples of Market failures due to derivatives
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)
Spot contract definition
An agreement to buy or sell an asset immediately at
the current market price
Forwards vs Futures
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
What is a Clearing House?
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
A long forward/futures hedge is appropriate when
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
why does Basis Risk arise
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
what is cross hedging
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
Investment assets
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
Consumption assets
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
when is continuous dividend yield used vs discrete
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
Out of futures and forwards, which usually have the longer term date
Forwards
Where are futures traded
Futures contracts are traded on exchanges
Where are forwards traded
OTC
Compare the sizes of the OTC and the exchange market
The over-the-counter market is ten times as big as the exchange-traded market.
Which entity in the United States takes primary responsibility for regulating futures market
Commodities Futures Trading Commission (CFTC)
The frequency with which futures margin accounts are adjusted for gains and losses is
Daily
the phrase ‘haircut’ refers to market value or face value
market value
When a firm has hedged heavily, how can they run into liquidity problems
liable to experience liquidity problems if the prices rise dramatically
describe an optimal hedge ratio in a futures hedge graphically
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).
When can hedging be a risky choice for a company
If all companies in an industry do not hedge, a company may increase its risk by choosing to hedge.
Describe the stack and roll technique in hedging
It creates long-term hedges by repeatedly using short-term futures contracts.
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
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
Describe the pricing limits for a consumption commodity
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
How is the forward price of a foreign currency typically quoted
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.
How is the futures price of a foreign currency quoted by the CME Group?
The number of U.S. dollars per unit of the foreign currency.
How can OTC traded forwards credit risk vary
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
How do 2 parties with varying credit scores compensate each other
For the uncollateralised OTC contracts, the weaker party has to compensate the stronger party through a CVA
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
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.
What factors must be considered when deciding whether to hedge currency exchange using forwards or futures
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
When hedging using futures or forwards
which has the better outcome when foreign currency
falls then rises / rises then falls
falls then rises - forwards early cash flows are negative
rises then falls - futures as we benefit from the early positive cash flows
When hedging using futures or forwards
which has the better outcome when foreign currency falls/rises
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
part with the short position often choses when/where to deliver the asset, how does this effect futures price
These options make the contract less attractive to the party with the long position and more attractive to the party with the short position
Explain how collateral requirements increased in
the OTC market in 2008
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
Explain what is meant by open interest
Open interest is the number of contract outstanding
Meaning of the term, cost of carry
cost of carry is the interest cost, plus storage, less the income earned
How would convenience yield and cost of carry impact a basis
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
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.
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.
Explain why a foreign currency can be treated
as an asset providing a known yield.
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
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
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
Contango definition
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.
Backwardation definition
Backwardation is when the current price of an underlying asset is higher than prices trading in the futures market
