Hedging and Futures Markets

Question 1

Define Hedging

Answer 1

Taking a position in the futures market that is opposite to that held in spot market to balance risk in one market to another

Question 2

What are Working’s 3 forms of hedging?

Answer 2

1) Arbitrage hedging/carrying charge hedger
2) Operational hedging
3) Anticipating hedging

Question 3

What are the issues with hedging?

Answer 3

1) Choice of underlying asset in the futures market (very specific)
2) Choice of the contract month (later date than maturity)

Question 4

How do hedgers reduce risk?

Answer 4

Take opposite position in futures market where they take on basis risk, which is somewhat lower than the price risk in spot market

Question 5

What is the relationship between correlation of current price to futures price and the basis risk?

Answer 5

Closer correlation to 1, the lower the basis risk.

Question 6

What are the 4 ways to calculate the hedge ratio?

Answer 6

1) Naive method (past data)
2) Regression analysis
3) Mechanical hedging
4) Value at risk