Hedging Strategies Using Futures

Question 1

define

short hedge

Hedging Strategies Using Futures

Answer 1

a hedge that involves a short position in futures contracts

define

Hedging Strategies Using Futures

Question 2

describe

when is a short hedge strategy appropriate?

Hedging Strategies Using Futures

Answer 2

if the hedger already owns an asset and expects to sell it at some time in the future; or,
if the hedger doesn’t own an asset, but expects to own it in the future

describe

Hedging Strategies Using Futures

Question 3

define

long hedge

Hedging Strategies Using Futures

Answer 3

involves taking a long position in a futures contract

define

Hedging Strategies Using Futures

Question 4

describe

when is a long hedge appropriate?

Hedging Strategies Using Futures

Answer 4

if the hedger knows it will have to purchase a certain asset in the future and wants to lock in a price now

describe

Hedging Strategies Using Futures

Question 5

Describe

arguments in favor of hedging

Hedging Strategies Using Futures

Answer 5

• Firms not in finance have no particular skills or expertise in predicting variables such as interest rates
• Experts can even be wrong about their predictions

Hedging Strategies Using Futures

Question 6

List reasons why

hedging is often not that straightforward

Hedging Strategies Using Futures

Answer 6

1. The asset whose price is being hedged may not be the same as the underlying asset in the futures contract
2. Uncertainty as to the exact of the disposal of the asset to hedged
3. May require the futures contract to be closed out before the delivery month

Hedging Strategies Using Futures

Question 7

Consequence of:

The asset whose price is being hedged may not be the same as the underlying asset in the futures contract

Hedging Strategies Using Futures

Answer 7

basis risk

Hedging Strategies Using Futures

Question 8

Consequence of:

Uncertainty as to the exact of the disposal of the asset to hedged

Hedging Strategies Using Futures

Answer 8

basis risk

Hedging Strategies Using Futures

Question 9

Consequence of:

May require the futures contract to be closed out before the delivery month

Hedging Strategies Using Futures

Answer 9

basis risk

Hedging Strategies Using Futures

Question 10

Explain

cross hedging

Hedging Strategies Using Futures

Answer 10

occurs when the two assets are different. jet fuel futures are not actively traded, it might choose to use heating oil futures contracts to hedge its exposure

Hedging Strategies Using Futures

Question 11

Formula

minimum variance hedge ratio

Hedging Strategies Using Futures

Answer 11

standard deviation of ΔS / standard deviation of ΔF

Hedging Strategies Using Futures

Question 12

optimal number of contracts

calculate the number of contracts that should be used in hedging, define:

Hedging Strategies Using Futures

Answer 12

Q_a: size of position being hedged (units)
Q_f: size of one futures contract (units)
N^*: optimal number of futures contracts for hedging

Hedging Strategies Using Futures

Question 13

minimum variance hedge ratio

An airline expects to purchase 2 million gal. jet fuel in 1 mo. and decidies to use heating oil futures for hedging. Assume the standard deviation of the jet fuel price is 0.0313, the standard deviation of the heating oil price is 0.0263 and the correlation is 0.928.

Hedging Strategies Using Futures

Answer 13

0.928*(0.0263 / 0.0313) = 0.78

Hedging Strategies Using Futures

Question 14

Explain

perfect hedge

Hedging Strategies Using Futures

Answer 14

Hedging Strategies Using Futures

Question 15

Explain

Does a perfect hedge always lead to a better outcome than an imperfect hedge

Hedging Strategies Using Futures

Answer 15

Hedging Strategies Using Futures

Question 16

Under what circumstances

minimum variance hedge portfolio lead to no hedging at all

Hedging Strategies Using Futures

Answer 16

Hedging Strategies Using Futures

Question 17

Explain

does a perfect hedge always succeed in locking in the current spot price of an asset for a future transaction?

Hedging Strategies Using Futures

Answer 17

Hedging Strategies Using Futures

Question 18

Explain

Is the hedge perfect if the minimum variance hedge ratio is 1.0?

Hedging Strategies Using Futures

Answer 18

Hedging Strategies Using Futures

Question 19

Explain

If there is no basis risk, is the minimum variance hedge ratio always 1.0?

Hedging Strategies Using Futures

Answer 19

Hedging Strategies Using Futures

Question 20

True or False

When the futures price of an asset is less than the spot price, long hedges are likely to be particularly attractive?

Hedging Strategies Using Futures

Answer 20

Hedging Strategies Using Futures

Question 21

What strategy should the beef producer follow?

The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound) 1.2. The standard deviation of monthly changes in the futures price of live cattle for the closest contract is 1.4. The correlation between the futures price changes and the spot price changes is 0.7. It is now October 15. A beef producer is committed to purchasing 200,000 pounds of live cattle on November 15. The producer wants to use the December live cattle futures contracts to hedge its risk. Each contract is for 40,000 pounds of cattle.

Hedging Strategies Using Futures

Answer 21

Hedging Strategies Using Futures

Question 22

Calculate

The expected return on the S&P 500 is 12% and the risk-free rate is 5%. What is the expected return on an investment with a beta of (a) 0.2, (b) 0.5, and (c) 1.4?

Hedging Strategies Using Futures

Answer 22

Hedging Strategies Using Futures

Question 23

What is the minimum variance hedge ratio?

A trader owns 55,000 units of a particular asset and decides to hedge the value of her position with futures contracts on another related asset. Each futures contract is on 5,000 units. The spot price of the asset that is owned is $28 and the standard deviation of the change in this price over the life of the hedge is estimated to be $0.43. The futures price of the related asset is $27 and the standard deviation of the change in this over the life of the hedge is $0.40. The coefficient of correlation between the spot price change and futures price change is 0.95.

Hedging Strategies Using Futures

Answer 23

Hedging Strategies Using Futures

Question 24

Should the hedger take a long or short futures position?

A trader owns 55,000 units of a particular asset and decides to hedge the value of her position with futures contracts on another related asset. Each futures contract is on 5,000 units. The spot price of the asset that is owned is $28 and the standard deviation of the change in this price over the life of the hedge is estimated to be $0.43. The futures price of the related asset is $27 and the standard deviation of the change in this over the life of the hedge is $0.40. The coefficient of correlation between the spot price change and futures price change is 0.95.

Hedging Strategies Using Futures

Answer 24

Hedging Strategies Using Futures

Question 25

What is the optimal number of futures contracts (no settlment adjusting)

A trader owns 55,000 units of a particular asset and decides to hedge the value of her position with futures contracts on another related asset. Each futures contract is on 5,000 units. The spot price of the asset that is owned is $28 and the standard deviation of the change in this price over the life of the hedge is estimated to be $0.43. The futures price of the related asset is $27 and the standard deviation of the change in this over the life of the hedge is $0.40. The coefficient of correlation between the spot price change and futures price change is 0.95.

Hedging Strategies Using Futures

Answer 25

Hedging Strategies Using Futures

Question 26

How can the daily settlement of futures contracts be taken into account?

A trader owns 55,000 units of a particular asset and decides to hedge the value of her position with futures contracts on another related asset. Each futures contract is on 5,000 units. The spot price of the asset that is owned is $28 and the standard deviation of the change in this price over the life of the hedge is estimated to be $0.43. The futures price of the related asset is $27 and the standard deviation of the change in this over the life of the hedge is $0.40. The coefficient of correlation between the spot price change and futures price change is 0.95.

Hedging Strategies Using Futures

Answer 26

Hedging Strategies Using Futures