Lecture 2 - Futures markets and hedging strategies Flashcards
What does the term open interest mean?
The open interest of a futures contract at a particular time is the total number of long positions outstanding or the total number of short positions outstanding.
What does the term trading volume mean?
The trading volume during a certain period of time is the number of contracts traded during this period.
The party with a short position in a futures contract sometimes has options as to the precise
asset that will be delivered, where delivery will take place, when delivery will take place, and so
on. Do these options increase or decrease the futures price? Explain your reasoning.
These options make the contract less attractive to the party with the long position and more attractive to the party with the short position. They, therefore, tend to reduce the futures price.
What are the most important aspects of the design of a new futures contract?
- The specification of the underlying asset
- The size of the contract
- The delivery arrangements
- The delivery months
Speculation in futures markets is pure gambling. It is not in the public interest to allow speculators to trade on a futures exchange.” Discuss this viewpoint.
Speculators are important market participants because they add liquidity to the market. However, regulators generally only approve contracts when they are likely to be of interest to hedgers as well as speculators.
Under which circumstances are a short hedge appropriate?
A short hedge is appropriate when a company owns or will own an asset and expects to sell the asset in the future.
Under which circumstances are a long hedge appropriate?
A long hedge is appropriate when a company knows it will have to purchase an asset in the future.
Explain what is meant by basis risk when futures contracts are used for hedging.
Basis risk arises from the hedger’s uncertainty as to the difference between the spot price and futures price at the expiration of the hedge.
What does an optimal hedge ratio of 0.642 mean?
This means that the size of the futures position should be 64.2% of the size of the company’s exposure in a three-month hedge.
“If there is no basis risk, the minimum variance hedge ratio is always 1.0.” Is this statement
true? Explain your answer.
If the basis is known, then the spot price and forward price change in exactly the same way, i.e the correlation coefficient is 1, and standard deviations are the same –> hedge ratio is 1
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 the delivery of 40,000 pounds of cattle. What strategy should
the beef producer follow?
The optimal hedge ratio is 0.6.
The beef producer requires a long position in 200,000x0.6=120,000 lbs of cattle. The beef producer should therefore take a long position in 3 December contracts closing out the position on November 15.
A futures contract is used for hedging. Explain why the daily settlement of the contract can give
rise to cash flow problems.
Suppose that you enter into a short futures contract to hedge the sale of an asset in six months. If the price of the asset rises sharply during the six months, the futures price will also rise and you may get margin calls. The margin calls will lead to cash outflows. Eventually, the cash outflows will be offset by the extra amount you get when you sell the asset, but there is a mismatch in the timing of cash inflows and outflows. Your cash outflows occur earlier than your cash inflows.
A similar situation could arise if you used a long position in a futures contract to hedge the purchase of an asset at a future time and the asset’s price fell sharply.
A futures contract is used for hedging. Explain why the daily settlement of the contract can give
rise to cash flow problems.
Suppose that you enter into a short futures contract to hedge the sale of an asset in six months. If the price of the asset rises sharply during the six months, the futures price will also rise and you may get margin calls. The margin calls will lead to cash outflows. Eventually, the cash outflows will be offset by the extra amount you get when you sell the asset, but there is a mismatch in the timing of cash inflows and outflows. Your cash outflows occur earlier than your cash inflows.
A similar situation could arise if you used a long position in a futures contract to hedge the purchase of an asset at a future time and the asset’s price fell sharply.
A futures contract is used for hedging. Explain why the daily settlement of the contract can give
rise to cash flow problems.
Suppose that you enter into a short futures contract to hedge the sale of an asset in six months. If the price of the asset rises sharply during the six months, the futures price will also rise and you may get margin calls. The margin calls will lead to cash outflows. Eventually, the cash outflows will be offset by the extra amount you get when you sell the asset, but there is a mismatch in the timing of cash inflows and outflows. Your cash outflows occur earlier than your cash inflows.
A similar situation could arise if you used a long position in a futures contract to hedge the purchase of an asset at a future time and the asset’s price fell sharply.
What is a margin?
A margin is cash or marketable securities deposited by an investor with his or her broker.
