Lecture-Ch.3 - Hedging Strategies Using Futures Chapter 3 1 Long Hedges A long futures hedge is appropriate when you know you will purchase an asset in

Lecture-Ch.3 - Hedging Strategies Using Futures Chapter 3 1...

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Hedging Strategies Using Futures Chapter 3 1
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Long Hedges A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price Example : It is May 15. A copper fabricator will need 100,000 pounds of copper on July 15. The spot price of copper is 340 cents per pound and the July futures price is 320 cents per pound. Copper fabricator can hedge by: May 15: Long 4 July futures (each 2
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Short Hedges A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price Example : It is May 15. An oil producer has negotiated a contract to sell 1 million barrels of crude oil. The price in the sales contract is the spot price on August 15.Oil producer can hedge by:May 15: Short 1,000 August futures (each contract is for 1000 barrels) 3
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Arguments in Favor 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 4
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Arguments against Hedging Shareholders are usually well diversified and can make their own hedging decisions It may increase risk to hedge when competitors do not Example: jewelery producer’s hedging of gold prices will make profits volatile Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult Hedging may reduce potential profits 5
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Convergence of Futures to Spot (Hedge initiated at time t 1 and closed out at time t 2) 6 Time Spot Price Futures Price t 1 t 2
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Short Hedge Suppose that F 1 : Initial Futures Price F 2 : Final Futures Price S 2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized= S 2+ ( F 1 – F 2) = F 1+ ( S 2 – F 2) = F 1 + b 2 7
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Long Hedge Suppose that F 1 : Initial Futures Price F 2 : Final Futures Price S 2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset= S 2 ( F 2 F 1) = F 1 + ( S 2 F 2) F 1+ b 1 8
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