FINM3405Answers Tutorial 2

FINM3405Answers Tutorial 2 - FINM3405 Derivatives Risk...

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FINM3405 Tutorial 2 © Philip Gray 2009 1 FINM3405 Derivatives & Risk Management Tutorial 2 Question 1 a) On 1 September, the spot price of gold is USD 926 per ounce. The risk to the business is that the price at which we will sell the gold late November will be lower than this. This will have a negative impact on firm profit. To summarise, we are exposed to falling gold prices. b) To eliminate the risk of a decrease in gold price, we want to lock in a sales price we will get for gold in November. We can lock in the selling price for gold by going short the gold futures. Another way to think about this is as follows. We can establish the correct hedge position (long or short?) by doing today in the futures market what we will be doing in the physical market in November. In November, we will be physically selling 100,000 ounces of gold, so we enter a short futures position today. No matter which way you look at it, entering a short gold futures position is the correct hedge. c) You have a short position covering 100,000 ounces of gold at a contracted futures price of $935 per ounce. In other words, we are able to physically deliver 100,000 ounces of gold and will receive USD93.5m (100,000 × USD 935). The contract specifications are likely to be very strict with respect to the quality of the gold delivered, the time and place for delivery. At expiry in late November: We physically deliver 100,000 ounces of gold to person on the other side of the contract. In exchange for this delivery, we receive 100,000 × $935 = USD 93.5m. d) To close-out the short position, we enter an equal and opposite futures position; namely, enter a long futures contract for 100,000 ounces of gold with November delivery. The futures price at which we close-out will be exactly (or very close to) the spot price of gold at the end of November ($930) – otherwise an arbitrage opportunity exists (see Tutorial 1 Question 5). Since we went short at $935 per ounce and closed-out by going long at $930 per ounce, we have a futures trading profit of $5 per ounce. On 100,000 ounces, this is a total profit of $500,000. That closes-out the futures position, but we still have a truckload of gold. We then physically sell our 100,000 ounces of gold at the end-of-November spot price of $ 930 per barrel and realise $93m. Add the $500,000 futures profit and the net monies received are $93.5m. Note that this is exactly the same as we achieved when the gold was physically delivered under the futures contract.
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FINM3405 Tutorial 2 © Philip Gray 2009 2 e) Sometimes, futures contracts are cash settled . All this means is that the futures exchange establishes which side of the contract won and which side of the contract lost, and how much. The loser pays the winner the difference, and no physical asset is exchanged. The SFE SPI futures contract are an example. Contract For Difference (CFDs) are also similar. In our case, we went short when the price was $935. At expiry, the price is $930. Short
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This note was uploaded on 08/27/2009 for the course FINM 3405 taught by Professor Philipgray during the Three '09 term at Queensland.

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FINM3405Answers Tutorial 2 - FINM3405 Derivatives Risk...

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