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Chapter 2 - Notes 2 Finance 5108 Basic concept is that...

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Notes 2 Finance 5108 Basic concept is that hedgers take the opposite position in the futures market than they have in the cash market. If they are long in the cash market they would short the futures (Short hedge) and if they are short in the cash market they go long in the futures market (Long Hedge). For example a firm has a long position in crude oil. Then to offset the risk the firm would sell futures contracts to hedge the position. A firm that need to buy 250,000 bushels of wheat for the making flour would go long the futures contract in order to hedge the exposure of a rise in prices. Hedging stabilizes the price of the inputs to production in order to lock in profits and reduce the variance of earnings; lock in the spread. Basis = cash mkt price (spot) - futures price Hedging = price -> basis Hedging is the process of changing price risk into basis risk. Basis risk is the fluctuation of the relationship between the hedging instrument and the cash market security. S&P 500: 1351.25 (Current index price) – 1358.25 = 7.00 Yen: 1/105.95 - .009387 = .00005 T 10yr: 115:16 – 117:00 = 1:16 or 1.5 points Example of a long hedge A perfect hedge is one in which the profit (loss) from the spot market position are exactly offset by the loss (gain) in the futures markets. Let us assume that a portfolio manager is long $1,000,000 face value (price 106%) of a treasury that matures in 2022 with an 8% coupon. The portfolio manager decides to lock in the value of the cash market. To do this a futures position must be entered into which will profit when the cash price falls. To do this we sell the appropriate number of futures contracts. In this case we sell 10 contracts. (Assumes a hedge ratio of 1). A hedge ratio is the dollar value of futures that must be entered into to hedge a dollar of assets. Assuming the cash market price is 106. And the current futures price is 105:08. Note bonds and bond futures trader in % and 32 nd of 1 % of face value.
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