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Unformatted text preview: CHAPTER 22 FORWARD AND FUTURES CONTRACTS Answers to Questions 1. There are many different reasons some futures contracts succeed and some fail, but the most important is demand. If people need a particular contract to expose themselves to or hedge a price risk, then the contract will succeed. Most people use Treasury bond futures to gain exposure to or hedge general long-term interest rate risk. The only additional advantage of futures on corporate bonds would be that the investors could gain exposure to changes in the credit spread. Apparently there is little demand for this, either because investors do not want to hedge or gain exposure to this risk or because the underlying market is not liquid enough to support futures. Either way, the lack of futures is motivated by a lack of demand in the asset or futures contract. The lack of chicken contracts most likely derives from a similar lack of demand. It could be that chicken prices are highly correlated with other existing contract prices, so investors do not need the additional chicken contract. Perhaps there are too many different types of chickens to have a single contract that would attract enough trading volume. 2. Before entering into a futures or forward contract, hedgers have exposure to price changes in the underlying asset. To hedge this risk, hedgers enter into contracts that most closely offset this price risk. The problem is that for most hedgers there is not a contract that exactly matches their exposure. Perhaps, the commodity they use is a different grade or needed in a different location than specified in the contract, so differences in prices between the actual asset the company is exposed to and the asset in the contract may exist and change over time. Likewise, a portfolio manager hedging a stock portfolio may hold a portfolio that is not perfectly correlated with the index future he/she is using to hedge with. To minimize basis risk it is necessary to find the contract whose price is most highly correlated with the price of the asset to be hedged. 3(a). To hedge price risk, you could enter into a long position in 100,000 gallons worth of gasoline futures. 3(b). Since you will have to post margin on the futures contract, the price swings in the futures contract will effect how much you earn on the capital posted as margin. If gas prices go up, your margin account will be credited and you will earn more interest. If gas prices go down, your account will be debited and you will earn less interest. If prices go down substantially, you will be required to post additional margin, and therefore tie up additional capital. How this effects your pricing of the forward contract you have sold depends on your opportunity cost of capital....
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This note was uploaded on 05/20/2010 for the course FIN 5DLS taught by Professor Leejohn during the One '10 term at La Trobe University.

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