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Hedging Page Subject Question description 9_quiz3_15 perfect hedge & futures / spot price 9 & quiz 3 & 15 10_16_quiz1245 basis & minimum variance hedge 10 & 16 & quiz 1, 2, 4, & 5 21_24_18 changing beta of a shareholding 21 & 24 & 18 23_quiz2 hedging with futures 23 & quiz 2 NOTE: Before printing, be sure to disable Property, Active page, Conditional colour. Hedging / revised: 18 Feb 2007 © Dr J R Hicks page 1 (of 1)
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Hedging 9 & quiz 3 & 15 perfect hedge & futures / spot price QUESTION A hedge is used to reduce risk in prices, interest rates, exchange rates and other market variables. Required: a) Explain what is meant by a perfect hedge. b) What are the main reasons for a hedge to be imperfect and what strategies can be used to overcome these? Give examples. c) Does a perfect hedge always lead to a better outcome than an imperfect hedge? Explain your answer. d) Does a perfect hedge always succeed in locking in the current spot price of an asset for a future transaction? Explain your answer. e) "For an asset where futures prices are usually less than spot prices, long hedges are likely to be particularly attractive." Explain this statement and illustrate it with an example. Hedging 9 & quiz 3 & 15 perfect hedge & futures / spot price ANSWER a) A perfect hedge is one that completely eliminates the hedger's risk. Any change in value of the underlying is offset by an opposite change in value of the hedge. b) Imperfect hedges are caused by differences in the: maturity date This can be overcome by rolling the hedge forward. Thus a company might enter into a series of futures contracts with short maturities (and greater liquidity), closing out the contract before [potential] maturity. underlying The underlying may differ in size, quality, etc. This is overcome by using a derivative which is strongly correlated with the asset to be hedged. An example would be the use by airlines of heating oil futures to hedge the price of aviation fuel. c) A perfect hedge does not always lead to a better outcome than an imperfect hedge. It just leads to a more certain outcome. Consider a company that hedges its exposure to the price of an asset. Suppose the asset's price movements prove to be favourable to the company. A perfect hedge totally neutralises the company's gain from these favourable price movements. An imperfect hedge, which only partially neutralises the gains, might well work out better. d) No. Consider for example the use of a forward contract to hedge a known cash inflow in a foreign currency. The forward contract locks in the forward exchange rate - which is in general different from the spot exchange rate. e) A company that knows it will purchase a commodity in the future is able to lock in a price close to the futures price. For example, say that a company will need 100 tonnes of copper in May and that the May futures price is 120 cents per pound and the current spot price is 140 cents per pound. If the futures price is usually less than the spot price then the expected
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