Ch10Sols - CHAPTER 10: FUTURES HEDGING STRATEGIES...

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10-1 CHAPTER 10: FUTURES HEDGING STRATEGIES END-OF-CHAPTER QUESTIONS AND PROBLEMS 1. The terms short and long refer to the position taken in the futures contract. A short (long) hedge means that you are short (long) futures. Since a hedge implies opposite positions in the spot and futures markets, a short (long) hedge means that you are long (short) in the spot market. 2. The basis is defined as the difference between the spot price and the futures price. At expiration, the spot price must equal the futures price, give or take a small differential for transaction costs. Therefore, over the life of the contract, the spot and futures prices will converge and the basis will go to zero at expiration. 3. The basis is the difference between the spot price and the futures price. If the basis is positive and strengthens, the spot price increases more or decreases less than the futures price (or the spot price goes up and the futures price goes down). Since a short hedge is long the spot and short the futures, this is beneficial. Since the long hedge is long the futures and short the spot, this hurts the long hedge. 4. The dealer is long sugar in the spot market and should sell sugar futures to set up a hedge S = .0479 f = .0550 b = S - f = .0479 - .0550 = -.0071 = S T - S - (f T - f) We are not given S T but it will not matter since S T and f T will cancel. So make up a value of S T , say .0465. = .0465 - .0479 - (.0465 - .0550) = .0071 In terms of the basis, = - b + b t = - (-.0071) + 0 = .0071 In dollars, = 112,000($.0071) = $795.20 Thus, the profit on the hedge is -1 times the original basis times the number of pounds. 5. b t = S t - f t = .0574 - .0590 = -.0016 = S t - S - (f t - f) = .0574 - .0479 - (.0590 - .0550) = .0055 In terms of the basis, = - b + b t = - (-.0071) + (-.0016) = .0055 The basis went from -.0071 to -.0016, a profit of .0055. In dollars, = 112,000($.0055) = $616 Thus, the basis strengthened so the hedger gained, though not as much as if the hedge had been held to expiration. 6. The most important factor is to have a strong correlation between the spot and futures prices. It is also
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10-2 important that the futures contract have sufficient liquidity. If the contract is not very liquid, then the hedger may be unable to close the position at the appropriate time without making a significant price concession. This weakens the effectiveness of the hedge by making the futures price less dependent on the spot market and the normal cost-of-carry relationship between the two markets. In addition, the contract should be correctly priced or at least priced in favor of the hedger. For example, a short (long) hedger would not want to sell (buy) a futures contract that was underpriced (overpriced) as this would reduce the hedging effectiveness. 7.
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Ch10Sols - CHAPTER 10: FUTURES HEDGING STRATEGIES...

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