101
CHAPTER 10:
FUTURES HEDGING STRATEGIES
ENDOFCHAPTER 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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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 costofcarry 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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 Fall '08
 staff
 Interest Rates, Hedging

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