FIN+4414+-+Managing+Risk+-+Chapter+23

FIN+4414+-+Managing+Risk+-+Chapter+23 - Managing Risk...

Info iconThis preview shows pages 1–16. Sign up to view the full content.

View Full Document Right Arrow Icon
Managing Risk
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Terminology : Basic definition. Comparison to options. Escrow, margin, and payment. Ability to earn interest on commodity/security price. Futures and Forward Contracts
Background image of page 2
“Marked-to-market” and daily profit and loss Dividends and Interest payments. Forward contracts. Futures and Forward Contracts
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Example: A wheat farmer expects to harvest wheat in August. The current price in March is $2.73 per bushel, which will cover the cost of production and give the farmer a fair rate of return. Hedging: Commodity Futures
Background image of page 4
The farmer can not be sure what wheat will sell for in August when the crop is harvested, but notices that September wheat futures are selling for $2.82 per bushel. How does the farmer hedge? Hedging: Commodity Futures
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
If the farmer is willing to settle for $2.73 per bushel, then, to hedge this price, the farmer should sell September wheat futures in March. In August, when the wheat is harvested, the price will be locked, given that spot and futures prices will, in general, move together. Hedging: Commodity Futures
Background image of page 6
August Outcome 1 : Harvest is large so spot price drops to $2.66 per bushel and September futures drops to $2.75. Hedging: Commodity Futures
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Cash Market Futures Market Sells wheat for Buys September $2.66 futures for $2.75 Result Result Loss of $0.07 Gain of $0.07 per per bushel bushel Hedging: Commodity Futures
Background image of page 8
Outcome : $2.66 = per bushel cash income .07 = per bushel cash gain from futures hedge $2.73 = per bushel realized price Hedging: Commodity Futures
Background image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
August Outcome 2 : Harvest is small so spot price rises to $2.94 per bushel and September futures increase to $3.03. Hedging: Commodity Futures
Background image of page 10
Cash Market Futures Market Sells wheat for Buys September $2.94 futures for $3.03 Result Result Gain of $0.21 Loss of $0.21 per per bushel bushel Hedging: Commodity Futures
Background image of page 11

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Outcome : $2.94 = per bushel cash income - .21 = per bushel cash loss from futures hedge $2.73 = per bushel realized price Hedging: Commodity Futures
Background image of page 12
Problems : The prior example was not a perfect hedge, since the wheat was harvested and sold in August, while the futures contract matured in September. Hedging: Commodity Futures
Background image of page 13

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
We had assumed that the spot- futures spread remained constant over time. This may or may not happen and exposes the farmer to what is called “spread variation risk”. Hedging: Commodity Futures
Background image of page 14
August the spot and futures prices have not moved by the same amount. That is, the original spread of $0.09
Background image of page 15

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 16
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

Page1 / 54

FIN+4414+-+Managing+Risk+-+Chapter+23 - Managing Risk...

This preview shows document pages 1 - 16. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online