Futures II

Futures II - Econ 174 FINANCIAL RISK MANAGEMENT LECTURE...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Econ 174 – FINANCIAL RISK MANAGEMENT LECTURE NOTES Foster, UCSD October 16, 2011 A. Introduction to Hedging Risk Exposure 1. The Basics: a) The setting and objective. 1) A hedger already has a portfolio of assets A or is in a line of business that is exposed to market risk from changes (up or down) in prices and values of assets and commodities. 2) With an appropriate futures contract, the hedger adds a financial instrument to the port-folio that is negatively correlated with its value, thereby eliminating or reducing it’s vul-nerability to value swings, at least up to the contract delivery date T. b) Short and long hedges. 1) Short – hedger wants to take a short position in a futures contract for a commodity or asset which the hedger already owns or will own and expects to sell at about time T. 2) Long – hedger wants to take a long position in a futures contract for a commodity or asset which the hedger will have to acquire or purchase at about time T. 3) In either case, with the futures contract, the hedger can lock in a fixed price F 0 (T) for the asset to be sold or purchased (if the position is held open until delivery at T). c) Closing the hedge. 1) Most futures contracts, including those used for hedging, are closed at time τ < T. Hedgers prefer to buy/sell the commodity through normal business channels. 2) Closure date τ is typically a month or more before delivery date T because F t (T) often fluctuates wildly just before the end of trading, despite convergence. 2. An Example (Short Hedge): a) The setting: 1) It is January 1. An oil refinery is producing 120,000 gallons of No. 2 heating oil which it has agreed to sell to a public utility at the end of March for whatever the spot price is on March 15. 2) The current (January) spot price is $1.58/gallon. 3) The refinery is worried that the price in March might be below $1.55/gallon, which is the refiner’s break-even point. b) The hedge. Hedging Notation (for 0 < t < T) Symbol Definition Q a , Q x Number of units of A or X S t , S(a) t , S(x) t Spot price of A or X B t = S t F t (T) Basis on a given contract Y t Value of hedged position
Background image of page 1

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

View Full DocumentRight Arrow Icon
Ec 174 FUTURES II p. 2 of 17 1) Acting in January, the refinery shorts three Heating Oil No. 2 futures contracts for March delivery at forward price F 0 = $1.595/gallon. Each contract is for delivery of 42,000 gallons at the end of March. 2) The refinery will close the position on τ = March 15, before the delivery period opens. c) Outcome #1 -- Suppose the spot price of heating oil on March 15 turns out to be S τ = $1.54 per gallon and the futures price F τ (MAR) = $1.53. 1) Without the hedge, the refinery would simply have to sell the 120,000 gallons to the public utility for 1.54 × 120,000 = $184,800. 2)
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 17

Futures II - Econ 174 FINANCIAL RISK MANAGEMENT LECTURE...

This preview shows document pages 1 - 3. Sign up to view the full document.

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