Convergence of Futures to Spot

Convergence of Futures to Spot - • The net loss is-2,775...

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Convergence of Futures to Spot (Hedge initiated at time t 1 and closed out at time t 2) Time Spot Price Futures Price t 1 t 2 1

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What is the cause of basis risk? 1. You don’t know exactly when you will receive or sell the asset. 2. There may not be a futures contract expiring on the date needed. 3. You can’t always match assets. 2
Return to gold example Suppose our gold dealer decides to close the position prior to expiration of the futures contract. On November 5 the spot price of gold was \$405.65 (St) and the December futures price (Ft) was \$408.50. basis = 405.65 - 408.50 = -2.85 3

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Result for gold dealer To close the position, the gold dealer sells the gold on the spot market and receives profit of 100(405.65 - 433.40) = -\$2,775 He also buys back a December futures contract to close the futures position and receives profit of 100(431.50 - 408.50) = \$2,300

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Unformatted text preview: • The net loss is-2,775 + 2,300 = -\$475 4 Short hedge lost • Notice that here (but not always) the net loss per ounce of gold is equal to the change in the basis. bt - b0 = (St -Ft) - (S0 - F0)-4.75 = (405.65-408.50) - (433.40-431.50) 5 Choice of Contract • Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge • When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. 6 1:1 Hedge ratio • Our gold dealer used a 1:1 hedge ratio. • Here the hedge ratio, h, is h = size of futures position size of cash market position • Was this “optimal”? • A minimum variance hedge ratio would minimize the variance of possible outcomes. 7...
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Convergence of Futures to Spot - • The net loss is-2,775...

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