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
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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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