Ch 3_Solutions

Ch 3_Solutions - CHAPTER 3 Problem 3.1. Under what...

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CHAPTER 3 Problem 3.1. Under what circumstances are (a) a short hedge and (b) a long hedge appropriate? A short hedge is appropriate when a company owns an asset and expects to sell that asset in the future. It can also be used when the company does not currently own the asset but expects to do so at some time in the future. A long hedge is appropriate when a company knows it will have to purchase an asset in the future. It can also be used to offset the risk from an existing short position. Problem 3.2. Explain what is meant by basis risk when futures contracts are used for hedging. Basis risk arises from the hedger’s uncertainty as to the difference between the spot price and futures price at the expiration of the hedge. Problem 3.3. Explain what is meant by a perfect hedge. Does a perfect hedge always lead to a better outcome than an imperfect hedge? Explain your answer. A perfect hedge is one that completely eliminates the hedger’s risk. A perfect hedge does not always lead to a better outcome than an imperfect hedge. It just leads to a more certain outcome. Consider a company that hedges its exposure to the price of an asset. Suppose the asset’s price movements prove to be favorable to the company. A perfect hedge totally neutralizes the company’s gain from these favorable price movements. An imperfect hedge, which only partially neutralizes the gains, might well give a better outcome. Problem 3.4. Under what circumstances does a minimum-variance hedge portfolio lead to no hedging at all? A minimum variance hedge leads to no hedging when the coefficient of correlation between the futures price changes and changes in the price of the asset being hedged is zero. Problem 3.5. Give three reasons why the treasurer of a company might not hedge the company’s exposure to a particular risk. Explain your answer. (a) If the company’s competitors are not hedging, the treasurer might feel that the company will experience less risk if it does not hedge. (See Table 3.1.) (b) The shareholders might not want the company to hedge because the risks are hedged within their portfolios. (c) If there is a loss on the hedge and a gain from the company’s exposure to the underlying asset, the treasurer might
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feel that he or she will have difficulty justifying the hedging to other executives within the organization. Problem 3.6. Suppose that the standard deviation of quarterly changes in the prices of a commodity is $0.65, the standard deviation of quarterly changes in a futures price on the commodity is $0.81, and the coefficient of correlation between the two changes is 0.8. What is the optimal hedge ratio for a three-month contract? What does it mean? The optimal hedge ratio is 0 65 0 8 0 642 0 81 . .
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Ch 3_Solutions - CHAPTER 3 Problem 3.1. Under what...

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