Lecture 6

Lecture 6 - Chapter 2 has much detail about the intricacies...

Info iconThis preview shows pages 1–2. Sign up to view the full content.

View Full Document Right Arrow Icon
Chapter 2 has much detail about the intricacies of futures markets. Read it closely. The most relevant to this class are: Positions Closed Out not usually delivered As delivery date nears, futures price should converge to spot price Futures contracts have daily settlement (so cash flows) Recall the basic types of investors: hedgers, speculators, and arbitrageurs. Chapter 3 concentrates on hedgers. A hedge is basically locking in cash flows at an early date before the asset changes hands. Consider a position, S t , that will have value S T at some future date, T. If that asset is hedged then a forward is sold at time T and bought at time t, so that the net asset position is S T F T + F t . We expect that, by the time of expiration, the spot and futures price will be equal (or else there would be arbitrage opportunities) so we expect that, by date T, S T F T = 0. So the hedge is exchanging a volatile price (S t becoming S T ) for a known price, F t . Short Hedge : own an asset and short a forward to sell at a pre-specified price. examples: gold mines might sell the gold, that's still in the ground, at pre-determined prices at some date in the future to "lock in" a profit; farmer can sell the crop forward; exporter with short-term receivables might pre-sell (sell forward) to lock in a profit rate. Consider an insurer selling annuities in Japan that doesn't want the business affected by FX fluctuations so it could sell forward contracts for 3, 6, 9, 12 months (based on expected sales over the year). If these revenues are to be invested in, say, US Treasury securities, then these securities can be bought forward as well. Hedge can be considered by comparing the money lost on the asset position with the money gained from the offsetting hedge. For instance, if the insurer above is getting ¥100,000,000 in 3 months. Right now the rate is 112¥/$ so this is worth $892,857.14. If the rate increases to 122¥/ $ then this is worth only $819,672.13. The movement of ¥10 in the FX rate meant a loss of $73,185.01 on the asset position. If the forward price is also 112¥/$ then selling ¥112 forward (getting one dollar delivered in 3 months) would mean that, if the yen increased to 122 per dollar then the short forward position would mean that the company could sell ¥112 for $1 and still have ¥10 left over to buy dollars (0.0819 worth). This 8-penny gain is small compared to the $73,185.01 loss but the company could sell more than ¥112. How many 112¥/$ contracts? 73,185.01/0.0819 = 892,857.14 worth (which is exactly the number we discovered earlier). This might seem like the long way to go about it but it is worth showing the basic method: one position loses a certain amount; it can be hedged if I can find some other position that would gain that same amount. Most companies use hedges with much more complicated structures, but the basic idea remains: construct two offsetting positions so that, as one loses the other gains (and vice versa). Long Hedge
Background image of page 1

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

View Full DocumentRight Arrow Icon
Image of page 2
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 04/04/2012 for the course FIN 420 taught by Professor Poniachek during the Spring '12 term at Rutgers.

Page1 / 5

Lecture 6 - Chapter 2 has much detail about the intricacies...

This preview shows document pages 1 - 2. Sign up to view the full document.

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