Or deliver the underlying commodity but instead has

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or deliver the underlying commodity but instead has the right, or choice, to accept delivery (for call holders) or make delivery (for put holders) of the underlying commodity anytime during the life of the contract. Futures and options modify a portfolio’s risk in different ways. Buying or selling a futures contract affects a portfolio’s upside risk and downside risk by a similar magnitude. This is commonly referred to as symmetrical impact. On the other hand, the addition of a call or put option to a portfolio does not affect a portfolio’s upside risk and downside risk to a similar magnitude. Unlike futures contracts, the impact of options on the risk profile of a portfolio is asymmetric. 4. a. The investor should sell the forward contract to protect the value of the bond against rising interest rates during the holding period. Because the investor intends to take a long position in the underlying asset, the hedge requires a short position in the derivative instrument. b. The value of the forward contract on expiration date is equal to the spot price of the underlying asset on expiration date minus the forward price of the contract: $978.40 – $1,024.70 = –$46.30 The contract has a negative value. This is the value to the holder of a long position in the forward contract. In this example, the investor should be short the forward contract, so that the value to this investor would be +$46.30 since this is the cash flow the investor expects to receive. 22-6
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Chapter 22 - Futures Markets c.The value of the combined portfolio at the end of the six-month holding period is: $978.40 + $46.30 = $1,024.70 The change in the value of the combined portfolio during this six-month period is: $24.70 The value of the combined portfolio is the sum of the market value of the bond and the value of the short position in the forward contract. At the start of the six- month holding period, the bond is worth $1,000 and the forward contract has a value of zero (because this is not an off-market forward contract, no money changes hands at initiation). Six months later, the bond value is $978.40 and the value of the short position in the forward contract is $46.30, as calculated in part (b). The fact that the combined value of the long position in the bond and the short position in the forward contract at the forward contract’s maturity date is equal to the forward price on the forward contract at its initiation date is not a coincidence. By taking a long position in the underlying asset and a short position in the forward contract, the investor has created a fully hedged (and hence risk-free) position, and should earn the risk-free rate of return. The six-month risk-free rate of return is 5.00% (annualized), which produces a return of $24.70 over a six- month period: ($1,000 × 1.05 (1/2) ) – $1,000 = $24.70 These results support VanHusen’s statement that selling a forward contract on the underlying bond protects the portfolio during a period of rising interest rates. The loss in the value of the underlying bond during the six month holding period is offset by
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