L the hedging risk or basis risk is the uncertainty

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l The hedging risk ( or basis risk ) is the uncertainty associated with b t . Fin330 40
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“Convergence” of Futures to Spot Price Fin330 41 Time Time (a) (b) Futures Price Futures Price Spot Price Spot Price Negative basis Positive basis
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Basis risk 1. What was the basis risk in the producer/buyer example above? 2. What was the effective price received by P and paid by B? Answers: Fin330 42
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Basis risk l Basis risk can lead to an improvement or a worsening of hedger’s position. l Consider a company that uses a short hedge : l an unexpected increase in the bias improves company’s position because it will get a higher price for the asset. l Consider a company that uses a long hedge : l an unexpected increase in the bias worsens company’s position because it will pay a higher price for the asset. Fin330 44
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Dates mismatch: Example l Today is t=0 . A US exporter expects to receive 50 million Japanese yen in t=1 . l The exporter enters into a t=2 futures contract at the price of F 0 =0.78 cents/Yen in t=0 . l The exporter clears out its position in t=1 . Fin330 45
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Dates mismatch: Example 1. Without the futures, what is exporter’s effective price and the payoff (in $) in t=1 ? 2. What is exporter’s effective price and the payoff (in $) if she enters into a futures contract and clears out her position in t=1? 3. What is exporter’s payoff (in $) in t=2 ? Fin330 46
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Dates mismatch: Example Answers: Fin330 47
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Appendix for self study 1. Margins and Marking to market 2. Examples of futures contracts 49
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Margins and Marking to Market l Both parties risk their counter-party walking away if the price goes against them. l To minimize risk, brokers require investors to deposit funds in a margin account . Clearing houses require brokers to do the same. l Margin requirements: l Initial margin : the amount to be deposited when entering into a contract. l Maintenance margin : A margin call is issued if account balance falls below maintenance margin. Then the investor is required to top up the margin account. 50
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Margins and Marking to Market l The balance of the margin account is adjusted to reflect the daily gain or loss— marking to market . l Settlement price is the average of the prices at which the contract is traded. It is used to compute gains/losses in the margin accounts. l In gold futures trading, the margin varies between 2% and 20% depending on the volatility of the spot market. l Futures positions are settled on a daily basis: gains and losses from a day's trading are deducted or credited to a person's account each day. 51
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Marking to Market: Example 1 l Consider a three-period futures contract on gold has a price of $850 and the spot price of Gold is $840 l S 0 =$840; F 0 =850 l Cash flow to the buyer and seller of this contract: Time Period Future Price Buyers’ CF Sellers’ CF 1 F 1 =880 2 F 2 =860 3 F 3 =855 NET 52
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Marking to Market: Example 1 l Consider a three-period futures contract on gold that has a price of $850 and the spot price of gold is $840 l S 0 =$840; F 0 =850 l Cash flow to the buyer and seller of this contract: Time Period Future Price Buyers’ CF Sellers’ CF 1 F 1 =880 +30 -30 2 F 2 =860 -20 +20 3 F 3 =855 -5 +5 NET +5 -5 53
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