L it is used when a financial asset or commodity is

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l It is used when a financial asset or commodity is needed in the future. l It allows the buyer to lock in a price for the input. Fin330 24
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Hedging l Why do firms/investors hedge against risk? l How does the hedging strategy depend on investor’s risk preferences? l What is the difference between a hedger and a speculator? Fin330 25
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Hedging: Example l A seller of engines (P) and a car producer (B) enter into a futures contract in t=0 , which requires P to deliver 1,000 engines to B in t=1 at a price of F 0 = $400/engine. l The spot price per engine in t=1 is uncertain. Denote it S 1 . l Assume that the locked-in production cost of an engine is $100, while the locked-in selling price of a car is $1T. The cost and the selling price are paid in t=1 . Fin330 26
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Hedging: Example 1. Without the futures, what is the payoff to P and B in t=1 ? 2. What are the payoffs to P and B per engine from entering into a futures contract, which is settled in cash in t=1 ? 3. After cash settlement, B still needs to buy engines to produce cars, while P still needs to get rid of engines. If they do so on the spot market in t=1 , what are the payoffs? Fin330 27
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Hedging: Example 4. What is the total payoff to P and B? 5. Plot the total payoffs to B and P as a function of S 1 with and without entering into the futures contract. Is hedging perfect? 6. Would payoffs in (2) be different if each party would close her position instead of settling it in cash? 7. What is the payoff to a speculator , who takes a short position on the futures contract in t=0 at the price F 0 with the contract size of 1,000 engines? Fin330 28
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Hedging: Example Answers: Fin330 29
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Producer’s hedging + = S 1 S 1 S 1 π π π Payoff without forward contract 30 Short futures Hedged profit
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Buyer’s hedging + = S 1 S 1 S 1 π π π Payoff without futures contract 31 Long futures Hedged profit
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Speculator’s payoff Fin330 32 S 1
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Overview 1. Forward/Futures: definition and payoffs 2. Settlement procedures 3. Convergence of Forward/Futures prices to spot prices 4. Hedging strategies using Forward/Futures 5. Basis risk 37
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Perfect Hedging 38 l In the producer/buyer example, hedging was perfect. l In practice, hedges are more complicated: 1. The asset to be hedged the asset underlying the futures. (Why?) 2. The expiration date of the futures the actual buying/selling date of the asset ( “Dates” mismatch ): l The hedger might not be exactly certain of the when the asset will be bought or sold. l The hedger is certain of the when the asset will be bought or sold but there exists no futures contract with the matching maturity. Fin330
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“Dates mismatch” Fin330 39
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Basis l Basis is the difference between the cash price for the asset to be hedged and the futures price: b t = S t –F t l Effective price received for a short hedge at t : S t + F 0 – F t = b t +F 0 l Effective price paid for a long hedge at t : S t + F 0 – F t = b t +F 0 l F 0 and S 0 are known; F t and S t are uncertain.
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