Summer 2012: 0472-378
Financial Markets & Institutions
Solution: Assignment #2 1.B
Basis = spot price of hedged asset – futures price. The stronger of the basis is due to an increase of the spot price. Since profit from short position = initial futures price – ultimate spot price, the seller of the contract suffers if the price initially locked-in turns out to fall below the price that could have been obtained at contract maturity.
Marking-to-market means that each day any profits or losses on the contract are calculated. You pay the exchange any losses and receive any profits. The result is the elimination of credit risk, and individuals can trade futures contracts without worrying about the identity of their counterparty.
You expect to receive a payment in Swiss francs and are worried that SFr may have depreciated in the meantime. You sell foreign exchange futures on SFr with a delivery date of two months. Suppose, for example, that you agree to deliver SFr in two months at a price of $1.08/SFr. If SFr depreciates, the price drops to (say) $1.06/SFr. In this case, the profit that you make on the foreign exchange futures offsets the lower value that you are likely to receive when time is due.
Price fluctuations can be good or bad, depending on which way they go. If you hedge with futures contracts, you do eliminate the risk associated with an adverse price change. However, you also eliminate the potential gain from a favorable move.
A firm has a fixed-rate loan, but it wishes to obtain the lowest possible interest rate. With an interest rate swap agreement, the firm receives a fixed-rate loan payment to better match its cash flows. Paying a floating-rate can take advantage of the fact that rates on floating-rate loans are generally lower than rates on fixed-rate loans.
The put option gives you the right to sell a T-bond futures for the exercise price (e.g. 110). If you hold a put on a T-bond futures and the futures price turns out to be greater (say, 115) than the exercise price, you should not exercise your option to sell the T-bond futures for less. The put will be left unexercised and will expire valueless.
When interest rates rise, value of the treasury securities falls. The put options on futures give the buyer the right to sell those financial futures for a fixed exercise price. While the puts are in-the-money and they will be exercised, the positive payoff may offset the losses in the portfolio.
Forward rate agreement (FRA) is a contract used to manage a firm’s exposure to interest rate risk by agreeing to borrow or lend at a specified future date at an interest rate that is fixed today. A firm thinks interest rates are going to increase and wants protection. This is the same as saying that it wants to hedge the rising interest rate. Now, a lender offers an FRA based on the 3-month forward rate of 4%. If the reference rate (LIBOR) is higher than 4%, at 4.5% (say), then the lender will pay the firm the difference of 0.5% at the time money is borrowed. If LIBOR is less than 4%, at 3.5% (say), the firm would pay the lender the difference of 0.5% at the beginning of the loan period. Regardless of the LIBOR, the firm has locked in an overall cost of 4% which is the forward rate of this contract.
Diversification is a strategy designed to reduce risk by spreading the portfolio across many assets. Specialization involves just one item in the holding. A narrow focus resolves the adverse selection problem due to asymmetric information. Adverse selection is a decision making results from the incentive for some people to engage in a transaction that is undesirable to everyone else.
A carrying-charge market refers to the case where the futures price is greater than the case price (i.e. the basis is negative). A variety of factors can lead to an economically justifiable difference between the two prices, including...
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