Hedging Strategies Using Futures
In the Chicago Board of Trade’s corn futures contract, the following delivery months are available: March, May, July, September, and December. State the contract that should be used for hedging when the expiration of the hedge is in a) June
A good rule of thumb is to choose a futures contract that has a delivery month as close as possible to, but later than, the month containing the expiration of the hedge. The contracts that should be used are therefore a) July
Does a perfect hedge always succeed in locking in the current spot price of an asset for a future transaction? Explain your answer.
No. Consider, for example, the use of a forward contract to hedge a known cash inflow in a foreign currency. The forward contract locks in the forward exchange rate — which is in general different from the spot exchange rate.
Explain why a short hedger’s position improves when the basis strengthens unexpectedly and worsens when the basis weakens unexpectedly.
The basis is the amount by which the spot price exceeds the futures price. A short hedger is long the asset and short futures contracts. The value of his or her position therefore improves as the basis increases. Similarly it worsens as the basis decreases.
Imagine you are the treasurer of a Japanese company exporting electronic equipment to the United States. Discuss how you would design a foreign exchange hedging strategy and the arguments you would use to sell the strategy to your fellow executives.
The simple answer to this question is that the treasurer should 1. Estimate the company’s future cash flows in Japanese yen and U.S. dollars 2. Enter into forward and futures contracts to lock in the exchange rate for the U.S. dollar cash flows. However, this is not the whole story. As the gold jewelry example in Table 3.1 shows, the company should examine whether the magnitudes of the foreign cash flows depend on the exchange rate. For example, will the company be able to raise the price of its product in U.S. dollars if the yen appreciates? If the company can do so, its foreign exchange exposure may be quite low. The key estimates required are those showing the overall effect on the company’s profitability of changes in the exchange rate at various times in the future. Once these estimates have been produced the company can choose between using futures and options to hedge its risk. The results of the analysis should be presented carefully to other executives. It should be explained that a hedge does not ensure that profits will be higher. It means that profit will be more certain. When futures/forwards are used both the downside and upside are eliminated. With options a premium is paid to eliminate only the downside.
Suppose that in Example 3.4 the company decides to use a hedge ratio of 0.8. How does the decision affect the way in which the hedge is implemented and the result?
If the hedge ratio is 0.8, the company takes a long position in 16 NYM December oil futures contracts on June 8 when the futures price is $68.00. It closes out its position on November 10. The spot price and futures price at this time are $75.00 and $72. The gain on the futures position is
The effective cost of the oil is therefore
or $71.80 per barrel. (This compares with $71.00 per barrel when the company is fully hedged.)
“If the minimum-variance hedge ratio is calculated as 1.0, the hedge must be perfect." Is this statement true? Explain your answer.
The statement is not true. The minimum variance hedge ratio is
It is 1.0 when [pic] and [pic]. Since [pic] the hedge is clearly not perfect.
“If there is no basis risk, the minimum variance hedge ratio is always 1.0." Is this statement true? Explain your...
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