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CHAPTER 26 Managing Risk

Answers to Problem Sets

1.

a. b.

c. d. e. f.

Price paid for immediate delivery. Forward contracts are contracts to buy or sell at a specified future date at a specified price. Futures differ from forwards in two main ways. They are traded on an exchange and they are marked to market. Investors who are long have agreed to buy the asset. Investors who are short have contracted to sell. The risk that arises because the price of the -asset used to hedge is not perfectly correlated with that of the asset that is being hedged. Profits and losses on a position are settled on a regular basis (e.g., daily). The advantage from owning the commodity rather than the promise of future delivery less the cost of storing the commodity. True False (you pay at delivery). True True

2.

a. b. c. d

3. 4. 5.

She is asking you to pay money, because your sale is showing a loss. F = 95.655. Northern Refineries has fixed the price that it will receive for its oil (we ignore possible basis risk). Because it now has a certain income, it gives up the possibility of pleasant surprises as well as unpleasant ones. F = 0.215, or 21.5%. a. A shortage of heating oil increases net convenience yield and reduces the futures price relative to spot price. Spot and futures prices decrease. The futures price rises relative to spot because convenience yield falls and storage costs rise.

6. 7.

b.

8.

Storage costs are likely to be high. Other things equal, firms will prefer to hold the future rather than the spot commodity, and net convenience yield will be low. a. b. Profit $856,000

9.

10.

Basis risk means that the hedging instrument is imperfectly correlated with the risk

to be hedged. It is highest in a, because Disney stock has considerable nonmarket risk. In b basis risk is likely to be small, and in c it should disappear. 11. Sell short $1.2 million of the market portfolio. In practice rather than sell the market you would sell futures on $1.2 million of the market index.

12.

a. b.

Sell Sell 3-month bond futures.

13.

Insurance companies have the experience to assess routine risks and to advise companies on how to reduce the frequency of losses. Insurance company experience and the very competitive nature of the insurance industry result in correct pricing of routine risks. However, BP, for example, has concluded that insurance industry pricing of coverage for large potential losses is not efficient because of the industrys lack of experience with such losses. Consequently, BP has chosen to self insure against these large potential losses. Effectively, this means that BP uses the stock market, rather than insurance companies, as its vehicle for insuring against large losses. In other words, large losses result in reductions in the value of BPs stock. The stock market can be an efficient riskabsorber for these large but diversifiable risks. Insurance company expertise can be beneficial to large businesses because the insurance companys experience allows the insurance company to correctly price insurance coverage for routine risks and to provide advice on how to minimize the risk of loss. In addition, the insurance company is able to pool risks and thereby minimize the cost of insurance. Rarely does it pay for a company to insure against all risks, however. Typically, large companies self-insure against small potential losses.

14.

If payments are reduced when claims against one issuer exceed a specified amount, the issuer is co-insured above some level, and some degree of on-going viability is ensured in the event of a catastrophe. The disadvantage is that, knowing this, the insurance company may over-commit in this area in order to gain additional premiums. If the payments are reduced based on claims against the entire industry, an on-going and viable insurance market may be assured but some firms may under-commit and yet still enjoy the benefits of lower payments. Basis risk will be highest in the first case due to the larger firm specific risk. The list of commodity futures contracts is long, and includes: Gold Sugar Aluminum Buyers include jewelers. Sellers include gold-mining companies. Buyers include bakers. Sellers include sugar-cane farmers. Buyers include aircraft manufacturers. Sellers include bauxite miners.

15.

16.

a. b.

(i) Loss = $1,500,000 (i) Gain = $1,500,000

(ii) Cost (Spot) = $11,000,000 (ii) Cost (Spot) = $14,000,000

The total cost is $12,500,000 (Spot+Loss). The total cost is still $12,500,000 (Spot-Gain). 17. Ft = 44,475.2 The futures are not slightly underpriced. 18. 19. 20. Contract Length (Months) 3 9 15 1.053% 0.78% 0.68% DurationA = 1.95 DurationB = 1 DurationC = 2.74 b. c. Short position of $4,540,000 in Security B and a short position of $5,460,000 in Security C Short position of $22,030,000 in Security A and a long position of $12,030,000 in Security C. 92.59 Long: Quiche & Pulgas Short: Wine

rf 22. a.

24. Gold Price Per Ounce $600 $630 $680 25. 26. (a) Unhedged Revenue $600,000 $630,000 $680,000 (b) Futures-Hedged Revenue $660,000 $660,000 $660,000 (c) Options-Hedged Revenue $605,000 $605,000 $635,000

By hedging his portfolio, Legs can cash in without selling his portfolio today. a. c. $75,000 b. = 0.75 You could sell $120,000 of gold (or gold futures) to hedge your position. However, since the R2 is less (0.5 versus 0.6 for Stock B), you would be less well hedged

29.

a.

Six-month futures prices are: Magnoosium: $2,828 per ton Oat Bran: $0.44 per bushel Biotech: $144.41 Allen Wrench: $58.54 5-Year T-Note: $108.20 Ruple: 3.017 ruples/$ The magnoosium producer would sell 1,000 tons of six-month magnoosium futures. Because magnoosium prices have fallen, the magnoosium producer will receive payment from the exchange. It is not necessary for the producer to undertake additional futures market trades to restore its hedge position. No, the futures price depends on the spot price, the risk-free rate of interest, and the convenience yield. The futures price will fall to $48.24 First, we recalculate the current spot price of the 5-year Treasury note. The spot price given ($108.93) is based on semi-annual interest payments of $40 each (annual coupon rate is 8%) and a flat term structure of 6% per year. Assuming that 6% is the compounded rate, the six-month rate is: 2.956% Incorporating similar assumptions with the new term structure specified in the problem, the new spot price of the 5-year Treasury note will be $118.16. Thus, the futures price of the 5-year T-note will be: $116.52 The dealer who shorted 100 notes at the (previous) futures price has lost money.

b. c.

d. e. f.

g.

The importer could buy a three-month option to exchange dollars for ruples, or the importer could buy a futures contract, agreeing to exchange dollars for ruples in three months time.