Problem 3.2 Explain what is meant by basis risk when futures contracts are used for hedaing Basis risk arises from the hodger’s uncertainty as to tho difference between the spot price and futures priee at the expiration of the hedge. Problem 3.3. Bxplain what is meant by a yerfect hedge. Does a perfect hedge always lead to a better outcome tan an imperfect hedge? Explain your answer A porfect hedge 's ono that complotely eliminates the hedgor’s risk. A porfoet: hodgo does nat always lead to a better outcome than an imperfoct hedge. Tt just leads to a more certain outcome. Consider a company that hedges its exposure to the price of an asset. Suppose the asset's price movements prove to be favorable to the company, A perfect ledge totally neutralizes the company’s gain from these favorable price movements. Am imperfect hhodge, which only partially neutralizes the gains, might well give a better outcome. Problem 8. Under what circumstances does a minimum-variance hedge portiolio lead to no hedg- ing at all? A minimum variance hedge leads to no hedging when tho coefliciont af corrvlation Dotwoon the futures price changes and changes in the price of the assot being hedged is Problem 3.5. Give three reasons that the treasurer of a company might not hedge the company’s exposure to a particular risk: (a) If the company’s competitors aro not hedging, the troasnrer might foel that the company will experience less risk fit dors not hecige. (See Table 3.1.) (b) The shareholders might not want the company to hedge. (c) Hf there is a loss on the hedge and a gain from the company's exposure to the underlying asset, the treasurer might feel that he or she will have difficulty justifying the hedging to other executives within the organization, Problem 3.6. ‘Suppose that the standard deviation of quarterly changes in the prices of a commodity 4s $0.65, the standard deviation of quartcrly changes in a futures price on the commodity '9 80.81, and the coefficient of correlation between the two changes is 0.8. What is the ‘optimal ledge ratio for « three-month contract? What does it mean? Tho optimal hedge ratio is 0.05 osx ON = 00aProblem 3.11. Imagine you are tho treasurer of a Japanese company exporting electronic equipment to the United States, Discuss how you would design a foreign exchange hedging strategy and te arguments you would use to sell the strategy to your fellow executives. The simple answer to this question is that the treasurer should (a) estimate the com- pany’s future cosh flows in Japanese yen and U.S. dollars and (b) 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 siory. As the gold jewelry example in Table 3.1 shows, the company should examine whether the magnitudes of the foreign cosh flows depend on the exchange rate. For example, will the company be able to raise the price of its product in US. dollars if tho yon approciates? If the company ean 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 fatures and options to hodgo its risk. ‘The results of the analysia should be proaonted carefully to other executives. Tt should be explained that a hedge does not ensure that profits will be higher. Tt means that profit will be more certain. When futures/forwards are used both the downside and upside are eliminated. With options a presiuin is paid to eliminate only the downside. Problem 8.12. Suppose that in Example 3.2 of Section 3.3 the company docides to use a hedge ratio of 0.8. How does the decison 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 Deces futures contracts on June 8 when the futures price is $68.00. It closes out its posi November 10. The spot price and futures price at this time are $70.00 and $69.10. ‘The gain on the futures position is (69.10 — 68.00) x 16, 000 = 17, 600 ‘The effective cost of the oll Is therefore 20,000 x 70 ~ 17, 600 = 1, 382, 400 or $69.12 per barrel. (This compares with $68.90 per barrel when the company is fully hedged.)Problem 3.13. “If the minimum-variance hedge ratio is calculated as 1.0, the hedge must be perfect.” Js this statement true? Explain your answer. ‘The statement is not true. The minimum variance hedge ratio is It 15 1.0 when p= 0.5 and ag = 2ap. Since p < 1.0 the hedge is clearly not perfect. Problem 3.14. ‘If there is no basis risk, tho minimum variance hedge ratio is always 1.0.” Is this statement true? Fxplain your answer. ‘The statement is true, Using the notation in the text, if the hedge ratio is 1.0, the hedger locks in a price of F; + by. Since both F) and by are known this has a variance of zero and must be the best hedge Problem 3.16. “For an asset where futures prices are usually less than spot prices, long: hedges are likely to be particularly attractive.” Explain this statement. A company that knows it will purchase a commodity in the future is able to lock in a price close to the futures price. This is likely to be particularly attractive when the futures price is less than the spot price Problem 3.16. ‘The standard deviation of montiily changes ia the spot price of live cattle Is (In cents per pound) 1.2. The standard deviation of monthly changes in the futures price of live cattle for the closest contract is 14. ‘The correlation between the futures price changes and the spot price changes Is 0.7, Tt is now October 15. A beef producer is committed to purchasing 200,000 pounds of live cattie on November 15. The producer wants to use the December live-cattle futures contracts to hedge its risk. Bach contract is for the delivery of 40,000 pounds of cattle. What strategy should the beef producer follow? ‘The optimal hedge ratio is ox? -p6 ia ‘The beef producer requires a long position in 200000 x 0.6 = 120,000 Ibs of cattle. ‘The beef producer should therefore take a long position in 8 December contracts closing out the position on November 15.