CHAPTER 11
ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Explain the major differences between futures contracts and forward contracts.
Answer:
FORWARDS: / FUTURES:The forward market is unstructured
Forward contracts trade over the counter.
Unstandardized, tailored to the needs of the counterparties. / Futures transactions are conducted on an organized exchange.
Numerous dealers match individual buyers and sellers and/or trade for their own accounts. / Contracts are made between buyers or sellers and the exchange.
No margin is required. / Margin requirements are imposed to ensure no one will default when prices move adversely.
Most forward contracts are settled by delivery. / Very few contracts are settled by delivery.
The forward market is useful when a set amount of currency is needed on a specific date. / The futures market is useful when it is necessary to hedge price risk over a period of time.
No marking to market / Marked to market daily.
All elements of the contract are negotiated. / All elements of the contract are standardized (Only price is variable).
Highly illiquid because of customized features. / Trade on exchanges, and are very liquid.
Default potential may be quite high. / Clearing house guarantees delivery and payment. Low default risk.
May not be tailored to counterparties’ needs.
2. What is the economic role of the margin account on a futures exchange?
Answer: The margin account protects futures market participants from default resulting from adverse price movements. As contracts are marked to market daily, increases in value are added to the margin account and decreases in value are subtracted. The exchange maintains these accounts so participants needn’t worry about default risk.
3. What determines the size of the margin requirement for a particular futures contract?
Answer: The size of the margin requirement is determined by the price volatility of the underlying asset.
4. What is the difference between hedging and speculating?
Answer: In the context of a futures transaction, a hedger will hold a position in the spot market opposite to that in the futures market. For example, a shipping firm that is short in the spot fuel oil market could hedge the price risk by going long in oil futures. Hedgers are primarily trying to reduce price risk. Speculators, on the other hand, will be long or short a futures contract without holding an offsetting position in the spot market. They are in effect accepting price risk in hopes of making money on price movements.
DO YOU UNDERSTAND?
1. Suppose you own a portfolio of stocks currently worth $10,000,000. The portfolio has a beta of 0.8. Assume the S&P 500 futures price is 1,200. Describe in detail the futures transaction you would undertake to hedge the value of your portfolio. How many contracts would you buy or sell?
Solution: You should sell (i.e., take a short position in) S&P 500 futures contracts. Since one futures is for $250 times the S&P 500 futures price, one contract is currently worth 1,200*250 = $300,000. Because the futures contract is assumed to have a beta of 1.0, you would have to sell contracts worth 20 percent less than the value of your portfolio to create the hedge:
# of futures to sell = (0.8* $10,000,000)/($250*1,200) = 26.67.
Thus, you will have to sell 26 or 27 S&P 500 futures contracts. If you sell 26 contracts, your portfolio will be slightly “underhedged”, and if you sell 27 contracts, it will be slightly “overhedged”.
2. Suppose your company needs to borrow $100 million in six months. The CFO is concerned that interest rates might rise in the next few months and wants to hedge the risk. How could you hedge this risk? Describe in detail the futures transaction you would undertake to hedge this risk. What futures contract would you use? How many contracts would you buy or sell? If the CFO is wrong and rates fall in the next few months, will the company be better off or worse off as a result of the hedge?
Answer: You should sell T-bond futures with a face value of $100 million expiring in six months. One T-bond futures contract traded on CME is for $100,000 in face value of T-bonds; thus, you need 100 contracts. If the CFO is right and interest rates increase, the short futures position will result in a gain that will offset a higher cost of funds. If the CFO is wrong and interest rates go down instead, the futures position will result in a loss which will offset the lower interest rate on borrowed funds.
3. Why does cross-hedging lead to basis risk?
Answer: Basis risk exists if the value of an item being hedged does not always keep the same price relationship to contracts purchased or sold in the futures market. Cross-hedging involves hedging with a futures contract whose characteristics do not exactly match those of the hedger’s risk exposure. Because the price movements of the hedged commodity are likely to be less than perfectly correlated with those of the futures contract in a cross-hedge, basis risk results.
DO YOU UNDERSTAND?
1. What are some considerations in the decision to use futures or options for hedging?
Answer: Gains and losses in futures contracts are virtually without limit. For that reason, some hedgers prefer options. Options can be used as one-way hedges; they provide price protection that is not available from futures. However, premiums on options may be high, and the value of options decays over time. The buyer of protection must decide whether the insurance value provided by the option is worth the price.
2. Explain the intuition of the relationship between the time to expiration for a put option and the value of the option.
Answer: Large changes in asset prices in both directions are more likely in the long run than in the short run. Thus, longer term options are more valuable than shorter term options, all else equal.
3. Explain the intuition of the relationship between the price volatility of an asset and the value of an option written on that asset.
Answer: The more volatile the price of an underlying asset is, the greater the chance that the option’s value will increase. Thus, options on assets with greater price variance tend to be more valuable.
4. If you hold some shares of stock and would like to protect yourself from a price decline without giving up a lot of upside potential, should you purchase call options or put options? Explain.
Answer: You should purchase put options. If the value of the stock goes below the exercise price, the payoff from the put at maturity increases. This increased payoff offsets losses from holding the stock. This strategy – having a long position in an asset and buying puts on it – is called a protective put.
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