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Problem Set Answers - Options, Futures and Other Derivatives

The document discusses hedging using futures contracts, including calculating optimal hedge ratios. It provides examples of hedging strategies using futures, including what position to take in futures contracts to minimize risk when hedging a stock portfolio. The examples calculate the number of futures contracts to short based on the portfolio value, stock beta, and current futures price.

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21 views

Problem Set Answers - Options, Futures and Other Derivatives

The document discusses hedging using futures contracts, including calculating optimal hedge ratios. It provides examples of hedging strategies using futures, including what position to take in futures contracts to minimize risk when hedging a stock portfolio. The examples calculate the number of futures contracts to short based on the portfolio value, stock beta, and current futures price.

Uploaded by

Victoria
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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2.3 Suppose that you enter into a short futures contract to sell July silver for $17.

20 per ounce.
The size of the contract is 5,000 ounces. The initial margin is $4,000, and the maintenance margin
is $3,000. What change in the futures price will lead to a margin call? What happens if you do not
meet the margin call?
There will be a margin call when $1000 has been lost from the margin account (until we reach the
maintenance margin.
5000∗( 17 , 20−Ft )=−1000
Ft =17 , 40
A 0,20 change in the future price will lead to a margin call. If the margin call is not met, the broker
closes out my position.
2.4 Suppose that in September 2012 a company takes a long position in a contract on May 2013
crude oil futures. It closes out its position in March 2013. The futures price (per barrel) is $68.30
when it enters into the contract, $70.50 when it closes out its position, and $69.10 at the end of
December 2012. One contract is for the delivery of 1,000 barrels. What is the company’s total
profit?
Total profit: 1000($70,50 - $68,30) =2200
2.12 Show that, if the futures price of a commodity is greater than the spot price during the
delivery period, then there is an arbitrage opportunity. Does an arbitrage opportunity exist if the
futures price is less than the spot price? Explain your answer.
Suppose that the futures price is above the spot price during the delivery period. Traders then
have a clear arbitrage opportunity:
1. sell (short) futures contract
2. Buy the asset
3. Make delivery
Strategy: buy the cheaper one (asset in this case), and sell the expensive one (future). So: the
arbitrager sells (shorts) the future contract and buys the asset (commodity), and makes delivery
for an immediate profit.
If the future price is less than the spot price, the exists an arbitrage opportunity but there is no
similar perfect strategy. Suppose next that the futures price is below the spot price during the
delivery period. Companies interested in acquiring the asset will find it attractive to enter into a
long futures contract and then wait for delivery to be made. An arbitrager can take a long futures
position but cannot force immediate delivery of the asset. The decision on when the delivery will
be made is made by the party with the short position.
5.3 Suppose that you enter into a 6-month forward contract on a non-dividend-paying stock when
the stock price is $30 and the risk-free interest rate (with continuous compounding) is 12% per
annum. What is the forward price?
rT 0 ,12∗0 ,5
F 0=S0 e → F 0=30 e =$ 31.86
5.9 A 1-year long forward contract on a non-dividend-paying stock is entered into when the stock
price is $40 and the risk-free rate of interest is 10% per annum with continuous compounding.
a) What are the forward price and the initial value of the forward contract?
0 , 1∗1
F 0=40 e =$ 44.21
The initial value of the forward contract is 0.
b) Six months later, the price of the stock is $45 and the risk-free interest rate is still 10%. What
are the forward price and the value of the forward contract?
The delivery price K = F0 = $44,21. The value of the forward contract:
−rT −0 , 1.0 ,5
F=S0−K e =45−44 , 21e =$ 2,946
0 , 1∗0 ,5
The forward price is: F 0=45 e =$ 47.31
5.12 Suppose that the risk-free interest rate is 10% per annum with continuous compounding and
that the dividend yield on a stock index is 4% per annum. The index is standing at 400, and the
futures price for a contract deliverable in four months is 405. What arbitrage opportunities does
this create?
(r−q )T ( 0.1−0.04 )∗0.33
F 0=S0 e =400. e =$ 408.08
Since 405 < 408.08, profits can be made by shorting/selling the stocks underlying the index and
taking long position in/buying future contracts. Strategy: BUY LOW (F 0), SELL HIGH: buy future
contracts; sell the shares underlying the index.
5.16 Suppose that 𝐹1 and 𝐹2 are two futures contracts on the same commodity with times to
maturity 𝑡1 and 𝑡2, where 𝑡1 < 𝑡2. Prove that: F 2 ≤ F 1 e r (t 2−t 1)
where 𝑟 is the interest rate (assumed constant) and there are no storage costs. For the purposes of
this problem, assume that a futures contract is the same as a forward contract.
If F 2> F 1 . er (¿t −t )¿, an investor could make a riskless profit by:
2 1

a. Buying futures contract with maturity t1


b. Selling futures contract with maturity t2
When the first futures contract matures, the asset is purchased for F 1 using funds borrowed at
rate r. It is then held until time t2, at which point it is exchanged for F 2 under the second contract.
The costs of the funds borrowed and accumulated interest at time t2 is F 1 . e
r (¿ t −t )¿
2 1
. A positive
profit of F 2−F1 . er (¿t −t )¿ is then realized at time t2. This type of arbitrage opportunity cannot
2 1

exist for long.


3.4 Under what circumstances does a minimum variance hedge portfolio lead to no hedging at all?
A minimum variance hedge leads to no hedging when the coefficient of correlation between the
futures price changes and changes in the price of the asset being hedged is 0.
ρ=Coecient of correlation between ∆ S∧∆ F
Relation between change in the asset price 𝑃 and related futures price 𝐹: Δ𝑃 = 𝑎 + hΔ𝐹 + 𝑒
If h = 0 ⇒ No hedging posible: there is no relation between Δ𝑃 and ΔF.
cov (∆ P , ∆ F )
h¿ =
var (∆ F)
Since cov ( ∆ P , ∆ F )=ρ σ S σ F , h=0 only if ρ=0.
3.6 Suppose that the standard deviation of quarterly changes in the prices of a commodity is
$0.65, the standard deviation of quarterly changes in a futures price on the commodity is $0.81,
and the coefficient of correlation between the two changes is 0.8. What is the optimal hedge ratio
for a 3-month contract? What does it mean?
The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the
¿ σS 8∗0 , 65
exposure. The optimal hedge ratio is: h =ρ =0 , =0.642
σF 0 , 81
This means that the size of the futures position should be 64.2% of the size of the company’s
exposure in a three-month hedge.
3.7 A company has a $20 million portfolio with a beta of 1.2. It would like to use futures contracts
on a stock index to hedge its risk. The index futures is currently standing at 1080, and each
contract is for delivery of $250 times the index. What is the hedge that minimizes risk? What
should the company do if it wants to reduce the beta of the portfolio to 0.6?
¿
h =β=1.2
The number of contracts that should be shorted is:
¿ P 1.2∗20000000
N =β = =88.88
F 1080∗250
Where P is the current value of the portfolio (20,000,000) and F the current value of one futures
contract (futures price times the contract size)= 1080*250.
To reduce the beta to 0.6, half of this portion is required: short position in 44 contracts.
3.18 On July 1, an investor holds 50,000 shares of a certain stock. The market price is $30 per
share. The investor is interested in hedging against movements in the market over the next month
and decides to use the September Mini S&P 500 futures contract. The index futures price is
currently 1,500 and one contract is for delivery of $50 times the index. The beta of the stock is 1.3.
What strategy should the investor follow? Under what circumstances will it be profitable?
¿ 1.3∗50,000∗30
N= =26
1500∗50
The investor should short 26 contracts to hedge the portfolio. It will be profitable if the stock in
the portfolio outperform the market in the sense that its return is greater than the predicted by
the capital asset pricing model.

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