Financial Economics (ECON 361) - Elias

Problem Set - Futures and Swaps

1. The futures price of gold is $1,000 per ounce. Futures contracts are for 100 ounces
of gold, and the margin requirement is $5,000 per contract. The maintenance margin
requirement is $1,500. You expect the price of gold to rise and enter into a contract to
buy gold.
(a) What is the value of the contract and how much must you initially pay to enter the
contract?

Solution: At the original futures price of $1,000 per ounce, the value of the
futures contract is

$1, 000 per ounce × 100 ounces = $100, 000

You must initially pay the margin requirement, $5,000, to enter the contract.

(b) If the futures price of gold rises to $1,055, what is the profit and return on your
position?

Solution: If the futures price of gold rises to $1,055, the contract is now worth

$1, 055 per ounce × 100 ounces = $105, 500

so the value of the contract has increased by $5,500 (from the original value),
which is your profit. The return on your investment is

$5, 500
= 110%
$5, 000

(c) If the futures price of gold declines to $978, what is the loss on the position?

Solution: If the futures price of gold declines to $978, the contract is now worth

$978 per ounce × 100 ounces = $97, 800

so the value of the contract has decreased by $100,000 - $97,800 = $2,200, which
is the loss on the position.

(d) If the futures price declines to $948, what must you do?
 Solution: If the futures price of gold declines to $948, the contract is now worth

$948 per ounce × 100 ounces = $94, 800

so the value of the contract has decreased by $100,000 - $94,800 = $5,200, which
is the loss on the position. The loss exceeds the initial margin of $5,000. Because
the amount you have in the margin account (-$200) is less than the maintenance
margin of $1,500, you are subject to a margin call and will have to deposit more
funds into your account with the broker. The amount you need to deposit is
$5,200 to restore the initial $5,000 margin.

2. The futures price of corn is $3.40 a bushel. Futures contracts for corn are based on
10,000 bushels, and the margin requirement is $2,000 per contact. You expect the price
of corn to fall and sell the contract short.
(a) What is the value of the contract and how much must you initially pay for the
contract?

Solution: At the original futures price of $3.40 per bushel, the value of the
futures contract is

$3.40 per bushel × 10, 000 bushels = $34, 000

You must initially pay the margin requirement, $2,000, to enter the contract.

(b) If the futures price of corn rises to $3.51 per bushel, what is the profit or loss on
your position?

Solution: If the futures price of corn rises to $3.51 per bushel, the contract is
now worth

$3.51 per bushel × 10, 000 bushels = $35, 100

so the value of the contract has increased by $1,100 (from the original value),
which is your loss on the position because you sold the contract short.

(c) If the futures price of corn declines to $3.28, what is the profit or loss on your
position?

Solution: If the futures price of corn declines to $3.28 per bushel, the contract
is now worth

$3.28 per bushel × 10, 000 bushels = $32, 800

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 so the value of the contract has decreased by $1,200 (from the original value),
which is your gain on the position because you sold the contract short.

(d) If the futures price declines to $3.18, what is the profit or loss on the position and
what may you do? (Hint: Compare the profit/loss on the position to the margin
requirement).

Solution: If the futures price of corn declines to $3.18 per bushel, the contract
is now worth

$3.18 per bushel × 10, 000 bushels = $31, 800

so the value of the contract has decreased by $2,200 (from the original value),
which is your gain on the position because you sold the contract short. Now
your margin account has $4,200 in it (the initial $2,000 margin requirement
plus the $2,200 profit), but the margin requirement is only $2,000, so you could
withdraw $2,200 from the account and still have the necessary $2,000 in the
account.

(e) How do you close your position?

Solution: You close the position by entering a contract to buy corn. The buy
and the sell contracts “offset” each other, which closes out your position.

3. You expect to receive a payment of 1 million British pounds in six months. One British
pound is currently worth $1.60 (i.e., the current exchange rate), but the futures price is
$1.56 (i.e., the futures exchange rate). You expect the price of the pound to decline (i.e.,
the value of the dollar to rise). If this expectation is fulfilled, you will suffer a loss when
the pounds are converted into dollars when you receive them six months in the future.
(a) Given the current exchange rate, what is the expected payment in dollars?

Solution: The payment in terms of the spot price of dollars is

1 million pounds × 1.60 dollars per pound = $1, 600, 000

(b) Given the futures exchange rate, how much would you receive in dollars?

Solution: The payment in terms of the futures price of dollars is

1 million pounds × 1.56 dollars per pound = $1, 560, 000

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(c) If, after six months, the pound is worth $1.40, what is your loss from the decline in
the value of the pound?

Solution: The payment in terms of an exchange rate of $1.40 per pound is

1 million pounds × 1.40 dollars per pound = $1, 400, 000

Compared to the current exchange rate of $1.60 per pound, your loss from the
decline in the value of the pound is

$1, 600, 000 − $1, 400, 000 = $200, 000

(d) To avoid this potential loss, you enter a contract for the future delivery of 1 million
pounds at the futures price of $1.56. What is the cost to you of this protection from
the possible decline in the value of the pound?

Solution: To hedge, you enter a contract for the future delivery (i.e., to sell
pounds). The contract’s value is $1,560,000 based on the futures price of $1.56.
When you receive the pounds after six months, you can now deliver them at the
price specified in the contract. The cost of the hedge is the difference between the
spot and futures price times the number of pounds: ($1.60 - $1.56)(1,000,000)
= $40,000.

(e) If, after entering the contract, the price of the pound falls to $1.40, what is the
maximum amount you lose?

Solution: Since you have a contract to sell pounds at $1.56, the price decline
is irrelevant. The loss remains $40,000.

(f) If, after entering the contract, the price of the pound rises to $1.80, how much do
you gain from your position?

Solution: Since the investor has a contract to sell pounds at $1.56, the price
increase is irrelevant. By hedging, the investor has forgone the opportunity for
profit that would result from an increase in the value of the pound.

(g) How would your answer to part (f) be different if you had not made the contract
and the price of the pound had risen to $1.80?

Solution: If the investor had not hedged, 1,000,000 pounds would now be worth
$1,800,000, and the investor would have earned a $200,00 profit on the increase
in the value of the pound from $1.60 to $1.80. Note that the intent of this hedge

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is to reduce the risk of loss from a price decline. To achieve this risk reduction,
the hedger forgoes the possible gain from the price increase.

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