IC 301
IC 301
Seminar 2
Hedging
Basis
Basis = Price of an underlying/asset – Price of Future
Basis risk: risk that offsetting investments will not experience price changes in completely opposite directions
Short hedge: long the asset, short the future
S-F
======> you are LONG the basis
Long hedge: short the asset, long the future: -S+F
-S+F = -(S-F)
======> you are SHORT the basis
Strip hedge vs Stack hedge
Strip hedge: using a strip of futures, where each of them has a different delivery date (normally sequential)
Highly liquid markets
Stack hedge:
The most nearby and liquid contract are used and rolled over to the next-to-nearest as time passes
Not exposed to price risk as hedged
Low liquidity for longer contracts, use short term contracts as a ‘stack’
‘Stack and roll’ hedging strategy
A position that is concentrated on one specific futures contract month (opposed to string which lasts as long as the future does)
All or vast portion of exposure is being hedged in the nearest contract. As it approaches maturity, investor should close it out and ‘roll over’ the position to the next nearby contract.
Contango: upward sloping forward curve (future price is higher than the anticipated spot at maturity)
Backwardation: downward sloping forward curve (future price is lower than the anticipated spot at maturity)
Who initiates delivery in a corn futures contract?
The party with the long position
B. The party with the short position
C. Either party
D. The exchange
Answer: B
You sell one December futures contracts when the futures price is $1,010 per unit. Each contract is on 100 units and the initial margin per contract that you provide is $2,000. The maintenance margin per contract is $1,500. During the next day the futures price rises to $1,012 per unit. What is the balance of your margin account at the end of the day?
A: $1,800
B: $3,300
C: $2,200
D: $3,700
Answer: A
The price has increased by $2. Because you have a short position you lose 2×100 or $200. The balance in the margin account therefore goes down from $2,000 to $1,800.
The frequency with which futures margin accounts are adjusted for gains and losses is…
A: Daily
B: Weekly
C: Monthly
D: Quarterly
Answer: A
Margin accounts have the effect of…
A: Reducing the risk of one party regretting the deal and backing out
B: Ensuring funds are available to pay traders when they make a profit
C: Reducing systemic risk due to collapse of futures markets
D: All of the above
Answer: D
Initial margin requirements dramatically reduce the risk that a party will walk away from a futures contract. As a result, they reduce the risk that the exchange clearing house will not have enough funds to pays profits to traders. Furthermore, if traders are less likely to suffer losses because of counterparty defaults there is less systemic risk
Clearing houses are…
A: Never used in futures markets and sometimes used in OTC markets
B: Used in OTC markets, but not in futures markets
C: Always used in futures markets and sometimes used in OTC markets
D: Always used in both futures markets and OTC markets
Answer: C
Clearing houses are always used by exchanges trading futures. Increasingly, OTC products are cleared through CCPs, which are a type of clearing house.
The basis is defined as spot minus futures. A trader is hedging the sale of an asset (he is going long) with a short futures position. The basis increases unexpectedly. Which of the following is true?
A: The hedger’s position improves.
B: The hedger’s position worsens.
C: The hedger’s position sometimes worsens and sometimes improves.
D: The hedger’s position stays the same.
Answer: A
The price received by the trader is the futures price plus the basis. It follows that the trader’s position improves when the basis increases.
A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract on an index is 900. Futures contracts on $250 times the index can be traded. What trade is necessary to reduce beta to 0.9?
A: Long 192 contracts
B: Short 192 contracts
C: Long 48 contracts
D: Short 48 contracts
Answer: D
To reduce the beta by 0.3 we need to short 0.3×36,000,000/(900×250) or 48 contracts.
Beta multiplied by portfolio value divided by the value of a futures contract
A company due to pay a certain amount of a foreign currency in the future decides to hedge with futures contracts. Which of the following best describes the advantage of hedging?
A: It leads to a better exchange rate being paid
B: It leads to a more predictable exchange rate being paid
C: It caps the exchange rate that will be paid
D: It provides a floor for the exchange rate that will be paid
Answer: B
Hedging is designed to reduce risk, not increase expected profit. Options can be used to create a cap or floor on the price. Futures attempt to lock in the price
Which of the following best describes “stack and roll”?
A: Creates long-term hedges from short term futures contracts
B: Can avoid losses on futures contracts by entering into further futures contracts
C: Involves buying a futures contract with one maturity and selling a futures contract with a different maturity
D: Involves two different exposures simultaneously
Answer: A
Stack and roll is a procedure where short maturity futures contracts are entered into. When they are close to maturity, they are replaced by more short maturity futures contracts and so on. The result is the creation of a long-term hedge from short-term futures contracts.
Which of the following increases basis risk?
A: A large difference between the futures prices when the hedge is put in place and when it is closed out
B: Dissimilarity between the underlying asset of the futures contract and the hedger’s exposure
C: A reduction in the time between the date when the futures contract is closed and its delivery month
D: None of the above
Answer: B
Basis risk increases as the time between the date when the futures contract is put in place and the delivery month increases. (C is not therefore correct). It also increases as the asset underlying the futures contract becomes more different from the asset being hedged. (B is therefore correct.)
LTCM case study: Questions
1. What type of fund was LTCM’s?
2. What were their strategies?
3. Did they employ leverage?
4. Between which years was the fund active?
5. If trading performance drops, how should a fund react and should LTCM have had a stop loss strategy?
6. How was their risk management strategy for derivatives?
7. What were the assumptions LTCM made that proved problematic?
8. Do you think LTCM had problems of size and liquidity restrictions?
9. What is moral hazard from a central bank’s point of view?
10. ‘ The market can remain irrational longer than you can remain solvent.’ Comment.
Long-Term Capital Management L.P. (LTCM): speculative hedge fund from 1994 until 2000, the main hedge fund failed in late 1990s
Scholes and Merton (board directors), among other things, developed along with the late Fischer Black, the Black-Scholes formula for option pricing.
Main strategies used: taking advantage of temporary changes in market behaviour (arbitrage)
fixed-income arbitrage (rates discrepancies)
statistical arbitrage; pairs trading (correlation)
IR swaps
+ high leverage to maintain
At the start: Convergence strategy
short overpriced + long under-priced, make profits when the two converge
Later on: merger arbitrage, S&P 500 options (volatility trading), derivatives, IR swaps
Due to time limitations, as arbitrage opportunities correct themselves fast, a lot of leverage had to be employed, in 1998 debt to equity ratio was 25 to 1.
Lost $4.6 billion in less than 4 months
1998: Russian default on debt, LTCM was holding a large portion of Russian govt bonds
+ huge positions, high leverage and risk to default on its own bonds
+ overconfidence -> unhedged positions betting on volatility in the options market, ‘bet on the return to the equilibrium’
+no stops
Despite the losses of 100 millions per day, LTCM models dictated to hold the positions
At the end: Bailed out by the Federal Reserve Bank of NY as its default was seen as major systemic risk