Risk Management
Why would a firm consider hedging?
To reduce a potential loss.
What is the simultaneous purchase and sale of an asset in different markets to exploit tiny differences in their prices ?
Arbitrage
Give one example of how price discovery functions in the commodity futures market.
Lease rates, which are readily available in financial futures markets, are not given in commodity markets. Lease rates are implied and, therefore, calculable from listed futures prices.
True or False, higher strike puts cost more and provide higher floor.
True.
Why are synthetics created and/or calculated when the actual derivative is available?
The pricing of a synthetic may reveal an arbitrage opportunity, or at least a cheaper method, by which to employ the desired strategy.
Name some advantages that futures contracts have over forward contracts.
Futures are more liquid and positions are easily closed. Futures eliminate counter party credit risk. Since futures are standardized, opening a position is easier and less expensive.
When is it possible for the lease rate to fall below zero?
In high growth segments of the economy the lease rate formula can become negative. When growth exceeds the opportunity cost of capital, negative values result.
Forward prices for gold, in dollars per ounce, for the next five years are 1350, 1400, 1560, 1675, and 1756, respectively. A mine can be opened for 3 years at a cost of $2,000. Annual mining costs are a constant $500 and interest rates are 5.0%. When should the mine be opened to maximize NPV?
Year 3
Why are managerial controls over option and forward trading departments vital to proper risk control?
Hedging requires matching derivative trading activities with the operations of the company. Trading that is not matched to the firm's business is speculation and increases the firm's risk.
Interest rates on the U.S. dollar are 6.5% and euro rates are 5.5%. The dollar per euro spot rate is 0.950. What is the arbitrage profit on a required 1 million euro payment if the forward rate is 0.980 dollars per euro and the exchange occurs in one year?
$21,000
Explain how a negative correlation between agricultural production and commodity prices creates a natural hedge.
The goal of hedging is to level the volatility in cash flows. The increased revenue, which accompanies higher output, will be offset by lower prices. Lower output and revenue, in turn, is offset by higher prices, thus, a natural hedge.
Farmer Jayne decides to hedge 10,000 bushels of corn by purchasing put options with a strike price of $1.80. Six-month interest rates are 4.0% and the total premium on all puts is $1,200. If her total costs are $1.65 per bushel, what is her marginal change in profits if the spot price of corn drops from $1.80 to $1.75 by the time she sells her crop in 6 months?
$0
Given a 25% chance of a 600,000 bushel yield and a 75% chance of a 500,000 bushel yield, what quantity should the farmer hedge in order to protect against an uncertain harvest. Assume the farmer is willing to take reasonable risk.
525,000
An investor wants to hold 200 euro two years from today. The spot exchange rate is $1.31 per euro. If the euro denominated annual interest rate is 3.0% what is the price of a currency prepaid forward?
$247
The spot price of corn is $5.85 per bushel. The opportunity cost of capital for an investor is 0.5% per month. If storage costs of $0.04 per bushel per month are factored in, all else being equal, what is the likely price of a 4-month forward contract?
$5.808
The S&P 500 Index is priced at $950.46. The annualized dividend yield on the index is 1.40%. The continuously compounded annual interest rate is 8.40%. What is the price of a forward contract that expires 9 months from today?
$1001.69
KidCo Cereal Company sells "Sugar Corns" for $2.50 per box. The company will need to buy 20,000 bushels of corn in 6 months to produce 40,000 boxes of cereal. Non-corn costs total $60,000. What is the company's profit if they purchase call options at $0.12 per bushel with a strike price of $1.60? Assume the 6-month interest rate is 4.0% and the spot price in 6 months is $1.65 per bushel.
$6,504 profit
The price of an S&P 500 Index futures contract is $988.26 when you decide to enter a long position. When the position is closed the futures price is $930.32. If there are no settlement requirements, what is your percentage gain or loss under a 15.0% margin requirement? (Ignore opportunity costs.)
39% loss
Oil is selling at a spot price of $42.00 per barrel. Oil can be stored at a cost of $0.42 per barrel per month. The opportunity cost of capital is 7.2% per year (or 0.6% per month). What is the gain or loss realized by an oil refinery that floats its exposure and purchases oil on the spot market in 2 months at a price of $43.00 per barrel, instead of hedging with a forward contract?
$0.35 gain
The spot price of gasoline is 258 cents per gallon and the annualized risk free interest rate is 4.0%. Given a lease rate of 1.0%, a continuously paid storage rate of 0.5%, and a convenience yield of 0.75%, what is the no-arbitrage price range of a 1-year forward contract (in cents)?
265.19 to 267.19