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Hedging Strategies

Using Futures
Chapter 3
1

HEDGERS
OPEN POSITIONS IN THE FUTURES
MARKET IN ORDER TO
ELIMINATE THE RISK
ASSOCIATED WITH THE
SPOT PRICE
OF THE UNDERLYING ASSET
2

Spot price risk


Pr

Sj
St
t

time

HEDGERS
PROBLEM: TO OPEN
A LONG HEDGE
OR
A SHORT HEDGE?
There are two ways to
determine whether to open a short
or a long hedge:
4

1.

A LONG HEDGE

OPEN A LONG FUTURES POSITION


IN ORDER TO HEDGE THE PURCHASE
OF THE PRODUCT AT A LATER DATE.
THE HEDGER LOCKS IN THE
PURCHASE PRICE.
A SHORT HEDGE
OPEN A SHORT FUTURES POSITION
IN ORDER TO HEDGE THE SALE OF
THE PRODUCT AT A LATER DATE.
THE HEDGER LOCKS IN THE SALE5

2.

A LONG HEDGE

OPEN A LONG FUTURES POSITION


WHEN THE FIRM HAS A
SHORT SPOT POSITION.
A SHORT HEDGE
OPEN A SHORT FUTURES
POSITION
WHEN THE FIRM HAS A
LONG SPOT POSITION.

Example: A LONG HEDGE


Date
t

Spot market

Futures market Basis

St = $800/unit Ft,T = $825/unit


-25
Contract to buy long one gold
Gold on k.
futures for
delivery
at T

Buy the gold


Short one gold
Sk = $816/unit futures for delivery
at T.
Fk,T = $842/unit -26
1

Amount paid:
or

816 + 825 842= $799/unit

825 + (816 842)

= $799/unit
7

Example: A SHORT HEDGE


Date
t

Spot market

Futures market Basis

St = $800/unit Ft,T = $825/unit


-25
Contract to sell short one gold
Gold on k,
futures for
delivery
at T

Sell the gold


Long one gold
Sk = $784/unit futures for delivery
at T.
Fk,T = $812/unit
-28
3

Amount received: 784 + 825 812


$797/unit
or

825 + (784 812)

8
= $797/unit

NOTATIONS:
t<T

t = current time; T = delivery time

F t,T =

THE FUTURES PRICE AT TIME t FOR


DELIVERY AT TIME T.

St =

THE SPOT PRICE AT TIME t.

k=

THE DATE UPON WHICH THE FIRM


TRADES THE ASSET IN THE SPOT
MARKET.

kT
Sometimes t = 0 denotes the date the
hedge is opened.
9

THE HEDGE TIMING


k = is the date on which the hedger
conducts the firm spot business and
simultaneously closes the futures
position. This date is almost always
before the delivery month; k T.
Today
Open the hedge:
open a futures
position

Trade spot and


Delivery
Close the futures
position

Time
10

THE HEDGE TIMIMG


Date k is (almost) always before the
delivery month.
WHY?
1. Often k is not in any of the delivery
months available.
2. From the first trading day of the
delivery month, the SHORT can
decide to send a delivery note. Any
LONG with an open position may be
served with this delivery note. 11

Spot and Futures prices over time


Commodities and assets are traded in
the
spot and futures markets
simultaneously.
Thus, the relationship between the sport
and futures prices:
At any point in time
And
Over time
Is of great importance for traders. 12

The Basis
The basis at any time point, j, is the
difference between the assets spot
price and the futures price on j.
BASISj = SPOT PRICEj - FUTURES
PRICEj
Notationally: Bj = Sj - Fj,T

j < T.

When discussing a basis, one must


specify the futures in question, i.e., a
specific delivery month. Usually,
however, it is understood that the
13

A LONG HEDGE
TIME
SPOT
FUTURES
B
t Contract to buy
LONG Ft,T

Bt

Do nothing
k

BUY Sk SHORT Fk,T Bk

T delivery
Actual purchase price

= Sk + Ft,T - Fk,T

= Ft,T + [Sk - Fk,T]


= Ft,T + BASISk

14

A SHORT HEDGE
TIME
SPOT
FUTURES
B
t Contract to sell
SHORT Ft,T Bt
Do nothing
k

SELL Sk LONG Fk,T

Bk

T delivery
Actual selling price = Sk + Ft,T - Fk,T
= Ft,T + [Sk - Fk,T]
= Ft,T + BASISk

15

In both cases,
Long hedge and short hedge
the hedgers purchase/sale price,
when the hedge is closed on date k,
is:
Ft,T + BASISk
This price consists of two portions:
a known portion:
and a random portion: the
BASIS

Ft,T
16

ALSO NOTICE:
t

The purchase/sale price when the


hedge is closed on date k is: Ft,T +
BASISk
Which may be rewritten:
=

Ft,T + BASISk + St St

St [St Ft,T - Bk]

St + [Bk Bt]

17

Spot prices and futures prices over


time
The key to the success of a hedge is
the relationship between the cash
and the futures price over time:
Statistically, Futures prices and Spot
prices of any underlying asset, co
vary over time. They tend to co
move together ; not in perfect
tandem and not by the same
amount, nevertheless, these
18
prices move up and down together

Open
close
the hedge

Long hedge Short


hedge

Fk,T
Ft,T

Sk

a success

a failure
Loss on

St

the hedge
Fk,T
Sk

a failure
success

Loss on
19

Example:
TIME
SPOT
t
St= $3.40
Do nothing
k

A LONG HEDGE
FUTURES
LONG

BASIS

Ft,T=$3.50

-$.10

BUY Sk=$3.80
F

k,T

=3.85

SHORT

-$.05

T delivery
Actual purchase price:
NO hedge:

$3.80

With hedge: $3.45 (Successful hedge)

20

Example:
TIME
SPOT
t
St= $3.40
Do nothing
k

A LONG HEDGE
FUTURES
LONG

BASIS

Ft,T=$3.50

-$.10

BUY Sk=$3.00
F

k,T

=3.05

SHORT

-$.05

T delivery
Actual purchase price:
NO hedge:

$3.00

With hedge: $3.45 (Unsuccessful hedge)


21

The basis upon delivery: BT = 0


On date k, the basis is
Bk = Sk - Fk,T

k < T.

If k coincides with the delivery date,


however, k = T. The basis is:
BT = ST - FT, T

at T.

BUT, FT,T is the futures price on date T


for delivery on date T, which implies
that:
FT,T = ST

BT =
22
0.

Convergence of Futures to Spot


over the life of the futures

Futures
Price
Spot Price

Spot Price
Futures
Price

Time

(a)

Time

(b)
23

Basis Risk
The Basis is the difference between the
spot and the futures prices. I.e., the Basis
is a RANDOM VARIABLE. Thus,
Basis risk
arises because of the uncertainty about the
Basis when the hedge is closed out on k.
The basis, however, is the difference of two
random variables and thus, the Basis is
LESS RISKY than each price by itself.
Moreover, we do know that BT = 0
upon delivery.
24

Generally, the basis fluctuates less


than both, the cash and the
futures prices. Hence, hedging
with futures reduces risk. Basis
risk exists in any hedge,
nonetheless.
Sk

Pr
Bk

Ft,T
St
t

BT = 0

Bt
k

time

25

We showed that for both types of


hedge
A SHORT HEDGE or A LONG HEDGE,
The price received/paid by the hedger:
Ft,T + BASISk
This price consists of two parts:
Part one:

Ft,T is KNOWN when the


hedge is opened.
26

Conclusion:
At time t, WITHOUT HEDGING
cash-price risk.
WITH HEDGING,
basis risk.
Hedging with futures is nothing more
than changing the firms spot price
risk
Into a smaller risk, namely,
27

A CROSS HEDGE:
When there is no futures contract on the
asset being hedged,
choose the contract whose futures price
is most highly correlated with the spot
asset price.
NOTE, in this case, the hedger creates a
two components basis:
one component associated with the
asset underlying the futures
and one component associated with the
spread between the two spot prices.
28

A CROSS HEDGE:
Let S1t
be the spot asset price at time t.
Remember! - This is the asset that the
hedger is trying to hedge; e.g. jet fuel.
Let S2t
be the spot price at time t of the asset
underlying the futures. E.g., natural
gas. This, of course, is a different
asset and that is why this hedge is
called a
CROSS HEDGE
29

A CROSS HEDGE
TIME

CASH

FUTURES

Contract to trade S1Ft,T(2)


Do nothing

Trade for

S1K

Fk,T(2)

T delivery
PAY/RECEIVE= S1K + Ft,T(2) - Fk,T(2)
= Ft,T(2) +[S2k - Fk,T(2)] +[S1k - S2k]
30

Arguments in Favor of Hedging


Companies should focus on the
main business they are in and
take steps to minimize risks
arising from interest rates,
exchange rates, and other market
variables

31

Arguments against Hedging


Explaining a situation where
there is a loss on the hedge and
a gain on the underlying can be
difficult.
Shareholders are usually well
diversified and can make their
own hedging decisions.
32

Delivery month? MOSTLY, the hedge


is opened with a futures for the
delivery month closest to the firms
spot trading of the asset, or the
nearest month beyond that date. The
key factor in choosing the futures
delivery month is the correlation
between the spot and futures prices
or price changes.
Statistically, in most cases, the spot
price highest correlation is with the
nearest delivery month futures price,
which is closest to the firms cash33

The number of Futures to use in the


hedge
Open a hedge.
Questions:
Long or Short?
Delivery month?
Commodity to use?
How many futures to use in the
hedge?

34

HEDGE RATIOS, NOTATION:


NS =
the
NF

The number of units of the


commodity to be traded in
SPOT market.
The number of units of the
commodity in ONE FUTURES
CONTRACT.

n
= The number of futures
contracts
to be used in the
hedge.
h

The hedge ratio.

35

HEDGE RATIOS:
Open a hedge.
Question:
Given that the firm has a contract to
trade NS units of the underlying
commodity on date k in the spot
market and given that one futures
covers NF units of the underlying
commodity:
How many futures to use in the
36
hedge? i.e., what is n?

HEDGE RATIOS, DEFINITION:

The number of units in the futures position


h
The number of units in the spot position

nN F
h
NS

NS
nh
.
NF

The hedge ratio, h, determines the


number of futures to hold, n.
37

THE NAVE HEDGE RATIO:

h = 1.

The total number of units


covered by the futures position =
nNF , exactly covers the number of
units to be traded in the spot
market = NS.

nN F
h
1
NS

NS
n
NF

38

Examples: NAVE HEDGE RATIO:


h = 1.
1.A firm will sell NS = 75,000
barrels of crude oil.
NYMEX WTI:

NF = 1,000 barrels.

SHORT:
n
= 75,000/1,000
= 75 NYMEX futures.
39

2.A firm will buy NS = 200,000


bushels of wheat.
CBT wheat futures: NF = 5,000.
LONG:
n = 200,000/5,000
= 40 CBT futures.
40

3.A firm will sell NS = 3,600


ounces of gold.
NYMEX gold futures:
ounces.

NF = 100

SHORT:
n

= 3,600/100
= 36 CBT futures.
41

How to open a long hedge with


multiple future spot trading? A Strip.
DATE
Sep1,07
75,000bbls

SPOT MARKET
Contract to buy
of WTI crude oil.
on: Oct 1,07;
Nov 1,07;
Dec 1,07;
Jan 2,08.

42

A STRIP.
A STRIP is a hedge in which there
are several long (or several short)
positions opened simultaneously
with equal time span between the
delivery months of the positions.
Each one of these futures exactly
hedges a specific future trade in the
spot market
43

Open a long STRIP with h = 1


DATE SPOT MARKET
POSITIONS

FUTURES MARKET

FUTURES

Sep1,07
contract to

92.00

buy 75,000bbls on
Oct 1,07;
Nov 1,07;
Dec 1,07;
Jan 2, 08.
Long 75 NOV 07

93.00

long 75 NOV

Long 75 DEC 08

93.50

long 75 DEC

07
08

44

Date
SPOT MARKET
POSITIONS

Sep1,07
75 NOV 2007
75 DEC 2007
75 JAN 2008
75 FEB 2008

FUTURES MARKET

contract to
92.00
buy 75,000bbls

Oct1,07 buy 75,000bbls


DEC 2007

Long
Long
Long
Long

75
75
75
75

NOV 2007
DEC 2007
JAN 2008
FEB 2008

93.00 short 75 NOV 07

FUTURES

93.00
93.50
93.85
94.60

93.10

long
long
long
long

long 75

long 75 JAN
2008
long 75 FEB
2008
Nov1,07 buy 75,000bbls
long 75 JAN 2008

92.90

short 75 DEC 07

93.05
long 75 FEB

2008
Dec1,07
FEB 2008

buy 75,000bbls

Jan2,08 buy 75,000bbls


POSITION

94.00 short 75 JAN 08

94.75 short 75 FEB 08

94.15

94.95

long 75

NO
45

ROLLING THE HEDGE FORWARD


Lack of sufficient liquidity in
contracts for later delivery months
may cause firms to hedge a longterm business trade employing
shorter term hedges. In this case,
the shorter term hedges must be
rolled over until the firm trade in
the cash market.
46

Roll over hedge with h = 1


DATE

SPOT MARKET

DEC, 07 contract to sell


100,000bbls on
JAN, 09.
MAY 08 Fs.

FUTURES MARKET

FUTURES POSITIONS

89.00 Short 100 NYMEX WTI; 88.20


Futures for delivery on
MAY 08

SHORT 100

And Roll over the hedge on


APR 2008
And
AUG 2008

47

Date

SPOT MARKET

DEC, 07 contract to

89.00

FUTURES MARKETF

FUTURES POSITIONS

short 100 MAY WTI

88.20

sell 100,000 bbls


MAY 2008
APR 08

Oct1,07 buy 75,000bbls

Short 100

long 100 MAY 2008


Short 100 SEP 2008

87.40
87.00
Short 100 SEP

Long 100 SEP 2008


Short 100FEB 2009

86.50
86.30
Short 100 FEB

2008
AUG 08
2009
JAN, 09 sell 100,000bbls

86.00

Long 100 FEB 2009


85.90
NO POSITION

The selling price without the rolling hedge:

$86.00/barrel

The selling price with the rolling hedge:

$87.70/barrel

$86.00 + (88.20 87.40) + (87.00 86.50) + (86.30 85.90) = 87.70.

48

Other hedge ratios.


Suppose that the relationship
between the spot and futures prices
over time is:
case one:
Case two:

Spot

Futures

$1

$2

$1

$0.5

Clearly, the Nave hedge ratio is not


appropriate in these cases.
49

THE MINIMUM VARIANCE HEDGE RATIO


OBJECTIVE: To minimize the risk
associated with the
hedge
RISK = VOLATILITY.

THE VOLATILITY MEASURE:


THE VARIANCE

50

THE MINIMUM VARIANCE HEDGE RATIO


Restating the hedge goal,
OBJECTIVE: Given that the firm will
trade
NS units in the spot
market,
find the number of futures,
n*
THAT MINIMIZES THE VARIANCE OF
THE CHANGE OF THE HEDGED 51

NOTATIONS
t

The hedge opening date.

St

Spot market price.

k
=
T
=
Fj,T=
for
T.

The hedge closing date.


The futures delivery date.
The futures price on date j
delivery at T.
tj
52

NOTATIONS
n = The number of futures
contracts
used in the hedge.
h = The hedge ratio.
NF = The number of units of the
asset in
one
contract.
NS = The number of units of the
asset
to be traded spot on k.
53

FROM THE GENERAL RELATIONSHIP


BETWEEN n and h (SLIDE 36) the optimal
number of futures, n* is determined by h*:

NS
n h
.
NF
*

Thus, we find h* and thereby


determine the optimal number of
futures to be held in the hedge, n*.
54

Derivation of the result:

The initial and terminal hedged


position
values:
VPt
= StNS +nNFFt,T
VPk

= SkNS +nNFFk,T

The position value change:


(Vp) = VPk - VPt
= (SkNS +nNFFk,T) - (StNS +nNFFt,T)
= NS(Sk- St) +nNF(FK,T - Ft,T).
55

Rewriting the last result:


(VP) = NS(Sk- St) +nNF(Fk,T - Ft,T).

(VP) = NS (Sk- St) +[nNF/NS](Fk,T -

(VP) = NS (Sk- St) +h(Fk,T - Fy,T)

t,T

PROBLEM: Find h* so as to
minimize
the Variance of (VP).
56

VAR(VP) = NS2 VAR[(Sk- St) +h(Fk,T - Ft,T)]


= NS2[VAR(S)+VAR(hF)+2COV(S;hF)]

= NS2 [VAR(S)+h2VAR(F)+2hCOV(S;F)]
Set:

d[VAR(VP)]/dh = 0:

2h*VAR (F) + 2COV(S; F) = 0.


h* = - COV(S;F)/VAR(F)
57

THE MINIMUM RISK HEDGE RATIO IS:

cov(S; F)
h* .
var(F)
S
n * NF
h* - S,F
.
F
NS
NS
n h
.
NF

58

This result can be rewritten as:

cov(S; F)
h* .
var(F)
S n * N F
h* - S,F

.
F
NS
NS
n h
.
NF

59

The negative sign in the formula


for h*, only indicates that in the
hedge position
the SPOT and the FUTURES
positions are in opposite
directions.
If the hedger is short spot,
the hedge is long.
If the hedger is long spot,
60

EXAMPLE 1: A company will buy 800,000


gallons of diesel oil in 2 months. It
opens a long cross hedge using NYMEX
heating oil futures. An analysis of price
changes over a 2 month interval yields:
(S) = 0.025;
(F)=0.033;and
(S;F) = 0.693.
The risk minimizing hedge ratio:
h* = -(.693)(0.025)/0.033 = -0.525.
One NYMEX heating oil contract is for
NS = 42,000 gallons, so
Long
n* = (0.525)[800,000/42,000]
= 10futures.
61

Notice that in this case, a NAVE HEDGE


ratio would have resulted in taking a
long position in:
n* = 800,000/42,000 = 19 futures.
Taking into account the correlation
between the spot price changes and the
futures price changes, allows the use of
The minimum variance hedge ratio and
thus, n* = 10 futures.
Of course, if the correlation and the
standard deviations take on other
values the risk-minimizing hedge ratio
may require more futures than the
62
nave ratio.

EXAMPLE 2:A firm will buy 1 million


gallons of jet fuel in 3 months. The
firm chooses to long cross hedge with
NYMEX heating oil futures.
(S)=0.04, (F)=0.02; (S;F) =
0.42.
The optimal hedge ratio:
h* = - (0.42)(0.04)/(0.02) = - 0.84.
Thus, to minimize the risk long 20
futures:

63

h* , using Regression:
DATA:

n+1 weeks.

S F e

i1,2, ..., n.

h*

64

EXAMPLE 3.Hedging for copper: A


STRIP.
On SEP 4, 2005 A U.S. firm has a
contract to purchase NS = 1,000,000
pounds of copper on the first trading
day of each of the following months:
FEB 06, AUG06, FEB07 and AUG07.
The firm decides to hedge these
purchases with NYMEX copper futures.
One NYMEX copper futures is for:
NF = 25,000 pounds of copper.
Following a regression analysis, the
65
firm decides to use:h* = - 0.7.

Date:

SEP 04 2005

Spot price: USD2.72/pound


Futures prices, USD/pound were:
For Delivery:

MAR 2006

2.723

SEP 2006

2.728

MAR 2007

2.716

SEP 2007

2.695
66

How to open the long Strip:


The number of futures to LONG is:
n* = (0.7)[1,000,000/25,000] = 28.
All prices are USD/pound.
Date SPOT
POSITIONS

FUTURES MARKET

SEP 05 contract

Long 28 MAR 2006 2.723

Long 28 MAR 2006

Long 28 SEP 2006

2.728

Long 28 SEP 2006

Long 28 MAR 2007 2.716

Long 28 MAR 2007

Long 28 SEP 2007

Long 28 SEP 2007

Do nothing

2.695

FUTURES

67

The following prices have


materialized on the first trading days
of the given months:
prices
are AUG0
USD/pound
SEP05
FEB06
FEB07 AUG0
DATE All
SPOT
2.72
PRICE
Futures prices
MAR0 2.723
6
SEP06 2.728
MAR0 2.716
7

2.69

6
2.65

2.77

7
2.88

for delivery
2.691
2.702 2.648
2.707 2.643 2.767

68

Date

SPOT MARKET

SEP 05 NOTHING
long 28 MAR 2006
2.728

FUTURES MARKETF

FUTURES POSITIONS

Long 28 MAR 2006


2.723
Long 28 SEP 2006

long 28 SEP 2006


Long 28 MAR 2007

2.716

long 28 MAR

Long 28 SEP 2007

2.695

long 28 SEP

short 28 MAR 06 2.691

long 28 SEP 2006


long 28 MAR 2007
long 28 SEP 2006

Aug 06 buy 1M units 2.65

short 28 SEP 06

long 28 MAR 2007


long 28 SEP 2007

Feb 07

short 28 MAR 07

2007
2007
Feb 06

buy 1M units 2.69

buy 1M units 2.77

Aug 07 buy 1M units 2.88

short 28 SEP 07

2.648
2.767
2.882

long 28 SEP 2007


NO POSITION

The average price for the un hedged strategy : (2.69+2.65+2.77+2.88)/4 =


$2.7475/pound
The average price for the hedged strategy:
(.3)2.69 + (.7)(2.69 + 2.723 2.691)
= 2.7124
69
(.3)2.65 + (.7)(2.65 + 2.728 2.648)
= 2.7060

Stock index futures.


Foreign currency futures.
In each case, we first describe the
SPOT MARKET
And then analyze the
FUTURES MARKET.

70

STOCK INDEX FUTURES


The first stock index futures began trading in 1982
on the KCBT. The underlying was the
VALUE LINE INDEX.
Soon afterwards, the CBT, tried to launch a DJIA
futures. It lost its court battle with the Dow Jones
Co. and could not establish that futures. Instead, it
started trading futures on the
MAJOR MARKET INDEX, the MMI.
Today, Stock Index Futures are traded on dozens of
different indexes.
71

STOCK

INDEXES (INDICES)

A STOCK INDEX IS A SINGLE NUMBER


BASED ON INFORMATION ASSOCIATED
WITH A
PORTFOILO OF STOCKS.
A STOCK INDEX IS SOME KIND OF AN
AVERAGE OF THE PRICES AND THE
QUANTITIES OF THE SHARES OF THE
STOCKS THAT ARE INCLUDED IN THE
PORTFOLIO THAT UNDERLYING THE
INDEX.
72

STOCK

INDEXES (INDICES)

THE MOST USED INDEXES ARE


A SIMPLE PRICE AVERAGE
AND
A VALUE WEIGHTED AVERAGE.
73

STOCK INDEXES - THE CASH MARKET


A. AVERAGE PRICE INDEXES: DJIA,
MMI:
N = The number of stocks in the index
Sj = Stock j market price;
D = Divisor

I=
;
j

j = 1,,N.

j = 1,..., N.

Initially, D = N and the Index is set at


an agreed upon level. To assure
74
continuity, the Divisor is adjusted over

EXAMPLES OF INDEX ADJUSMENTS


STOCK SPLITS: 2 FOR 1:
(S1S2 ,..., SN ) / D1I1
1.
2.

1
(S1 S2 ,...,SN ) / D 2 I1
2

Before the split:


(30 + 40 + 50 + 60 + 20) /5 = 40
I = 40 and D = 5.
An instant later:
(30 + 20 + 50 + 60 + 20)/D = 40
75
The new divisor is D = 4.5

CHANGE OF STOCKS IN THE INDEX


1.

(S1S2 (ABC) ,..., SN ) / D1I1

2.

(S1S2 (XYZ)...SN ) / D 2 I1

Before the change:


(31 + 19 + 53 + 59 + 18)/4.5 = 40
I = 40

and

D =4.5.

An instant later:
(30 + 150 + 50 + 60 + 20)/D = 40
The new divisor is D = 7.7576

A STOCK DIVIDEND DISTRIBUTION


Firm 4 distributes 40% stock
dividend.
Before the distribution:
(32 + 113 + 52 + 58 + 25)/7.75 =
36.129
D = 7.75.
An instant later:
(32 + 113 + 52 + 34.8 + 25)/D =
36.129

77

STOCK # 2 SPLIT 3 FOR 1.


Before the split:
(31 + 111 + 54 + 35 +
23)/7.107857587
= 35.7351
An instant later:
(31 + 37 + 54 + 35 + 23)/D =
35.73507
The new Divisor is D =
5.0370644.

78

ADDITIONAL STOCKS

1.

(S1S2 ,...,SN ) / D1I1

2.

(S1S2 ,...,SN SN+1 ) / D 2 I1

Before the stock addition:


(30 + 39 + 55 + 33 + 21)/5.0370644
= 35.338
An instant later:
(30 + 39 + 55 + 33 + 21 + 35)/D =
35.338
79

A price adjustment of Altria Group


Inc. (MO), (due to a distribution of
Kraft Foods Inc. (KFT) shares,) was
effective for the open of trade on
trade date April 2, 2007.As a result,
the new divisor for the DJIA became:
D = 0.123051408.
The last revision of the DJIAs
Divisor was on AUG 2007 and the
Divisor was set at:
D = 0.123017848

80

VALUE WEIGHTED INDEXES


S & P500, NIKKEI 225, VALUE LINE

NS

I
N S

tj tj

j 1,2,......, n

Bj Bj

B = SOME BASE TIME PERIOD


Initially:

t=B

The initial value of the Index is set


at an arbitrarily chosen value: M.81

** The S&P500 index base period was


1941-1943 with initial value: M = 10.
** The NYSE index base period was
Dec. 31, 1965 with initial value: M =
50.
** The NASDAQ composite index base
period was FEB 5 1971 With initail
82
value:

The rate of return on ANY


PORTFOLIO:
The return on a PORTFOLIO in any
period t, is:
the weighted average of the
individual stocks returns. The
weights are the percentages of the
stocks value in the portfolio.
NS
V

R Pt w tjR tj.

w tj

tj tj

N S

tj tj

tj

VtP

83

The Rate of Return on a portfolio

VPt +1VPt N t +1jSt +1j N tjStj


R Pt

VPt
N tjStj
R Pt

S N tjStj

t +1j t +1j

N S

tj tj

but, N t +1j N tj. Thus,

R Pt

N (S S )

N S
tj

t +1j

tj tj

tj

84

R Pt

St 1j Stj
N tjStj S
tj

N S

tj tj

N S R

. Rewrite this as :
N S
tj tj

tj

tj tj

N tjStj

N S

tj tj

R tj , or

Vtj

R tj . Finally,
VtP

R Pt w tjR tj.

w tj

N tjStj

N S

tj tj

Vtj
VtP

85

THE BETA OF A PORTFOLIO


THEOREM: Consider a portfolio
consisting of shares of N stocks.
The portfolios BETA is the weighted
average of the stocks betas. The
weights are the dollar value weights
of the stocks in the portfolio.
R

86

THE BETA OF A PORTFOLIO


Proof:
We use a well diversified index as a
proxy portfolio for the
market portfolio.
R

Let:
P denote the portfolio
underlying
the Index, I.
Let:
the

j denote the individual stock in


portfolio.
j = 1, 2, ,N.
87

By the definition of BETA:

COV(R P ; R M )
P
.
VAR(R M )
The Index is a proxy for the Market :
COV(R P ; R I )
P
.
VAR(R I )

From the previous theorem : R P w jR j,

COV([ w jR j ]; R I )
VAR(R I )

.
88

Recall that the covariance is


a linear operator, thus :
P

w COV(R ; R )

, or :
j

VAR(R I )

COV(R j ; R I )
P w j
w j j.

VAR(R I )
89

STOCK PORTFOLIO BETA


STOCK NAME

PRICE

FEDERAL MOUGUL
MARTIN ARIETTA
IBM
US WEST
BAUSCH & LOMB
FIRST UNION
WALT DISNEY
DELTA AIRLINES

P =

18.875
73.500
50.875
43.625
54.250
47.750
44.500
52.875

SHARES

9,000
8,000
3,500
5,400
10,500
14,400
12,500
16,600

VALUE

169,875
588,000
178,063
235,575
569,625
687,600
556,250
877,725
3,862,713

WEIGHT

BETA

.044
.152
.046
.061
.147
.178
.144
.227

1.00
.80
.50
.70
1.1
1.1
1.4
1.2

(.044)(1.00) + (.152)(.8) + (.046)(.5) + (.061)(.7)


+ (.147)(1.1) + (.178)(1.1) + (.144)(1.4) + (.227)

(1.2)
= 1.06

90

A STOCK PORTFOLIO BETA


STOCK NAME

BENEFICIAL CORP.
CUMMINS ENGINES
GILLETTE
KMART
BOEING
W.R.GRACE
ELI LILLY
PARKER PEN

PRICE

40.500
64.500
62.000
33.000
49.000
42.625
87.375
20.625

SHARES

11,350
10,950
12,400
5,500
4,600
6,750
11,400
7,650

VALUE

459,675
706,275
768,800
181,500
225,400
287,719
996,075
157,781
3,783,225

WEIGHT BETA

.122
.187
.203
.048
.059
.076
.263
.042

.95
1.10
.85
1.15
1.15
1.00
.85
.75

= .122(.95) + .187(1.1) + .203(.85) + .048(1.15) + .059(1.15) + .076(1.0)


+ .263(.85) + .042(.75)
= .95

91

Sources of calculated Betas and calculation


inputs
Example: (GE) 6/20/00
Source
Horizon
Value Line Investment Survey

(GE)
1.25

NYSECI

Index

Data

Weekly Price

5 yrs (Monthly)

Bloomberg
(Weekly)

1.21

S&P500I

Weekly Price

2 yrs

Bridge Information Systems


(daily)

1.13

S&P500I

Daily Price

2 yrs

S&P500I

Monthly P

ice3 (5) yrs

Nasdaq Stock Exchange

1.14

Media General Fin. Svcs. (MGFS)


Quicken.Excite.com
1.23
MSN Money Central

1.20

DailyStock.com

1.21

Standard & Poors Compustat Svcs


5 yrs (Monthly)

S&P500I

S&P Personal Wealth

1.2287

S&P Company Report)

1.23

Charles Schwab Equity Report Card 1.20


S&P Stock Report

1.23

Monthly Price

92

STOCK INDEX FUTURES


1. The monetary value of ONE
CONTRACT is:
(THE INDEX VALUE)($MULTIPLIER)
or
(I)($m)
2.

Accounts are settled by


CASH SETTLEMENT

93

A Stock Index Futures


Can be viewed as an investment
asset paying a dividend yield
The futures price and spot price
relationship is therefore
Ft.T = Ste(rq )(T-t) .
q = the annual dividend yield on
the
portfolio represented by
the index
94

A Stock Index Futures


For the formula to be true it is
important that the index
represents an investment asset
In other words, changes in the
index must correspond to changes
in the value of a tradable portfolio
The Nikkei index viewed as a
dollar number does not represent
an investment asset
95

STOCK INDEX HEDGING


Stock index hedgers may use the NAVE
hedge ratio, h = 1. Mostly, however,
hedgers use the minimum variance hedge
ratio. In this case, the underlying asset is a
stock index; actually the portfolio that
underlie the index. Thus, the parameter
that relates the spot asset and the index is
the Beta of the spot assets with the Index.
Remember: The index is the proxy for the
Market portfolio.
96

RECALL THAT

THE MINIMUM VARIANCE HEDGE RATIO


IS:

cov(S; F)
h* .
var(F)
S
h * - S,F

n * NF
.
NS

NS
n h
.
NF

97

S Sk - St
=
= rS
St
St

F Fk,T - Ft,T
=
= rF
Ft,T
Ft,T

S = St rS
F = Ft,T rF

COV(St rS , Ft,T rF )
COV(S; F)
h*= VAR( F)
VAR(Ft,T rF )
COV(rS , rF ) [St Ft,T ]
h*= 2
VAR(r F )
Ft,T

98

COV(rS , rF ) [St Ft,T ]


h*= 2
VAR(r F ) Ft,T
COV(rS , rF ) St
St
h*= -
.
VAR(r F ) Ft,T
Ft,T
NS
St N S
Spot Value at t
n* h*

-
NF
Ft,T N F
Futures Value at t
VS
n
VF
*

99

STOCK PORTFOLIO HEDGE


STOCK NAME

PRICE

FEDERAL MOUGUL
MARTIN ARIETTA
IBM
US WEST
BAUSCH & LOMB
FIRST UNION
WALT DISNEY
DELTA AIRLINES

18.875
73.500
50.875
43.625
54.250
47.750
44.500
52.875

SHARES

9,000
8,000
3,500
5,400
10,500
14,400
12,500
16,600

VALUE

WEIGHT BETA

169,875
88,000
178,063
235,575
569,625
687,600
556,250
877,725
3,862,713

.044
.152
.046
.061
.147
.178
.144
.227

= .044(1.00) + .152(.8) + .046(.5)


+ .061(.7) + .147(1.1) + .178(1.1)
+ .144(1.4)+ .227(1.2)
= 1.06

100

1.00
.80
.50
.70
1.1
1.1
1.4
1.2

TIME

CASH

MAR.31 VS = $3,862,713

FUTURES
SEP SP500I FUTURES. F = 1,052.60.
VF = 1,052.60($250) = $263,300

3,862,713
n = - 1.06
= - 16.
263,300
*

SHORT 16 SEP SP500I Fs.

JUL.27

VS = $3,751,307

LONG 16 SEP SP500I Fs


F = 1,026.99
GAIN = (1,052.60 - 1,026.99)($250)(16)
= $102,440.00

TOTAL VALUE

$3,853,747.00

101

ANTICIPATORY HEDGE OF A
TAKEOVER
A firm intends to purchase 100,000 shares of

XYZ ON DEC.17.

DATE

SPOT

FUTURES

NOV.17

S = $54/SHARE

MAR SP500I FUTURES IS F = 1,465.45

= 1.35

VF = 1,465.45($250)

VS = (54)100,000
= $5,400,000

5,400,000
$366,362.50
n= =
- 1.35
= - 20
366,362.50
*

LONG 20 MAR SP500I Futures.


DEC.17

S = $58/SHARE
PURCHASE 100,000 SHARES.

SHORT 20 MAR SP500I Futures


F = 1, 567.45

COST = $5,800,000
Gain: 20(1,567.45 - 1,465.45)$250
$5,800,000 - $510,000
= $52.9/SHARE
= $510,000
100,000
102

HEDGING A ONE STOCK PORTFOLIO


SPECIFIC STOCK INFORMATION INDICATES THAT THE STOCK SHOULD
INCREASE IN VALUE BY ABOUT 9%. THE MARKET IS EXPECTED TO DECREASE
BY 10%, HOWEVER. THUS, WITH BETA = 1.1 THE STOCK PRICE IS EXPECTED TO
REMAIN AT ITS CURRENT VALUE. SPECULATING ON THE UNSYSTEMATIC RISK,
WE OPEN THE FOLLOWING STRATEGY:
TIME

SPOT

FUTURES

JULY 1 OWN 150,000 SHARES


S = $17.375
VS = $2,606,250
= 1.1

DEC. IF PRICE F = 1,090


VF = 1,090($250) = $272,500

2,606,250
n = - 1.1
= - 11
272,500
*

SHORT 11 DEC. SP500I Futures


SEP.30

S = $17.125
V = $2,568,750

LONG 11 DEC SP500I Futures


F = 1,002.
Gain: $250(11)(1,090 - 1,002) = $242,000

ACTUAL

V = $2,810,750. An increase of about 8%

103

MARKET TIMING USING BETA


When we believe (speculate) that the
market trend is changing, we can
change the beta of our portfolio. We
may purchase high beta stocks and
sell low beta stocks, when we believe
that the market is turning upward; or
purchase low beta stocks and sell high
beta stocks, when we believe that the
market is moving down. Instead we
may try to change the beta of our spot
position by using the INDEX FUTURES
104

The Minimum Variance Hedge Ratio


in our case is: h* = -(VS/VF).
Assume that the current position is a
portfolio with current spot market
value of VS and n stock index
futures. Then:
The BETA of the spot position may be
altered from its current value, , to
a Target Beta = T, buying or selling
V
S
n futures:
n* [ ] .
T

VF

105

Proof:

VP VS nVF
(VP ) (VS ) n * (VF )

(VP ) (VS )
(VF ) (VS )
VF (VF )

n*

n*
.
VS
VS
VS
VS
VS VF
DEFINE
(VP )
rP
;
VS

(VS )
rS
;
VS

VF
ErP ErS n * ErF ErT
VS

and

(VF )
rF
.
VF
106

Again :

VF
E(rT ) E(rS ) n * E(rF ).
VS

Following the CAPM, we can write :


E(rT ) rf T [E(rM ) rf ] and
E(rS ) rf [E(rM ) rf ] and
E(rF ) E(rM ) rf .
Notice that in the last equation F is a futures
on the index and thus, it' s 1. Hence, it requires
no initial outlay and no opportunity cost is needed
in the furmula.
107

VF
E(rT ) E(rS ) n
E(rF )
VS
*

VF
rf [E(rM ) rf ] n
[E(rM ) rf ]
VS
*

rf T [E(rM ) rf ]
*

and solve for n :


VS
n* [ T ]
VF

108

MARKET TIMING HEDGE RATIO (page


66)
The rule: In order to change the BETA
of the spot position from to T, the
stock index futures may be used as
If T ; we wish to reduce to T
follows:

VS
SHORT n* [ T ]
contracts .
VF

If T ; we wish to increase to T
LONG

VS
n* [ T ]
contracts .
VF
109

MARKET TIMING HEDGE; EN EXAMPLE


STOCK NAME

PRICE

BENEFICIAL CORP.
CUMMINS ENGINES
GILLETTE
KMART
BOEING
W.R.GRACE
ELI LILLY
PARKER PEN

40.500
64.500
62.000
33.000
49.000
42.625
87.375
20.625

SHARES

11,350
10,950
12,400
5,500
4,600
6,750
11,400
7,650

VALUE

WEIGHT

459,675
706,275
768,800
181,500
225,400
287,719
996,075
157,781
3,783,225

BETA

.122
.187
.203
.048
.059
.076
.263
.042

(portfolio) = .122(.95) + .187(1.1) + .203(.85)


+ .048(1.15) + .059(1.15) + .076(1.0)
+ .263(.85) + .042(.75)
= .95

110

.95
1.10
.85
1.15
1.15
1.00
.85
.75

The portfolio manager speculates that


the market has reached a turning
point and is on its way up.
The idea is that in this case it is
possible to increase the portfolios
Beta employing Stock Index futures.
Suppose that the portfolio manager
wishes to increase the current Beta
from
= .95 to
111

TIME

SPOT

FUTURES

AUG.29

V = $3,783,225.

DEC SP500I Fs

= 0.95.

= 1,079.8($250) = $269,950

3,783,225
n * = (1.25 - .95)
=4
269,950
LONG 4 DEC SP500I Futures
NOV.29

V = $4,161,500

F = 1,154.53
SHORT 4 DEC SP500I Futures
GAIN (1,154.53 - 1,079.8)(250)(4)
= $74,730

TOTAL PORTFOLIO VALUE $4,236,230


THE MARKET INCREASED ABOUT 7% AND
THE PORTFOLIO VALUE INCREASED ABOUT 12%

112

FOREIGN
CURRENCY:
THE SPOT MARKET
EXCHANGE RATES:
THE PRICE OF ONE CURRENCY IN
TERMS OF ANOTHER CURRENCY
IS THE EXCHANGE RATE 113

SPOT EXCHANGE RATES:


THERE ARE TWO QUOTE FORMATS:
1.S(USD/FC) = THE NUMBER OF USD
IN
ONE UNIT OF THE
FOREIGN
CURRENCY.
2.S(FC/USD) = THE NUMBER OF THE
FOREIGN
CURRENCY
UNITS
IN ONE USD.
114

1
S(FC /FC ) =
1 2 S(FC /FC )
2 1
Example :
S(USD/EUR) = 1.4821
S(EUR/USD) .67476
1
1

= 1.4821 S(USD/EUR)
S(EUR/USD) .67476
115

WHEN WE HAVE BID AND ASK QUOTES :


1
S(FC/USD)

ASK S(USD/FC)
1
S(FC/USD)

BID S(USD/FC)
S(GBP/USD)
S(USD/GBP)
S(USD/GBP)
S(GBP/USD)

ASK
BID
ASK
BID

BID

ASK

GBP.5USD, buy ONE USD pay .50GBP.


USD2.00/GBP, sell ONE GBP get USD2.
USD2.083/GBP, buy ONE GBP pay USD2.083.
GBP.480/US D, sell ONE USD get .48GBP.
116

BUY
USD
GBP
S(GBP/USD)ASK S(USD/GBP)BID
= GBP 0.50

= USD 2.083

PAY

RECEIV S(GBP/USD)BID S(USD/GBP)BID


E
= GBP 0.48
= GBP 2.000
USD

GBP

117

CURRENCY CROSS RATES


LET FC1, FC2 AND FC3 DENOTE THREE
DIFFERENT CURRENCIES.
IN THE ABSENCE OF ARBITRAGE :

S(FC1/FC3)
S(FC1/FC2) =
S(FC2/FC3)
S(FC3/FC2)
=
118
S(FC3/FC1)

CURRENCY CROSS RATES DEC


17.07
(www.x-rates.com)

USD

GBP

CAD

EUR

MXN

USD

2.01400

0.989609

1.439200

0.092080
1

GBP
CAD

0.496524

0.491364

0.714597

0.045720

1.010500

2.03515
1

1.454310

0.093047

EUR

0.694830

1.39938
0

0.687611

0.063980

MX
N

10.86010
9

21.8723
0

10.74730
0

15.62990
0

119

CURRENCY CROSS RATES


EXAMPLE:

FC1 = USD; FC2 = MXN;


FC3 = GBP.

USD

GBP

MXN

USA
1
2.01400
0.0920801
UK 0.496524 1
0.045720
MEX
10.860109 21.87230 1

120

CURRENCY CROSS RATES


EXAMPLE

Let FC1 USD; FC2 MXN; FC3 GBP.

S(GBP/MXN)
S(USD/MXN) =
S(GBP/USD)
S(USD/GBP)
=
.
S(MXN/GBP)
121

CURRENCY CROSS RATES


EXAMPLE

S(GBP/MXN) 0.045720.
S(GBP/USD) 0.496524.
S(USD/GBP) 2.014000.
S(MXN/GBP) 21.872300.
S(GBP/MXN) 0.045720

0.092080.
S(GBP/USD)
0.496524
S(USD/GBP)
2.014000

0.092080.
S(MXN/GBP) 21.872300
122

AN EXAMPLE OF CROSS SPOT RATES ARBITRAGE


COUNTRY

USD

GBP

CHF

U.S.A

1.0000

1.5640

0.5580

U.K

0.6394

1.0000

0.3546

SWITZERLAND

1.7920

2.8200

1.0000

THEORY :

S(GBP/USD)
= S(CHF/USD)
S(GBP/CHF)

BUT : 0.6394 = 1.8031 1.7920


0.3546
SIMILARLY :

BUT :

S(USD/GBP)
= S(CHF/GBP)
S(USD/CHF)

1.5640
= 2.8029 < 2.8200
0.5580

123

THE CASH ARBITRAGE ACTIVITIES:


Start:

End.

USD1,000,000
USD1,006,134

0.6394

0.5580

GBP639,400
CHF1,803,108
2.8200

124

Forward rates, An example:


GBP

DEC 17, 2007

SPOT
USD1.997200/GBP
1 Month forward
USD1.995300/GBP
2 Months forward
USD1.993760/GBP
3 Months forward
USD1.992010/GBP
6 Months forward

125

FOREIGN CURRENCY CONTRACT SPECIFICATIONS


CURRENCY

SIZE

MINIMUM

FUTURES

CHANGE USD/FC

CHANGE F

JAPAN YEN

12.5M

.000001

USD12.50

CANADIAN DOLLAR

100,000

.0001

USD10.00

62,500

.0002

USD12.50

SWISS FRANC

125,000

.0001

USD12.50

AUSTRALIAN DOLLAR

100,000

.0001

USD10.00

MEXIAN PESO

500,000

.000025

USD12.50

BRAZILIAN REAL

100,000

.0001

USD10.00

EURO FX

125,000

.0001

USD12.50

BRITISH POUND

* MUST CHECK FOR DAILY PRICE LIMITS


* CONTRACT MONTHS FOR ALL CURRENCIES:
DECEMBER

MARCH, JUNE, SEPTEMBER,

* LAST TRADING DAY: FUTURES TRADING TERMINATES AT 9:16 AM ON THE


SECOND BUSINESS DAY IMMEDIATELY PRECEEDING THE THIRD WEDNESDAY OF
THE CONTRACT MONTH.
* DELIVERY BY WIRED TRASFER. 3RD WEDNESDAY OF CONTRACT MONTH

126

SPECULATION: TAKE RISK FOR EXPECTED PROFIT


AN OUTRIGHT NAKED POSITION WITH CANADIAN DOLLAS:
t - MARCH 1.

S(USD/CD) = .6345 <=> S(CD/USD) = 1.5760

T- SEPTEMBER

F(USD/CD) = .6270 <=> F(CD/USD) = 1.5949

SPECULATOR:

THE CD WILL NOT DEPRECIATE TO THE


EXTENT IMPLIED BY THE SEP. FUTURES.
INSTEAD, IT WILL DEPRECIATE TO A PRICE
HIGHER THAN USD.6270/CD.

TIME
MAR 1

CASH
DO NOTHING

FUTURES
LONG n, CD SEP FUTURES
AT USD.6270/CD

AUG 20

DO NOTHING

SHORT n, CD SEP FUTURES


AT USD.6300/CD

PROFIT = (USD.6300/CD - USD.6270/CD)(CD100,000)(n) = USD300(n).

127

HEDGING
IN THE FOLLOWING EXAMPLES WE USE
THE NAVE HEDGE RATIO:
h = 1.
Two ways:
1.n = NS/NF
2.n = VS/VF
128

BORROWING U.S. DOLLARS SYNTHETICALLY ABROAD


OR
HOW TO BEAT THE DOMESTIC BORROWING RATE

A U.S. FIRM NEEDS TO BORROW USD200M FROM MAY 25, 2003 TO DECEMBER 20,
2003, FACES THE FOLLOWING DATA:

BID

ASK

SPOT:

USD1.25000/EUR

USD1.25100/EUR

DEC FUTURES:

USD1.25850/EUR

USD1.26000/EUR

ITALY:

6.7512%

6.9545%

USA:

8.6100%

8.75154%(360-day year)

Interest rates:
(365-day year)

129

TIME

SPOT

FUTURES

MAY 25

(1) BORROW EUR160,000,000

LONG 1,332 DEC EUR FUTURES FOR

FOR 6.9545% FOR 209 DAYS

(2) EXCHANGE THE EUR INTO


INTO USD200,000,000 AND USE

F = 1.26000

166,500,000
n
= 1,332
125,000

THIS SUM TO FINANCE THE PROJECT


DEC 20 LOAN VALUE ON DEC. 20
160,000,000e(0.069545)(209/365)
= EUR166,500,000

TAKE DELIVERY OF EUR166,500,000


PAYING USD209,790,000
REPAY THE LOAN.

THE IMPLIED REVERSE REPO RATE FOR 209 DAYS =

1
209,790,000
ln[
] = .0823, or 8.23%.
209/360 200,000,000
130

EXAMPLES OF HEDGING FOREIGN CURRENCY


EXAMPLE 1: A LONG HEDGE.
ON JULY 1, AN AMERICAN AUTOMOBILE DEALER ENTERS INTO A CONTRACT TO IMPORT
100 BRITISH SPORTS CARS FOR GBP28,000 EACH. PAYMENT WILL BE MADE IN BRITISH
POUNDS ON NOVEMBER 1. RISK EXPOSURE: IF THE GBP APPRECIATES RELATIVE TO THE
USD THE IMPORTERS COST WILL RISE.
TIME

SPOT

FUTURES

JUL. 1

S(USD/GBP) = 1.3060

LONG 46 DEC BP FUTURES

CURRENT COST = USD3,656,800

FOR F = USD1.2780/GBP

DO NOTHING

NOV. 1

h 1;

3,656,800
n=
= 46
62,500(1.2780)

S(USD/GBP) = 1.4420

SHORT 46 DEC BP FUTURES

COST = 28,000(1.4420)(100)

FOR F = USD1.4375/GBP

= USD4,037,600

PROFIT: (1.4375 - 1.2780)62,500(46)


= USD458,562.50

ACTUAL COST = USD3,579,037.50

131

EXAMPLE 2: A LONG HEDGE


ON MARCH 1, AN AMERICAN WATCH RETAILER AGREES TO PURCHASE 10,000 SWISS
WATCHES FOR CHF375 EACH.
THE SHIPMENT AND THE PURCHASE WILL TAKE PLACE ON AUGUST 26.

TIME

SPOT

FUTURES

MAR. 1

S(USD/CHF) = .6369

LONG 30 SEP CHF FUTURES

CURRENT COST 10,000 (375)(.6369) F(SEP) = USD.6514/CHF

AUG. 25

= USD2,388,375

CONTRACT = (.6514)125,000

DO NOTHING

= USD81,425.

S=USD.6600/CHF

SHORT 30 SEP CHF FUTURES

BUY 10,00 WATCHES FOR

F(SEP) = USD.6750/CHF

(375)(.6600)(10,000)

PROFIT(.6750 - .6514)125,000(30)

TOTAL $2,475,000.

= USD88,500.

2,388,375
n=
= 30
81,425

ACTUAL COST USD2,386,500

132

EXAMPLE 3: A LONG HEDGE


ON MAY 1, AN ITALIAN EXPORTER AGREES TO SELL 1,000 SPORTS CARS TO AN
AMERICAN DEALER FOR USD50,000 EACH.
THE SHIPMENT AND THE PAYMENT WILL TAKE PLACE ON OCT 26.

TIME

SPOT

FUTURES

MAY. 1

S(EUR/USD) = .87000

LONG 298 DEC EUR FUTURES

CURRENT VALUE:

F(DEC) = USD1.17EUR

= EUR43,500,000

43,500,000
n=
= 348
125,000

S=EUR.81300/USD

SHORT 348 DEC EUR FUTURES

DELIVER THE CARS FOR

F(DEC) = USD1.29000/EUR

PAYMENT: EUR40,650,000.

PROFIT(1.29 1.17)(125,000)(348)

OCT. 26

=USD5,220,000

ACTUAL PAYMENT IN EUR:


40,650,000 + 5,220,000(.813) = EUR44,893,860.

133

EXAMPLE 4: A LONG HEDGE: PROTECT AGAINST DEPRECIATING


DOLLAR
ON MAY. 23, AN AMERICAN FIRM AGREES TO BUY 100,000 MOTORCYCLES FROM A
JAPANESE FIRM FOR JY202,350 . Payment and delivery will take place on DEC 20.

CURRENT PRICE DATA: ASK

BID

SPOT:

USD.007020/JY

USD.007027/JY

(142.4501245)

142.3082396)

USD.007190/JY

USD.007185/JY

DEC FUTURES:

ON DECEMBER 20 THE FIRM WILL NEED THE SUM OF JY20,235,000,000.


TODAY, THIS SUM IS VALUED AT 20,235,000,000(.007027) = USD142,191,345

N = USD142,191,345/(JY12,500,000)(USD.007190/JY) = 1,582.

134

TIME

CASH

FUTURES

MAY 23

DO NOTHING

LONG 1,582 JY FUTURES FOR

V = USD142,191,345

F(ask) = USD.007190/JY

S = USD.0080/JY

SHORT 1,582JY Fs.

BUY MOTORCYCLES

FOR USD.0080/JY

FOR USD161,880,000

PROFIT: (.0080-.00719)12,500,000(1,582)

CASE I:
DEC 20

= USD16,017,750
NET COST: USD161,880,000 - USD16,017,750 = USD145,862,250.
CASE II:
DEC 20

S = USD.0065/JY

SHORT 1,582 JY Fs.

BUY MOTORCYCLES

FOR USD.0065/JY

USD131,527,500

LOSS: (.00719-.0065)12,500,000(1,582)
= USD13,644,750

NET COST: USD145,172,250.

135

EXAMPLE 5: A SHORT HEDGE


A US MULTINATIONAL COMPANYS ITALIAN SUBSIDIARY WILL GENERATE EARNINGS
OF EUR2,516,583.75 AT THE END OF THE QUARTER - MARCH 31. THE MONEY WILL BE
DEPOSITED IN THE NEW YORK BANK ACCOUNT OF THE FIRM IN U.S. DOLLARS.
RISK EXPOSURE: IF THE DOLLAR APRECIATES RELATIVE TO THE EURO THERE WILL
BE LESS DOLLARS TO DEPOSIT.
TIME

CASH

FEB. 21 S(USD/EUR) = 1.18455

FUTURES
F(JUN) = USD1.17675/EUR

CURRENT SPOT VALUE

F = 125,000(1.17675) = USD147,093.75

= USD2,981,019.28

n = 2,981,019.28/147,093.75 = 20.

DO NOTHING

SHORT 20 JUN EUR FUTURES

MAR 31 S(EUR/USD) = 1.1000


DEPOSIT 2,768,242.125

LONG 20 JUN EUR FUTURES


F(JUN) = USD1.10500
PROFIT: (1.17675 -1.10500)125,000(20) =
USD179,375

TOTAL AMOUNT TO DEPOSIT USD2,947,617.125

136

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