702 Part Eight Risk Management
bre44380_ch26_673-706.indd 702 09/30/15 12:09 PM
- Futures hedging Legs Diamond owns shares in a Vanguard Index 500 mutual fund worth
$1 million on July 15. (This is an index fund that tracks the Standard and Poor’s 500 Index.)
He wants to cash in now, but his accountant advises him to wait six months so as to defer a
large capital gains tax. Explain to Legs how he can use stock index futures to hedge out his
exposure to market movements over the next six months. Could Legs “cash in” without actu-
ally selling his shares? - Hedge ratios Price changes of two gold-mining stocks have shown strong positive correla-
tion. Their historical relationship is
Average percentage change in A = .001 + .75 (percentage change in B)
Changes in B explain 60% of the variation of the changes in A (R^2 = .6).
a. Suppose you own $100,000 of A. How much of B should you sell to minimize the risk of
your net position?
b. What is the hedge ratio?
c. Here is the historical relationship between stock A and gold prices:
Average percentage change in A = −.002 + 1.2 (percentage change in gold price)
If R^2 = .5, can you lower the risk of your net position by hedging with gold (or gold
futures) rather than with stock B? Explain. - Risk management Petrochemical Parfum (PP) is concerned about a possible increase in
the price of heavy fuel oil, which is one of its major inputs. Show how PP can use either
options or futures contracts to protect itself against a rise in the price of crude oil. Show how
the payoffs in each case would vary if the oil price were $70, $80, or $90 a barrel. What are
the advantages and disadvantages for PP of using futures rather than options to reduce risk? - Futures prices Consider the commodities and financial assets listed in Table 26.5. The
risk-free interest rate is 6% a year, and the term structure is flat.
a. Calculate the six-month futures price for each case.
b. Explain how a magnoosium producer would use a futures market to lock in the selling
price of a planned shipment of 1,000 tons of magnoosium six months from now.
c. Suppose the producer takes the actions recommended in your answer to (b), but after one
month magnoosium prices have fallen to $2,200. What happens? Will the producer have
to undertake additional futures market trades to restore its hedged position?
d. Does the biotech index futures price provide useful information about the expected future
performance of biotech stocks?
e. Suppose Allen Wrench stock falls suddenly by $10 per share. Investors are confident that
the cash dividend will not be reduced. What happens to the futures price?
Asset Spot Price Comments
Magnoosium $2,800 per ton Net convenience yield = 4% per year
Oat bran $0.44 per bushel Net convenience yield = 0.5% per month
Biotech stock index $140.2 Dividend = 0
Allen Wrench Co. common stock $58.00 Cash dividend = $2.40 per year
5-year Treasury note $108.93 8% coupon
Westonian ruple 3.1 ruples = $1 12% interest rate in ruples❱ TABLE 26.5^ Spot prices for selected commodities and financial assets. See
Problem 28.