Chapter 11: ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Explain the major differences between futures contracts and forward contracts.
Solution: a. Futures contracts are standardized. Forward contracts are customized.
b. Parties in a futures contract hold formal contracts with the futures exchange. Parties to a forward contract hold formal contracts with each other.
c. Forward contracts are typically satisfied by actual delivery of the commodity. Futures contracts can be satisfied by making an offsetting transaction (purchase or sale) in the futures exchange.
d. Futurescontractshavelessdefaultriskbecausetheyaremarkedtomarket daily.Forwardcontractsaremarkedtomarketonlyatmaturity.
e. Futures contracts have less default risk because parties to the contracts must post margin money to guarantee performance on the contract. There is no margin on a forward contract.
2. What is the economic role of the margin account on a futures exchange?
Solution: The margin account protects futures market participants from default resulting from adverse price movements. As contracts are marked to market daily, increases in value are added to the margin account and decreases in value are subtracted. The exchange maintains these accounts so participants needn’t worry about default risk.
3. What determines the size of the margin requirement for a particular futures contract?
Solution: Thesizeofthemarginrequirementisdeterminedbythepricevolatilityoftheunderlyingasset.
4. What is the difference between hedging and speculating?
Solution: In the context of a futures transaction, a hedger will hold a position in the spot market opposite to that in the futures market. For example, a shipping firm that is short in the spot fuel oil market could hedge the price risk by going long in oil futures. Hedgers are primarily trying to reduce price risk. Speculators, on the other hand, will be long or short a futures contract without holding an offsetting position in the spot market. They are in effect accepting price risk in hopes of making money on price movements.
DO YOU UNDERSTAND?
1. Suppose you own a portfolio of stocks currently worth $100,000. The portfolio has a beta of 1.2. Describe in detail the futures transaction you would undertake to hedge the value of your portfolio. Which futures contract would you use? How many contracts would you buy or sell?
Solution: The investor should sell S&P 500 futures contracts short. Because the futures contract is assumed to have a beta of 1.0, you would have to sell contracts worth 20 percent more than the value of your portfolio to create the hedge.
2. Suppose your desired holding period is five years, but you find yourself with a bond portfolio having a duration of seven years. Describe the futures transaction you would undertake to hedge the value of your portfolio at the end of five years. What futures contract would you use? Would you buy or sell these futures contracts to shorten the duration of your bond portfolio?
Solution: Since you are long in bonds, you should hedge the position by selling short futures contracts on similar bonds. You should pick the futures contract whose underlying bond most closely resembles the bonds in your portfolio with respect to maturity and default risk. This will minimize your basis risk.
3. Why does cross-hedging lead to basis risk?
Solution: Basis risk exists because the value of an item being hedged may not always keep the same price relationship to contracts purchased or sold in the futures market. Cross-hedging involves hedging with a futures contract whose characteristics do not match those of the hedger’s risk exposure. Since the price movements of the hedged commodity are likely to be less than perfectly correlated with those of the futures contract in a cross-hedge, basis risk results.
DO YOU UNDERSTAND?
1. Which do you think has more default risk, a futures contract or a swap contract? Why?
Solution: Swap contracts do not typically involve margin money nor do they mark to market daily. Therefore, futures contracts have less default risk. Swap contracts, however, are less risky than forward contracts because swaps involve cash settlement before maturity.
2. What are some considerations in the decision to use futures or options for hedging?
Solution: Gains and losses in futures contracts are virtually without limit. For that reason, some hedgers prefer options. Options give a one-sided type of price protection that is not available from futures. However, premiums on options may be high, and the value of options decays over time. The buyer of protection must decide whether the insurance value provided by the option is worth the price.
3. Explain the relationship between the time to expiration for a call option and the value of the option.
Solution: European options can only be exercised at maturity. American options can be exercised any time before maturity.
4. Explain the relationship between the price variance of an asset and the value ofan option written on that asset.
Solution: The more price variability a stock has, the greater the chance that the buyer can exercise the option for either a larger profit or a larger loss. However, the buyer will never exercise the option and take a loss. Thus, options with greater price variance tend to be more valuable.
5. If you hold some shares of stock and would like to protect yourself from a price decline, without giving up a lot of upside potential, should you purchase call options or put options? Explain.
Solution: You should purchase put options. When the value of the stock goes below the exercise price, the payoff from the put at maturity increases. This increased payoff offsets losses from holding the stock.