Upgrade to remove ads
Finc416 Chapter 4
Terms in this set (34)
- is one where the asset at risk is the same as the asset underlying the derivative contract used to hedge.
- If our firm is about to purchase gold, and we are hedging with gold forwards or futures, then this would be a
perfect direct hedge
is a direct hedge where the quantity at risk matches the size of the derivative contract, and where the expiration date of the derivative used for hedging matches exactly the time we are going to purchase the gold.
- when the spot and forward are based on the same asset, we can remove all risk when the hedge is perfect (no quantity or basis risk)
- if our hedge is direct, but not perfect, it will suffer from
- risk attributable to uncertain movements in the spread between a futures price and a spot price
- if our hedge is not direct, then the hedge is
- An example would be hedging titanium with gold futures, or hedging a unique stock portfolio with S&P500 futures.
- can also suffer from basis risk and from correlation risk.
short natural exposure" or "short business exposure"
- If we are a consumer of an asset, then we say we have
- For example, if our firm is about to purchase gold, then we have a _______________ to gold prices.
- Why short? Well, if gold prices rise we would be worse off, but if gold prices fall we would be better off. This is similar to short spot or forward contract payoffs.
"long natural exposure" or "long business exposure
- If we are a producer of an asset, then we say we have ________
- For example, if our firm is about to sell gold, then we have a _____________ to gold prices.
- Why long? Well, if gold prices rise we would be better off, but if gold prices fall we would be worse off.
- This is similar to long spot or long contract payoffs.
is one where a party uses long derivatives to hedge a short natural exposure
is one where a party uses short derivatives to hedge a long natural exposure.
Imperfect Direct Hedge
Next, let's imagine Tiffany's still needs to buy gold in 60 days, but for whatever reason the gold forward contract they are using expires in 70 days. Let's call the spot price they buy gold at in 60-days St and the price used for the forward contract ST. Now they will pay St in 60-days and receive long forward payoff in 70 days. Here is the Net Future Value of the transaction in 70 days:
Basis risk stats
- is reduced (on average) when the time between the spot and forward market transactions is reduced.
- since spot price and forward price converge at maturity, basis risk is reduced as the time between the spot and forward market transactions approaches zero.
Adjusting Perfect Direct Hedges
Now, imagine that Tiffany's has a deal with a supplier who always gives them a 2% discount to spot. Can we still make the hedge perfect? Recall, our initial example was perfect because our spot market transaction price was the same as the spot price used to define the hedge payoff:
the sensitivity of a position to the change in the price of asset underlying the derivative used to hedge.
- the h* in equation above is also the equation for a slope coefficient from an ordinary least squares regression
As a hedger, the goal is reduce risk
so we would want to choose a quantity of gold, h, to long forward that minimizes the variance of returns on P
Most typical are equity correlation swaps
where payment on some notional $N would be +/- N(realized avg correlation - fixed avg correlation) using some pre-determined basket of stocks to measure average return correlation
Closely related are variance swaps,
where one can hedge against variance being different than expected.
is creating by taking a long forward position in one market and a short forward in another market. Spreads are a natural hedge for firms that may be at risk between the difference in prices across two markets
is the difference between cost of crude oil and price of a refined petroleum product, usually using gasoline and distillate fuel. Both single and multi-product crack spreads are calculated. The most common multi product figure is the 3:2:1 crack spread, calculated by subtracting the cost of three barrels of crude oil from the price of two barrels of gasoline, and one barrel of distillate.
- are a useful way to look at supply trends and refinery margins in different markets, as it compares a locally priced commodity (wholesale products) to a globally priced one (crude oil). Crack spread futures are used by independent refiners to hedge against adverse price movements.
Natural gas vs electricity
Precious metal spreads
Gold vs silver
Platinum vs palladium
- These don't have names like the top energy and ag products above, but very common spreads are the the platinum-palladium and gold-silver spreads.
Soybeans vs soybean oil and/or meal
A trader (or firm) enters long soybean contracts and also shorts contracts in soybean meal and/or soybean oil. If you do the opposite,
is two forward (or futures) positions in the same market, with contracts differing in maturity. The trade is closed when the nearest contract expires (or else you are then attempting cash-and-carry arbitrage if you went long the near-term contract and short the long-term contract).
- is a bet in how the slope of the futures (or forward) term structure will change
- The change in time component is predictable, but the change in interest rates, storage costs and convenience yields is not predictable.
So, with the interest rate shock (POSIVITVE)
we simulated a positive shift in term structure of interest rates and we can see that the difference between Dec and Sep prices went from 0.325 (2.637-2.312) to 0.33243 - the term structure got STEEPER, while the spot price of NG didn't change
So, with the interest rate shock
we simulated a negative shift in term structure of interest rates and we can see that the difference between Dec and Sep prices went from structure got FLATTER, while the spot price of NG didn't change
Hedging with swaps is done
when firms have a time-series of cash flows that are at risk. Non-financial firms will typically enter swaps on interest rates, foreign exchange rates (via FX swaps or currency swaps), fuel, and other commodities depending on the nature of their business
involves the exchange of principal at the beginning and end of the swap, and only interest payments in the interim.
- are structured much like interest-only corporate debt
- calls for the exchange of principal. As it allows a firm to simultaneously swap out the maturity payments
perfect matched book
- If these swaps are on the same notional, and payments are over the same time periods, then this would be a
- the bank would have zero risk* in their position as the bank becomes simply a conduit through which cash flows between AAA and BBB
Hershey's is a consumer (purchaser) of diesel fuel. Therefore Hersey's has a _______ business exposure to diesel fuel. which would be hedged by using a ______ ULSD forward or futures contracts.
Newmont Goldcorp was the largest gold mining firm in the world during 2018. As a producer (seller) of gold, NEM has a ______ business exposure to gold prices. Which they would hedge by using ____ gold forward or futures contracts/
If a client is fully invested in the S&P500, a _______ hedge could be created by using S&P500 futures. In contrast, if a client has a unique portfolio, a ______ hedge could be created by using S&P500 futures.
A US firm is seeking to hedge 5 million Australian Dollars receipt to be received on December 31st. A perfect direct hedge will short _____________
5 million Aud, maturing Dec 31st
The expected reliability of cross hedge is most likely to increase as _______ increases
Suppose a US firm is worried about the USD value of their monthly Aud cash flows over the next 12 months. In this case the firm would enter a ___________ to _________ aud at a fixed rate each month.
swap contract; sell or "short"
According to the chart in our powerpoint slides, one barrel of crude oil produces about how many gallons of gasoline?
You might also like...
FIN 3826 Chapter 17
BUA 350 MT1
Investments Chapter 17
Other sets by this creator
Finc412: Insurance Companies
Finc412: Credit Risk
Finc412 Commercial Banks part 2
Finc412 Commercial Banks
Other Quizlet sets
Physics Lecture 20 Example Problems (Rotational In…
MBS 601 - Exam 3
Creative iMedia R081