FIN555 Homework 5 (Solution)

FIN 555, Spring 2019 Risk Management and Insurance
Homework #5
Due Tuesday, April 23, 2019
1. Futures contracts trade with every month as a delivery month. A company is hedging the
purchase of the underlying asset on June 15. Which futures contract should it use?
a. The May contract

b. The June contract
c. The July contract
d. The August contract
2. Which of the following is true?
a. The optimal hedge ratio is the slope of the best fit line when the spot price (on the y-axis)
is regressed against the futures price (on the x-axis).
b. The optimal hedge ratio is the slope of the best fit line when the futures price (on the y
axis) is regressed against the spot price (on the x-axis).
c. The optimal hedge ratio is the slope of the best fit line when the change in the spot price
(on the y-axis) is regressed against the change in the futures price (on the x-axis).
d. The optimal hedge ratio is the slope of the best fit line when the change in the futures
price (on the y-axis) is regressed against the change in the spot price (on the x-axis).
3. Your utility company will need to buy 100,000 barrels of oil in 10 days of time, and it is
worried about fuel costs. Suppose you go long 100 oil futures contracts, each for 1,000
barrels of oil, at the current futures price of $60 per barrel. Further suppose futures prices
change each day as follows:
1 Satrio, Reiner
1) What is the mark-to-market profit or loss (in dollars) that you will have on each date?
2) What is your total profit or loss after 10 days? Have you been protected against a rise in
oil prices?
3) What is the largest cumulative loss you will experience over the 10-day period? In what
case might this be a problem?
Day 0 1 2 3 4 5 6 7 8 9 10
Price 60.00 59.50 57.05 57.75 58.00 59.50 60.50 60.75 59.75 61.75 62.50
Daily MTM 0 (50,000) (245,000) 70,000 25,000 150,000 100,000 25,000 (100,000) 200,000 75,000
Cumulative P/L 0 (50,000) (295,000) (225,000) (200,000) (50,000) 50,000 75,000 (25,000) 175,000 250,000
End P/L 250,000

Max Loss (295,000) Problem if oil price is actually cheaper than contracted price
4. You are a consultant in risk management.
1) If a corn farmer wants to lock in a selling price for his 100,000 bushels of corn
anticipated to harvest. Should you suggest him to sell/short or buy/long corn futures?
2) How many corn futures contracts should he sell or buy given that the size is 5,000
bushels per futures contract? 100,000/5,000 = 20 Futures Contract
3) If a producer/buyer needs 1,000,000 bushels of corn, how would you answer 1) and 2)?
 Buyer should Buy a Futures Contract to secure a buying price

 Buy 1,000,000/5,000=200 Futures Contract
5. On March 1, the price of gold is $1,000 and the December futures price is $1,015. On
November 1, the price of gold is $980 and the December futures price is $981. A gold
producer entered into a December futures contracts on March 1 to hedge the sale of gold on
November 1. It closed out its position on November 1. After taking account of the cost of
hedging, what is the effective price received by the company for the gold?
6. The following table gives data on monthly changes in the spot price and the futures price for
a certain commodity.
∆S +0.50 +0.61 -0.22 -0.35 +0.79 +0.04 +0.15 +0.70 -0.51 -0.41
∆F +0.56 +0.63 -0.12 -0.44 +0.60 -0.06 +0.01 +0.80 -0.56 -0.46
1) Use the data to calculate a minimum variance hedge ratio for a company that knows it
will purchase the commodity in one month.
2) Evaluate how well a hedging strategy based on the minimum variance hedge ratio would
have worked during each month of the ten-month period covered by the data. That is,
2 Satrio, Reiner
compute the value of the hedge for each of the ten months by adding the loss/gain from
both the spot and futures positions.
STDEV Spot 0.4680

STDEV Futures 0.4853
Correlation 0.9806
Hedge Ratio 0.9456
7. The standard deviation of monthly changes in the spot price of live cattle is 1.2 cents per
pound. The standard deviation of monthly changes in the futures price of live cattle is 1.4.
The correlation between the spot and futures price changes is 0.7. It is now October 15. A
beef producer plans to purchase 200,000 pounds of live cattle on November 15 and wants to
use the December futures contract to hedge risk. Each futures contract is for the delivery of
40,000 pounds of cattle. What strategy should he/she follow?
Cattle
STDEV Spot 1.20 Hedge Amount 200,000
STDEV Future 1.40 Contract Size 40,000
Correlation 0.70 Contract 5
Hedge Ratio 0.60 N* 3.00
8. A company wishes to hedge its exposure to a new fuel whose spot price changes have a 0.6
correlation with gasoline futures price changes. The company will lose $1 million for each
one cent increase in the price per gallon of the new fuel over the next three months. The new
fuel's price change has a standard deviation that is 50% greater than price changes in
gasoline
futures prices.
1) If gasoline futures are used to hedge the exposure, what should the hedge ratio be?
STDEV Spot 1.50

STDEV Future 1.00
Correlation 0.60
Hedge Ratio 0.90
2) What is the company's exposure measured in gallons of the new fuel? What position
measured in gallons should the company take in gasoline futures? 0.9 Gallon
3) Suppose each futures contract is on 42,000 gallons of gasoline. How many gasoline
futures contracts should be traded? 21
4) Suppose the spot price of the new fuel is $2.05 per gallon and the futures price of
gasoline is $1.98 per gallon. With an adjustment for the daily settlement of futures, how
many gasoline futures contracts should be traded? 22
3 Satrio, Reiner

FIN555 Homework 5 (Solution)

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FIN 555, Spring 2019 Risk Management and Insurance

a. The May contract

2. Which of the following is true?

End P/L 250,000

4. You are a consultant in risk management.

 Buyer should Buy a Futures Contract to secure a buying price

STDEV Spot 0.4680

STDEV Spot 1.50

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