Nicole Seaman

Director of FRM Operations
Staff member
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Learning objectives: Define and differentiate between short and long hedges and identify their appropriate uses. Describe the arguments for and against hedging and the potential impact of hedging on firm profitability. Define and calculate the basis, discuss various sources of basis risk, and explain how basis risks arise when hedging with futures. Define cross hedging and compute and interpret hedge ratio and hedge effectiveness.

Questions:

21.13.1. There exist three categories of derivatives traders: hedgers, speculators, and arbitrageurs. Non-financial firms use futures contracts to either hedge or speculate. In regard to hedging with futures contracts, which of the following statements is TRUE?

a. The purpose of a corporate hedge is to increase corporate profits
b. Shareholders prefer their company hedge all of its material financial risks
c. If the outcome with hedging is worse than the outcome without hedging, then the hedge was poorly designed
d. Basis risk exists because, when the hedge is closed, there is uncertainty about the difference between the spot and futures price


21.13.2. Rootridge Industries is a U..S Company that plans to purchase 1.0 million Euros in two years. Today it hedges this future purchase with Euro FX futures contacts; this size of each Euro FX contract is 125,000 Euros. The current spot price is EURUSD $1.150.

Consider the following scenario approximately two years into the future: Prior to their delivery, the futures contracts are closed out at a price of EURUSD $1.300, and the Euros are simultaneously purchased in the spot market when the basis is positive two cents; i.e., +$0.02. Under this scenario, what will be the net cost (including the hedge) in U.S. dollars to acquire the 1.0 million Euros?

a. $854,700 USD
b. $1.0 million USD
c. $1.170 million USD
d. $1.320 million USD


21.13.3. The daily standard deviation of Bitcoin (BTC) is $200.00 while the standard deviation of the futures contract price (on the same BTC) is $340.00. The correlation between the two changes is 0.850. If the size of one futures contract is five Bitcoins (5 BTC), and the trader seeks to hedge the purchase of 100 Bitcoins (100 BTC), then how many contracts should be shorted to hedge?

a. One (1)
b. Three (3)
c. Ten (10)
d. Twenty five (25)

Answers here:
 
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