Cours 3

Question 1

What is a perfect hedge?

Answer 1

It is a hedge that completely eliminates the risk.

Question 2

What are the problems that give rise to the basis risk?

Answer 2

1) The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract.
2) The hedger may not be certain of the exact date the asset will be bought or sold.
3) The hedge may require the futures contract to be closed out before its delivery month.

Question 3

What is a strengthening of the basis?

Answer 3

It is when there is an increase in the basis.

Question 4

What are the 2 components of choosing the future contract to be used for hedging?

Answer 4

1) The choice of the asset underlying the futures contract.
2) The choice of the delivery month.

Question 5

What is the hedge ratio?

Answer 5

It is the ratio of the size of the position taken in futures contracts to the size of the exposures.

Question 5

What are the arguments against hedging?

Answer 5

• Can decrease profits relative to an unhedged situation.
• If you are the only firm to hedge in an industry, it is possible that this could lead to an unfavorable situation with respect to unhedged competitors.
• Hedging risk with futures contracts can lead to liquidity problems.

Question 5

In what circumstances can the basis risk increase?

Answer 5

When the time difference between the hedge expiration and the delivery month increases.

Question 5

What is the hedge’s effectiveness?

Answer 5

It is defined as the proportion of the variance eliminated by hedging.

Question 5

What is the effect of cross hedging on the basis risk?

Answer 5

It increases basis risk.

Question 5

What are the arguments in favor of hedging?

Answer 5

• Manufacturing, retail, or service companies do not have the expertise to predict movements in interest rates, exchange rates, or commodity prices.
• It is normal for these companies to focus on their core business and avoid the uncertainties associated with changes in interest rates, exchange rates, or commodity prices.
• Hedging activities will then allow more stable and less risky profits.

Question 5

What would be 3 arguments for a treasurer not to hedge a competition?

Answer 5

1) If the company’s competitors are not hedging, the treasurer might feel that the company will experience less risk if it does not hedge.
2) The shareholders might not want the company to hedge.
3) If there is a loss on the hedge and a gain from the company’s exposure to the underlying asset, the treasurer might feel that he will have difficulty justifying the hedging to other executives within the organization.

Question 6

What is the process of tailing the hedge?

Answer 6

Tailing the hedging procedure is the procedure that takes into account the impact of marking to market for the optimal number of contracts.