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What is the total profit? How is it taxed if the company is a a hedger and b a speculator? Assume that the company has a December 31 year end.
A cattle farmer expects to have , pounds of live cattle to sell in three months. The livecattle futures contract traded by the CME Group is for the delivery of 40, pounds of cattle. How can the farmer use the contract for hedging? The farmer can short 3 contracts that have 3 months to maturity. If the price of cattle falls, the gain on the futures contract will offset the loss on the sale of the cattle.
If the price of cattle rises, the gain on the sale of the cattle will be offset by the loss on the futures contract. Using futures contracts to hedge has the advantage that the farmer can greatly reduce the uncertainty about the price that will be received.
Its disadvantage is that the farmer no longer gains from favorable movements in cattle prices. It is July A mining company has just discovered a small deposit of gold. It will take six months to construct the mine. The gold will then be extracted on a more or less continuous basis for one year. Futures contracts on gold are available with delivery months every two months from August to December Each contract is for the delivery of ounces.
Discuss how the mining company might use futures markets for hedging. The mining company can estimate its production on a month by month basis. It can then short futures contracts to lock in the price received for the gold. For example, if a total of 3, ounces are expected to be produced in September and October , the price received for this production can be hedged by shorting 30 October contracts. Explain how CCPs work. What are the advantages to the financial system of requiring CCPs to be used for all standard derivatives transactions between financial instituitions.?
A CCP stands between the two parties in an OTC derivative transaction in much the same way that a clearing house does for exchange-traded contracts. It absorbs the credit risk but requires initial and variation margin from each side.
In addition, CCP members are required to contribute to a default fund. The advantage to the financial system is that there is a lot more collateral i. The disadvantage is that CCPs are replacing banks as the too-big-to-fail entities in the financial system.
There clearly needs to be careful oversight of the management of CCPs. Further Questions Problem 2. Trader A enters into futures contracts to buy 1 million euros for 1. Trader B enters in a forward contract to do the same thing. The exchange rate dollars per euro declines sharply during the first two months and then increases for the third month to close at 1.
Ignoring daily settlement, what is the total profit of each trader? When the impact of daily settlement is taken into account, which trader does better? The total profit of each trader in dollars is 0.
Substantial losses are made during the first two months and profits are made during the final month. It is likely that Trader B has done better because Trader A had to finance its losses during the first two months.
Explain what is meant by open interest. Why does the open interest usually decline during the month preceding the delivery month? On a particular day, there were 2, trades in a particular futures contract. This means that there were buyers going long and sellers going short.
Of the 2, buyers, 1, were closing out positions and were entering into new positions. Of the 2, sellers, 1, were closing out positions and were entering into new positions.
Open interest is the number of contract outstanding. Many traders close out their positions just before the delivery month is reached. This is why the open interest declines during the month preceding the delivery month. The open interest went down by We can see this in two ways. First, 1, shorts closed out and there were new shorts. Second, 1, longs closed out and there were new longs. One orange juice future contract is on 15, pounds of frozen concentrate. Suppose that in September a company sells a March orange juice futures contract for cents per pound.
At the end of December the futures price is cents; at the end of December the futures price is cents; and in February it is closed out at cents. The company has a December 31 year end. How is it realized? What is the accounting and tax treatment of the transaction if the company is classified as a a hedger and b a speculator?
The price goes up during the time the company holds the contract from to cents per pound. If the company is classified as a hedger this loss is realized in , If it is classified as a speculator it realizes a.
A company enters into a short futures contract to sell 5, bushels of wheat for cents per bushel. This will happen if the price of wheat futures rises by 20 cents from cents to cents per bushel. You could go long one June oil contract and short one December contract. The strategy therefore leads to a profit.
Note that this profit is independent of the actual price of oil in June and December. It will be slightly affected by the daily settlement procedures. What position is equivalent to a long forward contract to buy an asset at K on a certain date and a put option to sell it for K on that date? The combined payoff is therefore max ST — K, 0. This is the payoff from a call option. The equivalent position is therefore a call option.
How much margin or collateral does the company have to provide in each of the following two situations? The banks do not have to post collateral. If the transactions are cleared bilaterally, the company has to provide collateral to Banks A, B, and C of in millions of dollars 0, 15, and 25, respectively.
What credit exposure does the bank have? The counterparty may stop posting collateral and some time will then elapse before the bank is able to close out the transactions.
You are required to download the data for crude oil and answer the following: a Assuming that daily price changes are normally distributed with zero mean, estimate the standard deviation of daily price changes. Calculate the standard deviation of two-day changes from the standard deviation of one-day changes assuming that changes are independent. It chooses two days because it considers that it can take two days to close out a defaulting member.
How high does the margin have to be when the normal distribution assumption is made? Each contract is on 1, barrels of oil. What do your results suggest about the appropriateness of the normal distribution assumption?
How frequently would the balance in the account of a client with a long position be negative immediately before a margin payment is due so that the client has an incentive to default? Assume that balances in excess of the initial margin are withdrawn by the client. This suggests that price changes have heavier tails than the normal distribution.
In July , a small chocolate factory receives a large order for chocolate bars to be delivered in November. It will need 10 metric tons of Cocoa in September to fill this order.
For each alternative, what is: a the upfront cost? Ten trading days later, the futures price of the index drops to 1, triggering a margin call for the trader. What is the change margin account balance indicate gain or loss for: a the trader and b the hedge fund? What is the margin call for the trader? A speculator sells a July wheat futures contract at cents per bushel. Each futures contract is for 5, bushels. The futures price drops to on December 31, and rises to in May when she closes the contract.
What is the gain or loss for accounting purposes in ? In December , a company expects to buy , MMBtu of natural gas before the end of March , but does not know exactly when. To hedge against volatile gas prices, it implements a rolling forward hedge by taking a long position on 10 twomonth natural gas futures only held for 1 month.
The commodity is purchased in March Assume a hedge ratio of 0. A trader owns 55, troy oz of silver and decides to hedge with 6-month silver futures contracts. Each futures contract is on 5, troy oz. The standard deviation of the change in the spot price of silver is 0. The standard deviation of the change in silver futures prices is 0.
The coefficient of correlation between the two is 0. What is the minimum variance hedge ratio? What is the optimal number of futures contracts without tailing the hedge? What is the optimal number of futures contracts with tailing the hedge? Semi-annually b. Quarterly c. Monthly d. Weekly e. Daily 9. Given the zero rates and cash flows for a bond see table below : a.
What is the theoretical price? What is the bond yield? A stock provides a dividend yield of 5. What is the two-year forward price for a stock? What is the continuously compounded cost of carry for the stock? A US investor sees an arbitrage opportunity in the currency markets. Assume the continuously compounded interest rates in the US and Switzerland are 0.
The 3-month currency forward price is 1. What is the theoretically correct forward price? Consider a currency swap with 3 years remaining. A financial institution receives 3. The British rate is 2. By valuing the currency swap as fixed-rate bonds, what is: a. An investor buys 5 call option contracts, each on shares with a strike of There is a 6-for-5 stock split. Give the following: a. The new strike price 50 b. The new number of shares underlying the 5 contracts What is the implied risk-free interest rate?
Note: Total payoff does not include initial investment a. What is the initial investment? What is the total payoff when the stock price in 9 months is ?
A 1-year option is offered on a non-dividend-paying stock. When the Black-ScholesMerton model is used a. What is the value of d1? What is the value of d2? What is the price of a call option, c? What is the price of a put option, p? What is the present value of the dividends? Discuss the pros and cons of executive stock options versus paying executives directly with stock.
However, this overlooks the asymmetric payoffs of options. If the company does badly then the shareholders lose money, but all that happens to the executives is that they fail to make a gain. Unlike the shareholders, they do not experience a loss. Many people think that a better type of pay for performance is a restricted stock unit. The gains and losses of the executives then mirror those of other shareholders. It is sometimes argued that the asymmetric payoffs of options can lead top senior executives taking risks they would not otherwise take.
A two-step binomial tree is used to value an option on the Australian dollar. The strike price is 1. Each step is 3 months. The current price of one AUD is 1. The US risk free rate is 2. What is the proportional up movement, u, for the currency? What is the probability of an up movement, p? You bet! Just post a question you need help with, and one of our experts will provide a custom solution. You can also find solutions immediately by searching the millions of fully answered study questions in our archive.
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