FINC 425 - Quiz/Test #3 with Accurate
Solutions
Compare and contrast futures markets and forward markets - ANS-a. Both futures
markets and forward markets consist of an agreement to buy or sell an asset at a
current time in the future at a certain price.
b. Forward contracts are traded in over-the-counter markets, whereas futures contracts
are traded on exchanges.
Compare and contrast forward markets and spot markets - ANS-In the spot market,
traders are trading a foreign currency for almost immediate delivery, whereas traders in
the forward market are trading for delivery at a future time.
Compare and contrast futures markets and spot markets - ANS-The spot price is for
immediate/almost immediate delivery, whereas the futures price is the price for delivery
at sometime in the future.
3 characteristics of futures markets - ANS-1. Margin
2. Position limit
3. Price range
Limit move - ANS-a move in either direction equal to the daily price limit
First notice day (FND) - ANS-the first day on which a notice of intention to make delivery
can be submitted to the exchange
Last notice day (LND) - ANS-the last day to notice of intention to make delivery
Last trading day - ANS-generally a few days before the last notice day
How can an investor avoid the risk of having to take delivery? - ANS-an investor with a
long position should close out the contracts prior to the first notice day
Characteristics of short hedge - ANS-a. Sell futures (cash inflow)
b. Lose the spot price (opportunity cost)
c. Close futures position by buying them both (cash outflow)
d. Sell commodity in the spot market
Characteristics of long hedge - ANS-a. Buy futures (cash outflow)
b. Do not have to spend in the spot market (opportunity "inflow")
, c. Close position by selling the futures (cash inflow)
d. Buy commodity in the spot market
Which is more preferred: long hedge or short hedge? - ANS-Short hedge because it is
easier to sell in the spot market
Cross-hedging - ANS-occurs when two assets are different
Quantity risk - ANS-not all risks faced by a business can be hedged via a futures market
Basis - ANS-spot market - futures price
Basis risk - ANS-a. Difference in quality of commodities of spot and futures market
b. Difference in hedging "maturity" and futures market
Factors affecting minimum variance hedge ratio - ANS-Depends on the relationship
between changes in the spot price and changes in the *ADD*
Hedging efficiency - ANS-Answers how much risk is eliminated
How to measure hedging efficiency - ANS-E = (risk of pre-hedge position - risk of post-
hedge position)/ (risk of pre-hedge position)
How to measure risk elimination - ANS-Risk of pre-hedge position - risk of post-hedge
position
Factoring in 'beta' in hedging activity equity portfolio - ANS-a. When the portfolio does
not exactly mirror the index, use the parameter beta from the CAPM to determine the
appropriate number of contracts to short
b. When beta is 2.0, use twice as many contracts to hedge the portfolio
Valuation of stock index futures and their uses - ANS-Stock index futures can be used
to hedge a well-diversified equity portfolio
Tailing a futures contract - ANS-Hedge using the dollar value of the spot and futures
position
Formula for tailing a futures contract - ANS-N = H x (Va/Vf)
Va = value of spot
Vf = value or futures market
Pros of hedging - ANS-a. Avoid unpleasant surprises
b. Reduces risks
Cons of hedging - ANS-a. Can result in a decrease in profits relative to its position with
no hedging
Solutions
Compare and contrast futures markets and forward markets - ANS-a. Both futures
markets and forward markets consist of an agreement to buy or sell an asset at a
current time in the future at a certain price.
b. Forward contracts are traded in over-the-counter markets, whereas futures contracts
are traded on exchanges.
Compare and contrast forward markets and spot markets - ANS-In the spot market,
traders are trading a foreign currency for almost immediate delivery, whereas traders in
the forward market are trading for delivery at a future time.
Compare and contrast futures markets and spot markets - ANS-The spot price is for
immediate/almost immediate delivery, whereas the futures price is the price for delivery
at sometime in the future.
3 characteristics of futures markets - ANS-1. Margin
2. Position limit
3. Price range
Limit move - ANS-a move in either direction equal to the daily price limit
First notice day (FND) - ANS-the first day on which a notice of intention to make delivery
can be submitted to the exchange
Last notice day (LND) - ANS-the last day to notice of intention to make delivery
Last trading day - ANS-generally a few days before the last notice day
How can an investor avoid the risk of having to take delivery? - ANS-an investor with a
long position should close out the contracts prior to the first notice day
Characteristics of short hedge - ANS-a. Sell futures (cash inflow)
b. Lose the spot price (opportunity cost)
c. Close futures position by buying them both (cash outflow)
d. Sell commodity in the spot market
Characteristics of long hedge - ANS-a. Buy futures (cash outflow)
b. Do not have to spend in the spot market (opportunity "inflow")
, c. Close position by selling the futures (cash inflow)
d. Buy commodity in the spot market
Which is more preferred: long hedge or short hedge? - ANS-Short hedge because it is
easier to sell in the spot market
Cross-hedging - ANS-occurs when two assets are different
Quantity risk - ANS-not all risks faced by a business can be hedged via a futures market
Basis - ANS-spot market - futures price
Basis risk - ANS-a. Difference in quality of commodities of spot and futures market
b. Difference in hedging "maturity" and futures market
Factors affecting minimum variance hedge ratio - ANS-Depends on the relationship
between changes in the spot price and changes in the *ADD*
Hedging efficiency - ANS-Answers how much risk is eliminated
How to measure hedging efficiency - ANS-E = (risk of pre-hedge position - risk of post-
hedge position)/ (risk of pre-hedge position)
How to measure risk elimination - ANS-Risk of pre-hedge position - risk of post-hedge
position
Factoring in 'beta' in hedging activity equity portfolio - ANS-a. When the portfolio does
not exactly mirror the index, use the parameter beta from the CAPM to determine the
appropriate number of contracts to short
b. When beta is 2.0, use twice as many contracts to hedge the portfolio
Valuation of stock index futures and their uses - ANS-Stock index futures can be used
to hedge a well-diversified equity portfolio
Tailing a futures contract - ANS-Hedge using the dollar value of the spot and futures
position
Formula for tailing a futures contract - ANS-N = H x (Va/Vf)
Va = value of spot
Vf = value or futures market
Pros of hedging - ANS-a. Avoid unpleasant surprises
b. Reduces risks
Cons of hedging - ANS-a. Can result in a decrease in profits relative to its position with
no hedging
