EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

EF4420 Derivative Analysis and Advanced Investment Strategies

Problem Set 1

This problem set is to be turned in by Friday, February 3rd 11:00 pm. Please present your work using MS
Word or PDF and submit online on Canvas. You may use Excel for calculation but the final solution should
be presented in MS Word or PDF. Data for Question 1 and 2 can be found in the Excel file PS 1 Data.

1. Operation of Margin Accounts

Suppose that we take a short position of one futures contract on crude oil on September 1, 2016. Daily
futures prices until September 15, 2016 are given in the Q1 sheet of the Excel file. The one contract is
for delivery 1,000 barrels of oil. The initial margin is $8,000 and the maintenance margin is $5,000. What
is gain/loss from the settlement for each day? What is the balance in the margin account? Do we receive a
margin call? To answer these, fill the following table.

Date Futures price Daily gain Margin account Margin calls

($ per barrel) balance
Sep. 1 44.94 8,000
Sep. 2
Sep. 6
Sep. 7
Sep. 8
Sep. 9
Sep. 12
Sep. 13
Sep. 14
Sep. 15

1 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

2. Minimum Variance Hedge Ratio

Consider a company that is going to sell 1 million gallons of gasoline in the future. To hedge the price risk,
the company considers using futures contract on heating oil. In the Q2 sheet of the Excel file, you can find
the data for the spot price of gasoline and futures price of heating oil from September 1, 2016 to December
30, 2016. What is the minimum variance hedge ratio? To hedge, how many gallons of heating oil should the
company short in futures contract?

Cov(S,F )
Hint 1. Note that the hedge ratio is given by V ar(F ) , where S and F are changes in price.

Hint 2. Thus, using the data, first calculate the change in price each day, that is, S = St St1 and
F = Ft Ft1 . Next, use these price changes to calculate the covariance and the variance.

3. Cross Hedge
Revisit the company in question 2. On January 2, the company knows that it is going to sell 1 million
gallons of gasoline on January 18. To hedge the risk, the company shorts the futures contract on heating oil
and uses the optimal hedging ratio we obtain in the question 2. The futures price on January 2 is $1.704 per
barrel. Later, on January 18, the spot price of gasoline turns out to be $1.549 per barrel, while the futures
price of heating oil turns out to be $1.640 per barrel. What is the total revenue to the company?

2 Instructor: Yongjin Kim