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# An individual is long 100 oz. of gold. The spot price is \$300/oz.

## The expected monthly price changes in the spot pric

of gold is \$4/oz., and the standard deviation of monthly spot price changes is estimated to be \$15. The futures price
delivery one year hence is \$340/oz. The standard deviation of monthly futures price changes is \$18. The correlation
monthly changes in spot price of gold with monthly changes in the futures price of gold is 0.88. Given these data, Ta
illustrates how a diagram like Figure 7.4 is created, and the risk minimizing number of futures contracts is found.
Figure 7.6 illustrates the relationship between expected price changes and the SD of price changes. As futures cont
are initially sold, risk declines, until about 0.7 futures contract has been sold. Beyond 0.7 futures contract sold, risk i
Thus, the risk-minimizing hedge is found to be h* = 0.7.
DS = a + h DF
Expected
change in SD of CF
S= \$300 F = \$340 h CF changes
E(S) = \$4 E(F) = \$0.667 0 4.000 15
sigmaS = 15 sigmaF = \$18 0.1 3.933 13.4432
Correl = 0.88 0.2 3.867 11.9549 18
0.3 3.800 10.5641
MVHR = 0.733 0.4 3.733 9.3145
0.5 3.667 8.2704 16
\$0 0.6 3.600 7.5180
0.7 3.533 7.1498
ESP = 0.00 0.71 3.527 7.1370 14
0.72 3.520 7.1286
0.733 3.511 7.1246
12
0.8 3.467 7.2250
0.9 3.400 7.7305
1.0 3.333 8.5907 10
1.1 3.267 9.7118
1.2 3.200 11.0145
1.3 3.133 12.4419 8
1.4 3.067 13.9556
1.5 3.000 15.5306
6
3.000 3.200 3.4
ce changes in the spot price
o be \$15. The futures price for
nges is \$18. The correlation of
0.88. Given these data, Table 7.1
ures contracts is found.
ce changes. As futures contracts
futures contract sold, risk increases.

## contracts M2M Interst

Chart Title 2000
18 2000 #VALUE! #VALUE!
2000 0 -
2000 0 -
16
0

14

12

10

6
3.000 3.200 3.400 3.600 3.800 4.000 4.200
A jewelry manufacturer who has 200,000 ounces of gold in inventory fears that the prices will fall over next 60 days.
The current spot price of gold is \$350/oz. and the futures price for a contract that expires 60 days hence is \$359/oz.
The hedger know that the basis of -9 will work in his favor since he is a short hedger. The spot interest rate is 12% p
Naively, the manufacturer proceeds to sell 2000 futures to hedge his inventory. This is an untailed hedge.

If she went wrong and price instead rise over next 60 days, the manufacturer will experience M2M cash outflows.
Assume that initial margin is satisfied by using a bank LC and the M2M cash outflows will be financed by bank loan.
suppose the following were the spot and futures prices on various days:

## Days left in Futures Additional Interest on borrowing No. of contracts =

Day the hedge Price margin reqd until hedge termination Short loan rate =
0 60 \$359
3 57 \$365 1200000 \$22,487.67 Gain in spot mkt =
18 42 \$370.20 1040000 \$14,360.55 Loss in futures mkt =
51 9 \$377 1360000 \$4,024.11 unhedged profit
60 0 \$372 -1000000 Less: interest expense
\$2,600,000 \$40,872.33

ESP = 358.80

By applying a tail to the original hedge ratio of 2000 contracts, the hedger can almost completely neutralize the effle
daily resettlement. Assume that interest rates is constant. A tail is created by reducing the number of contracts
sold from 2000 to the present value of 2000.
On the initiation day of the hedge, the PV of 2000 = 2000 / (1+12%*60/365) = 1,961.31
On every subsequent day, additional (fractions of) futures contracts should be sold, so that the hedge is always sho
PV of 2000 futures contracts.
One day after the hedge is initiated, the hedger should be short a total of 2000/(1+12%*59/365) viz. 1961.9 contrac

Size of the tail = 2000 - no. of contracts actually sold on any day

Days left in Futures contracts sold margin Interest on borrowing
Day the hedge Price required until hedge termination
0 60 \$359 1961.31
3 57 \$365 1963.21 1,177,926 22,074.01
18 42 \$370.20 1972.76 1,025,835 14,164.96
51 9 \$377 1994.10 1,355,988 4,012.24
60 0 \$372 2000.00 (1,000,000) -
\$2,559,749 \$40,251.20
ces will fall over next 60 days.
res 60 days hence is \$359/oz.
The spot interest rate is 12% p.a.
an untailed hedge.

## erience M2M cash outflows.

will be financed by bank loan.

## No. of contracts = 2,000

Short loan rate = 12% contracts M2M Interst
1961
Gain in spot mkt = \$4,400,000 1963 1176600 22,049.16
Loss in futures mkt = (\$2,600,000) 1973 1020760 14,094.88
unhedged profit \$1,800,000 1994 1341640 3,969.78
Less: interest expense \$40,872
\$1,759,128 \$3,970

## completely neutralize the efflect of

ng the number of contracts initially

contracts
o that the hedge is always short the

## No. of contracts = 2,000

Short loan rate = 12%