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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:
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
Additional
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.
contracts
o that the hedge is always short the