Deck 13: Futures Hedging

Question 1

Kellogg will buy 2 million bushels of oats in two months.Kellogg finds that the ratio of the standard deviation of the change in spot and futures prices over a two-month period for oats is 0.86 and the coefficient of correlation between the two-month change in the price of oats and the two-month change in its futures price is 0.75.How many contracts do they need to hedge their position,if the size of each oats contract is 5,000 bushels,and oat trades in the CME Group?

A) 230
B) 258
C) 260
D) 279
E) None of these answers are correct.

Answer 1

B

Question 2

Which of the following statements related to a corporation hedging in the real world is INCORRECT?

A) Corporations should not hedge because a shareholder can always replicate such policies themselves trading related securities.
B) In case a decision is made to hedge,corporations can do it at lower transaction costs than shareholders can.
C) A company hedge is often better than a shareholder's hedge because companies can dedicate competent personnel to hedging.
D) A company can hedge by issuing a whole range of securities that individuals cannot create on their own.
E) A company can hedge for strategic reasons that may lie beyond an ordinary shareholder's knowledge.

Answer 2

A

Question 3

Suppose that the variance of quarterly changes in the spot prices of a commodity is 0.49,the standard deviation of quarterly changes in a futures price on the commodity is 0.64,and the coefficient of correlation between the two changes is 0.8.The optimal hedge ratio for the contract is:

A) 0.771
B) 0.363
C) 0.700
D) 0.875
E) None of these answers are correct.

Answer 3

D

Question 4

Which of the following statements related to the benefits of corporate hedging using forward and futures contracts is INCORRECT?

A) Hedging can enable the locking-in of stable prices and facilitate the planning of production and marketing activities with greater certainty.
B) Hedging can permit forward pricing of products.
C) Hedging can facilitate the raising of capital.
D) Hedging can reduce the risk of default and financial distress.
E) Hedging can enable a firm to develop a diverse product line.

Question 5

Hedging with forwards and futures contracts is different due to the nature of the two contracts.Which of the following statements is incorrect in terms of a comparison of the two derivatives?

A) Forward contracts are better at reducing legal risk.
B) Futures contracts are better at reducing transaction costs.
C) Futures contracts are better at reducing credit risk.
D) Futures contracts are more standardized.
E) Futures contracts are better at reducing liquidity risk.

Question 6

Goldmines Inc.(fictitious name)makes a pretax profit of $150 million when gold prices increase (which happens with probability 0.5)but zero otherwise.Alternatively,the company can hedge with gold futures and have a known profit of $70 million.
Assuming a tax rate of 30 percent,the expected after-tax profit for an unhedged firm and the after-tax profit for a hedged firm,respectively,are:

A) $52.5 million for the unhedged firm and $49 million for the hedged firm
B) $50 million for the unhedged firm and $49 million for the hedged firm
C) $50 million for the unhedged firm and $52.1 million for the hedged firm
D) $52.5 million for the unhedged firm and $52.1 million for the hedged firm
E) None of these answers are correct.

Question 7

Which of the following statements related to the hedging of fuel price risk by airlines is INCORRECT?

A) Fuel is a major cost of the airline business and it can range from 10 percent (in good times)to more than 35 percent (in bad times)of average expenses.
B) All airlines hedge price risk of between 75 to 100 percent of their fuel purchase.
C) The amount of fuel needs hedged by the airlines has ranged from zero to over 75 percent.
D) What Southwest Airlines characterizes as their successful derivatives hedging program was some combination of hedging and speculation that worked well for a time.
E) An airline's decision to charge for checked-in baggage is a natural hedge,because loss of revenue from losing customers is offset by money received from the fees and making airplanes lighter (which are cheaper to fly).

Question 8

The variance of monthly changes in the spot price of live cattle is (in cents per pound)is 1.7.The variance of monthly changes in the futures price of live cattle for the April contract is 1.5.The correlation between these two price changes is 0.75.Today is March 11.The beef producer is committed to purchasing 400,000 pounds of live cattle on April 15.The producer wants to use the April cattle futures contract to hedge its risk.How many contracts should the producer buy,if the contract size is 40,000 pounds?

A) 5
B) 7
C) 8
D) 11
E) None of these answers are correct.

Question 9

Suppose that the variance of quarterly changes in the spot prices of a commodity is 0.49,the variance of quarterly changes in a futures price on the commodity is 0.81,and the coefficient of correlation between the two changes is 0.6.The optimal hedge ratio for the contract is:

A) 0.10
B) 0.4667
C) 0.5444
D) 0.9
E) None of these answers are correct.

Question 10

An airlines company is unlikely to use the following derivative for risk management:

A) a commodity swap
B) a credit default swap
C) an interest rate swap
D) an oil futures contract
E) an option on oil futures contract

Question 11

The difference between the futures and the spot price is known as:

A) the basis
B) the depth
C) liquidity
D) the strike
E) the spread

Question 12

Goldmines Inc.(fictitious name)makes a pretax profit of $150 million when gold prices increase (which happens with probability 0.5)but zero otherwise.Alternatively,the company can hedge with gold futures and have a known profit of $70 million.
Suppose that Goldmines has accumulated losses totaling $30 million.It can deduct this loss from this year's profit and thus lower its tax burden.If unutilized,this opportunity disappears.Assuming a tax rate of 30 percent,the expected after-tax profit for an unhedged firm and the after-tax profit for a hedged firm,respectively,are:

A) $50 million for the unhedged firm and $49 million for the hedged firm
B) $55 million for the unhedged firm and $54 million for the hedged firm
C) $57 million for the unhedged firm and $59 million for the hedged firm
D) $57 million for the unhedged firm and $58 million for the hedged firm
E) None of these answers are correct.

Question 13

Let the spot price of gold today be $1,500 per ounce.Jewelry maker Jewelrygold Inc.sets up a buying hedge by going long gold futures.The basis is -$50 today and -$5 on the day the company lifts the hedge by buying gold in the spot market and selling the futures.The company's effective buying price for gold is:

A) $1,505
B) $1,545
C) $1,550
D) $1,555
E) None of these answers are correct.