Solutions Ch 2 2.

26 One orange juice futures contract is on 15,000 pounds of frozen concentrate that in September 2009 a company sells a March 2011 orange juice futures contract 120 cents per pound. In December 2009, the futures price is 140 cents; in December 2010 it is 110 cents and in February 2011 it is closed out at 125 cents. The company has a December year end. What is the companys profit or loss on the contract? F=140 F=110 F=125 P&L = -20*15000 P&L=+30*15000 P&L=-15*15000

Total P&L =-5*15000=75,000 2.27 A company enters into a short futures contract to sell 5000 bushels of wheat for 450 cents per bushel. The initial margin is $3000 and the maintenance margin is $2000. What price change would lead to a margin call? Under what circumstances could $1500 be withdrawn from the margin account? A drop in the margin account of more than $1000 will cause a margin call. The margin account will drop if the price increases (since this is a short position) by more than $1000/5000=$0.20 or 20 cents. 1500 could be withdrawn if the price drops by $1500/5000=$0.30 or 30 cents. 2.28 Suppose that there are no storage costs for crude oil and the interest rate for both borrowing and lending is 5% per annum. How could you make money on January 8, 2007 by trading June 2007 and December 2007 contracts on Crude oil? Settle June 2007 January 8 January 9 60.01-0.1=59.91 60.01 Settle December 2007 62.94-0.28=62.66 62.94

Right now: Long June contract & Short September Contract In June: receive oil, borrow 59.91 at 5%, pay 59.91, store the oil In September: deliver oil and receive 62.66, return loan of 59.91*e^(5%*(6/12))=61.42. 2.25 Explain what is meant by open interest. Why does the open interest usually decline in the month preceding the deliver month? On a particular day, there are 2000 particular futures contracts. Of the 2000 traders on the long side of the market, 1400 closing out position and 600 were entering into new positions. Of the 2000 traders on the short side of the market, 1200 were

closing out their positions and 800 were entering in new positions. What is the impact of the days trading on the open interest? Open interest measures how many open contracts are in the market. Open interest declines when we are very close to expiration as traders close out their positions. Open interest declined by 600. Here is why: Long Volume Closed positions New positions Contracts closed on both sides Contracts changed hands New contracts initiated on both sides 2000 1400 600 1200 200 600 Short 2000 1200 800 1200 200 600 -1200 0 + 600 Total: -1200+600= - 600 Impact on Open Interest

Solutions chapter 3 3.6 Suppose that the standard deviation of quarterly changes in the prices of a commodity is 0.65, the standard deviation of quarterly changes in a futures price on the commodity is 0.81 and the coefficient of correlation between the two changes is 0.8. What is the optimal hedge ratio if the correlation coefficient between the two changes is 0.8. What is the optimal hedge ratio for a three month contract? What does it mean? Hedge ratio = 0.81*0.65/0.8 = 0.642. This means that the size of the futures position should be 64.2% of the size of the companys exposure in a month hedge. Hedge ratio = 1.2 * $ 20,000,000/ $1080*250 = 88.89 In order to hedge the company should short 89 futures contracts. This would reduce beta to zero. If instead the company wanted to reduce the beta to 0.6, it should short (1.2-0.6)*20,000,000/1080*250 = 44 contracts 3.24 It is July 16. A company has a portfolio of stocks worth $100 million. The beta of the portfolio is 1.2. The company would like to use the CME December futures contract on the S&P 500 to change the beta of the portfolio to 0.5 during the period July 15 to November 16. The index futures price is 1000 and each contract is on 250 times the index. a. What position should the company take? b. Suppose that the company changes its mind and decides to increase the beta of the portfolio from 1.2 to 1.5. What position in futures contract should it take?

a) The company should short (1.2-0.5) 100,000,000/1000*250 = 280 futures contracts b) The company should long (1.5-1.2) *100,000,000/1000*250 = 120 futures contracts 3.27 A fund manager has a portfolio worth $50,000,000 with a beta of 0.87. The management is concerned about the performance of the market over the next two months and plans to use three month futures contracts on S&P 500 to hedge the risk. The current level is 1250 and one contract is on 250 times the index, the risk free rate is 6% per annum and the dividend yield on the index is 3% per annum. The current three month futures price is 1259. a. What position should the fund manager take to hedge exposure to the market over the next two months? b. Calculate the effect of your strategy on the fund managers returns if the index in 2 months is 1000, 1100, 1200, 1300, 1400. Assume that the one month futures price is 0.25% higher than the index level at this time. a. N = 0.87*50,000,000/1259*250 = 138.2

The manager should short 138 contracts b. Suppose the index is $1000 in 2 months: Futures price = 1000*1.0025=1002.5 Gain from short position = 138*(1259-1002.5)*250=8,849,250 Loss on index = (1000-1250)/1250=-20% Dividend is 3% per annum, or 0.5% per 2 months Therefore, Total loss on the index = -20%+0.5% = -19.5% Assuming CAPM holds perfectly, then we estimate the returns on our portfolio to be: Rp = Rf+b*(Rm-Rf) = 1%+0.87 (-19.5%-1%) = -16.835% Rf =1% per 2 months, since it is 6% per annum Current position on original portfolio = 50,000,000 * (1-16.835%) = 41,582,500 Current position including the hedge = 41,582,500 +8,849,250 = 50,431,750

Similar treatment for 1100 and 1200

Suppose the index is $1300 in 2 months: Futures price = 1300*1.0025=1303.25 P&L from short position = 138*(1259-1303.25)*250=-1,526,625 (loss) Gain on index = (1300-1250)/1250=4% Dividend is 3% per annum, or 0.5% per 2 months Therefore, Total gain on the index = 4%+0.5% = 4.5% Assuming CAPM holds perfectly, then we estimate the returns on our portfolio to be: Rp = Rf+b*(Rm-Rf) = 1%+0.87 (4.5%-1%) = 4.045% Rf =1% per 2 months, since it is 6% per annum

Current position on original position = 50,000,000 * (1+4.045%) = 52,022,500 Current position including the hedge = 52,022,500 +-1,526,625 = 50,495,875

Similar treatment for 1400

Chapter 5 solutions 5.23 An index is 1200. The three month risk free rate is 3% per annum and the dividend yield over the next three months is 1.2% per annum. The six month risk free rate is 3.5% per annum and the dividend yield over the next six months is 1% per annum. Estimate the futures price of the index for three month and six month contracts. All interest rates and dividend yield are continuously compounded. F= S*e^((r-q) T) F = 1200*e^((3%-1.2%)*(3/12)) = 1205.415 F=1200*e^((3.5%-1%)*(6/12))=1215.094 5.24 The current USD/ euro exchange rate is 1.4 dollar per euro. The six month forward exchange rate is 1.3950. The six month USD interest rate is 1% per annum, continuously compounded. Estimate the six month euro interest rate. F = S*e^(r-rf) 1.3959 = 1.4 *e^((1%-reuro)*(6/12))reuro=1.58% 5.25 The spot price of oil is $80 per barrel and the cost of storing a barrel of oil for one year is $3, payable at the end of the year. The risk free interest rate is 5% per annum continuously compounded. What is an upper bound for the one-year futures price of oil? F=(S+U)*e^((r-cy)*1), U= PV of storage cost, cy = convenience yield U=3*exp(-5%*1)=2.85 F=(80+2.85)*e^((5%-cy)*1) = (82.85*e^(5%))/(e^cy) = 87.101/ (e^cy) Since cy is greater or equal to zero, F<= 87.101 When cy is zero F=87.101, which is the upper boundary.