BFF3751 Derivatives 1

Tutorial 2 Answers

Question 1

a) In deciding whether a long or short forward contract is the appropriate hedge, follow
the approach presented in the lecture and it’s hard to get it wrong:

• What is the risk we face? Spot wool price is $14 per kilogram. In three months’
time, we will purchase wool. Our danger is that wool price will rise before we make
our purchase.
• What derivative position will make money if this unfavourable scenario eventuates?
Recall the payoff diagram to long positions. When prices rises, you make money
with a long position.

Hence, we will enter a long forward contract for the delivery of 500 kilograms of wool
in three months’ time at the quoted delivery price of $14.50 per kg.

b) With many commodities, physical delivery is possible. That is, a long forward contract
on wool is a commitment to buy 500 kilograms of wool at the $14.50 delivery price. In
most cases, however, derivative traders close-out just prior to maturity (this is mainly
for convenience). As the maturity time approaches, the forward contract has served its
hedging purpose. The contract can be closed out, then the wool is purchased on the spot
market.

(time 0) Enter long forward contract to purchase 500 kgs of wool $7,250
(3 mths) Close-out by shorting forward contract for 500 kgs of wool $6,000
Loss on forward contract $1,250

Purchase 500 kgs of wool on spot market $6,000

Total cost of 500 kgs of wool (6,000+1,250) $7,250

Aside: the question doesn’t explicitly state that the forward price when we close out is
$12 per kilogram. The calculation above assumes that, when we close out the long
forward by entering a short forward, the forward price (F) is $12. The reason we can
safely assume this is that, as the forward contract approaches expiry, F converges to the
spot price of the underlying wool. Tutorial 1 Question 6 demonstrated why this must
be the case (to prevent arbitrage opportunities).

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c) Your partner is correct … had we not locked-in a $14.50 price for wool via the forward
contract, we could indeed have purchased 500 kgs of wool in the spot market for $6,000
(500 kgs × $12). But we had no way of knowing that wool price would fall. If we had
remained unhedged, and wool price had in fact risen, the wool would have cost us a lot
more than $7,250.

Your business partner needs to understand that hedging is not about guessing which
way price is going to move. Hedging is about removing the risk of an unfavourable
price movement by ‘locking in’ the price at which we can buy wool at in three months’
time. In fact, had we not hedged using the long forward contract – if we had done
nothing – this is effectively amounts gambling that prices won’t rise. And this is a risk
many businesses are not prepared to take.

d)

(time 0) Enter long forward contract to purchase 500 kgs of wool $7,250
(3 mths) Close-out by shorting forward contract for 500 kgs of wool $8,000
Gain on forward contract $ 750

Purchase 500 kgs of wool on spot market $8,000

Total cost of 500 kgs of wool (8000 – 750) $7,250

What we see is that we were effectively hedged. Irrespective of whether the price of wool falls
(as it did in part b) or rises (as it did in part d), we know with complete certainty that we will
end up paying $7,250 to purchase the required 500 kgs of wool (effectively $14.50 per
kilogram).

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Question 2

a) On 1 September, the spot price of gold is USD 926 per ounce. The risk to the business is
that the price at which we will sell the gold late November will be lower than this. This will
have a negative impact on company profit. To summarise, we are exposed to falling gold
prices.

b) To eliminate the risk of a decrease in gold price, we need to enter a futures position that
makes money if gold price falls. It is important to know the payoff diagrams to long and
short positions! A short futures position makes money when the price of the underlying
asset falls. Hence, we enter a short futures contract covering 100,000 ounces of gold
with delivery in November.

Another way to think about this is as follows. We can establish the correct hedge position
(either long or short) by doing today in the futures market what we will be doing in the
physical market in November. In November, we will be physically selling 100,000 ounces
of gold, so we enter a short futures position today (since a short futures position is a
commitment to sell the underlying gold). No matter which way you look at it, entering a
short gold futures position is the correct hedge.

c) You have a short position covering 100,000 ounces of gold at a contracted futures price of
$935 per ounce. In other words, we are able to physically deliver 100,000 ounces of gold
and will receive USD 93.5m (100,000 ounces × USD 935). The contract specifications are
likely to be very strict with respect to the quality of the gold delivered, the time and place
for delivery. At expiry in late November:

• Our short futures position means that we have an obligation to deliver (i.e., sell)
100,000 ounces of gold.
• Therefore, we physically deliver 100,000 ounces of gold to the person on the other
side of the contract, and.
• In exchange for this delivery, we receive 100,000 ounces × $935 = USD 93.5m.

d) To close-out the short position, we enter a futures position equal in magnitude and
opposite in direction to the initial futures position. That is, since we initially entered a
short futures position covering the delivery of 100,000 ounces of gold on 30 November, we
close out by entering a long futures contract for the delivery of 100,000 ounces of gold on
30 November. The futures exchange effectively says: “he has an obligation to sell 100,000
of gold on 30 November, and he also has an obligation to buy 100,000 ounces of gold on
30 November, so these two positions cancel each other out”.

As the clock ticks down to the expiry of this futures contract on 30 November, the futures
price will be exactly (or very close to) the spot price of gold at the end of November ($920)
– otherwise an arbitrage opportunity exists (see Tutorial 1 Question 6).

Since we went short at $935 per ounce and closed-out by going long at $920 per ounce, we
have a futures trading profit of $15 per ounce. On 100,000 ounces, this is a total profit of

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 $1,500,000. Closing out the initial short futures position is as simple as getting on the
computer and hitting “sell to close” on the Nov-expiry gold futures contract.

That closes-out the futures position, but we still have a truckload of gold to sell (remember,
we mine gold, so still have to sell our gold to someone). We physically sell our 100,000
ounces of gold at the end-of-November spot price of $920 per ounce and realise $92m. Add
the $1,500,000 profit from the futures hedge and the net monies received are $93.5m. Note
that this is exactly the same outcome that would be achieved if the gold was physically
delivered under the futures contract.

e) Sometimes, futures contracts are cash settled. This happens when physical delivery of the
underlying asset is not possible. When contracts are cash settled, if we have not closed out
our initial short position by the time the November contract expires, then the futures
exchange will close it out automatically for us. Effectively, the futures exchange calculates
whether we made a profit or loss. If we made a profit, they amount is transferred to our
account. If we made a loss, they take it from our account. No physical asset is exchanged.
The ASX SPI200 futures contract are an example of contracts that are cash settled.

In our case, we went short when the price was $935. At expiry, the price is $920. Short
positions make money when prices fall, so we receive the difference of $15 per ounce. On
100,000 ounces, this is a profit of $1,500,000.

As in part d), we still have to sell the truckload of gold at the spot price of $920, raising
$92m. Overall, our total cashflow remains $93.5m.

To summarise:

The purpose of this question is to illustrate the fact that it doesn’t matter whether a
futures/forward contract is closed out or physically delivered or cash settled at expiry.
The net effect on cash is identical (or very close to it). In most of the tutorial questions in
this unit, my calculations assume the futures position is closed-out rather than physically
delivered. In fact, the majority of futures contracts in practice are closed-out rather than
physically delivered.

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Question 3 (*)
nb: These answers will round all exchange rates to 4 decimal places (recommended). Students
might get slightly different answers if they use more dps or fewer dps.

Before we get started: questions involving exchange rates often confuse students. This is
because exchanges rates can be expressed in two ways (direct or indirect quotes). The fool-
proof way to avoid confusion is as follows.

In this question, we have to pay an invoice in Euros. So just treat the Euro as you would any
other asset (e.g., gold, wool, share price, etc). If the question involved gold, you would ask
“what is the price of gold?” If the question involved wool, you would ask “what is the price of
wool?” This question involves Euros, so we need to focus on “what is the price of Euros?”
Hence, using direct quotes is the way to go.

a) At the spot (current) exchange rate of 0.6000, the ‘price’ of one EUR is AUD 1.6667
(1 ÷ 0.6000). Buying EUR 10,000 would cost AUD 16,667.

b) We have to buy Euros one year from now (because the invoice for our purchase is in
Euros). Currently, one Euro costs AUD 1.6667. The risk is that the price of EUR rises.
If this happens, our purchase will cost more one year from now. The price of EUR rises
when it strengthens relative to the AUD.

c) In one year's time, the spot rate is 0.6500. Therefore, the ‘price’ of one EUR is AUD
1.5385 (1 ÷ 0.6500). Thus, the Euro has weakened relative to the AUD. It used to be
worth AUD 1.6667, but now it’s only worth AUD 1.5385. The cost of buying EUR
10,000 is AUD 15,385.

We got lucky here. We were unhedged and therefore left ourselves exposed to a
strengthening Euro. However, the Euro weakened relative to the AUD so we were able
to purchase the EUR 10,000 a little cheaper.

d) In one year's time, the spot rate is 0.5700. The ‘price’ of one EUR is AUD 1.7544 (1
÷0.5700). The EUR has strengthened. It used to be worth AUD 1.6667, but now it’s
worth AUD 1.7544. The cost of buying EUR 10,000 is AUD 17,544.

In this case, we will regret not having hedged our exposure. We feared that the Euro
would strengthen and this it exactly what happened. Therefore, purchasing the
rewquired EUR 10,000 has become more expensive.

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e) The decision to take a long or short derivatives position can be addressed as follows:

• What is the risk we face? Part (d) established that, if the Euro strengthens relative
to the AUD, our purchase will cost more. Hence, our fear is that the price of the
Euro will rise.

• What derivative position will make money if this unfavourable scenario eventuates?
Recalling the payoff diagrams for long and short positions, we know that long
positions make money when prices rise.

Hence, we hedge our exposure by entering a long forward contract to purchase EUR
10,000 one year from now. This locks-in a price of AUD 1.6584 for our purchase (1 ÷
0.6030).

f) These calculations assume that we close-out the forward position, calculate whether we
made a profit or loss, then buy the required EUR 10,000 on the spot market.
Realistically, a forward contract on a currency would be physically delivered.
Nonetheless, as we learned in Question 2, it makes no difference to the bottomline
whether we close out of physically deliver.

Think about this before you do the calcs. The Euro has actually weakened in this case.
We took a long forward contract to profit when the Euro strengthened. Given that the
Euro has weakened, our calcs must show a loss on closing out the forward position.

(in July) Enter long forward contract to buy Euros 10,000 × 1.6584 16,584
(one year later)Close-out with short forward contract 10,000 × 1.5385 15,385
Loss 1,199

(one year later)Buy EUR 10,000 at spot rate 10,000 × 1.5385 15,385

Net Cost (15,385 + 1,199) 16,584

g) In this case, the EUR has strengthened, which was the thing that we feared and
prompted us to enter a hedge. So our calcs must surely show a profit on closing out the
forward position.

(in July) Enter long forward contract to buy Euros 10,000 × 1.6584 16,584
(one year later)Close-out with short forward contract 10,000 × 1.7544 17,544
Gain 960

(one year later)Buy EUR 10,000 at spot rate 10,000 × 1.7544 17,544

Net Cost (17,544 – 960) 16,584

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Parts (f) and (g) illustrate that we had a perfect hedge. No matter which direction the EUR/AUD
exchange rate moves, we have locked-in a total cost of AUD 16,584 for the purchase.

Aside: you may notice that this question is just a counter exam from the lecture example. In
the lecture example, we had made a sale and would receive GBP 10m. We were exposed to the
GBP weakening so we hedged by entering a short forward covering GBP. In this question, we
will be paying Euros. This exposed us to loss if the Euro strengthened. Hence we hedged by
entering a long forward covering Euros.

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Question 4 (*)

a) By convention, the SPI200 futures contracts have a standard contract size of $A25 times
the quoted index number. Since the November-maturity SPI200 contract is quoted at
4530, the notional value of one contract is $113,250.

This does not mean that longing one of these SPI200 futures contracts costs $113,250.
Nor does it mean shorting one of these contracts raises $113,250. No money changes
hands upfront. It merely means that we have a commitment to trade an asset for a
locked-in price of $113,250.

b) Our portfolio is currently worth $5m. We will use the Nov-maturity SPI200 futures to
effectively lock-in a portfolio value of $5m. The number of SPI200 contracts to use
also depends on the beta of your portfolio:

 Value to be Hedged   5,000,000 

No. of Contracts β 
= =  0.70
=   31 contracts
 Value of one SPI200   4530 × $25 

Note: the number of contracts is rounded to the nearest whole number; you can't trade
a fraction of a contract! This means our hedge will be slightly less than perfect.

c) Calculating the gain/loss on the futures position is always trivial. Our initial position
was to enter 31 long SPI200 contracts when the quoted futures price was 4530. We then
close out by entering 31 short SPI200 contracts at 3600. The loss on SPI200 futures is:

(1 June) Enter long SPI200 futures 31 × $A25 × 4530 3,510,750

(30 Nov) Close-out with short SPI200 futures 31 × $A25 × 3600 2,790,000
Loss 720,750

To calculate what our stock portfolio is worth after the sharp market decline, we will
use the CAPM. If the dividend yield on the market portfolio is 5% p.a., then over a 6
month period (June-November), the market would have generated about 2.5% dividend
yield. Similarly, if the riskless interest rate is 3% p.a., this is roughly 1.5% over a 6-
month period.

If the market index fell from 4500 to 3600, this is a 20% fall (3600/4500 – 1). However,
the market portfolio generated a 2.5% dividend yield, so the overall return on the market
portfolio is -17.5%.

Plug these inputs into the CAPM:

Rf + β p ( Rm − Rf
Rp = )
= 0.015 + 0.70 ( −0.175 − 0.015 )
= −11.8%

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 This makes sense. The market fell by -17.5% overall. Since our portfolio is a little less
risky than the market, our portfolio will fall by less than -17.5%. From our starting
portfolio value of $5m, an 11.8% drop is equivalent to $590,000. Hence, after the sharp
market decline, our portfolio will only be worth $4,410,000.

Combining the two calcs above, our net worth in November is $3,689,250 ($4,410,000
- $720,750).

Hopefully, alarm bells are ringing LOUDLY for you here:

• It is very odd that we established a hedge to protect against a market drop, yet
when we calculated the gain/loss on the futures position, we lost $720,750 when
the market dropped.
• It is also odd that, despite hedging against price movements, our $5m portfolio
is now worth only $3,689,250. If the hedge was effective, we should be locked-
in at around $5m.

So we suffered a loss on our portfolio value and another loss on the futures trading.
What happened to offsetting one loss with a gain on the other position? Something is
very wrong here!

d) Our initial position was to enter 31 long SPI200 contracts when the quoted futures price
was 4530. We then close out by entering 31 short SPI200 contracts at 4950. The gain
on SPI200 futures is:

(1 June) Enter long SPI200 futures 31 × $A25 × 4530 3,510,750

(30 Nov) Close-out with short SPI200 futures 31 × $A25 × 4950 3,836,250
Gain 325,500

If the market index rose from 4500 to 4950, this is a 10% rise (4950/4500 – 1). In
addition, the market portfolio generated a 2.5% dividend yield, so the overall return on
the market portfolio is +12.5%.

Plug these inputs into the CAPM:

Rf + β p ( Rm − Rf
Rp = )
0.015 + 0.70 ( 0.125 − 0.015 )
=
= +9.2%

This makes sense. The market rose by 12.5% overall. Since our portfolio is a little less
risky than the market, our portfolio will rise by a little less than 12.5%. From our
starting portfolio value of $5m, a 9.2% rise is equivalent to $460,000. Hence, after the
bull market, our portfolio will be worth $5,460,000.

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 Combining the two calcs above, our net worth in November is $5,785,500 ($5,460,000
+ $325,500).

Again, something is not right here! Hedging is about offsetting one position against
another. Here, we made a gain on our share portfolio and a gain on the futures trading.
This is not a hedged position.

e) Our advice to hedge using a long SPI200 position was incorrect. We have a long share
position (i.e., we own shares). An effective hedge is achieved when the derivatives
position is the opposite (i.e., short). We should have entered 31 short Nov-expiry
SPI200 futures. We must fire our advisor – she effectively doubled our risk!

f) If our original futures trade had been 31 short SPI200 contracts, we would make a gain
when the market drops to 3600:

(1 June) Enter short SPI200 futures 31 × $A25 × 4530 3,510,750

(30 Nov) Close-out with long SPI200 futures 31 × $A25 × 3600 2,790,000
Gain 720,750

Adding the futures trading gain ($720,750) to the portfolio value (4,410,000) gives a
net value of $5,130,750. That makes more sense. We started with a portfolio worth
$5m. After hedging against a market drop, our finishing portfolio value is still pretty
close to $5m.

Similarly, if we had correctly entered short SPI200 contracts to hedge when the market
rises to 4950, we must make a loss on the short futures:

(1 June) Enter short SPI200 futures 31 × $A25 × 4530 3,510,750

(30 Nov) Close-out with long SPI200 futures 31 × $A25 × 4950 3,836,250
Loss 325,500

Deduct the futures trading loss ($325,500) from the portfolio value ($5,460,000) gives
a net value of $5,134,500). This is more like what we expect from hedging. Irrespective
of whether the underlying market index drops or rises, our ending value does not change
much.

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