Hedging Exercises

1. Suppose it is the end of May. Suppose the following sterling interest rates are
currently available :

Term % Sterling rate

1 month 8.00-8.15
2 months 8.15-8.25
3 months 8.25-8.35
4 months 8.35-8.40

A corporate Treasurer is expecting to borrow £1m in 1 month’s time for 3 months.

(a) How does he hedge his position against a rise in the borrowing rate in 1
month’s time using the money market rates above? What is the effective rate
that he locks in now?

The rates in one month’s time are as follows:

Term % Sterling rate

1 month 8.05-8.30
2 months 8.05-8.35
3 months 8.20-8.25
4 months 8.25-8.35
5 months 8.30-8.40

(b) What are the hedged and unhedged positions?

(c) Was the hedge successful?

(d)` Suggest a reason why the Hedger used the money market instruments instead
of futures contracts.

Solution:

(a) He hedges by borrowing now for 4 months @ 8.40% and depositing the funds
for 1 month @ 8.00%. We want to calculate 3m forward rate in 1 months time:

0.08 rf 0.0840
Solve : (1 + )(1 + ) = 1 +
12 4 3
 0.084 
1 + 
: rf =  3 − 1 * 4
 0.08 
 1+ 
 12 
rf = 0.08477 = 8.48%
Futures price = 100 - 8.48 = 91.52
(b) The unhedged position would have been borrowing at 8.25% which is more
favourable than borrowing at 8.48%. The hedged position is borrowing at 8.48%.
(c) But by hedging manager is ensuring that he does not borrow at a rate higher than
8.48%.
(d) The futures would have required marking to market.
 2. (a) Explain briefly why FTSE 100 Index futures can be used to hedge against the value of an
equity portfolio falling.
(b) Explain the role of the beta, β of the portfolio in the hedge.
(c) The formula for the value of an unhedged portfolio at expiry is given by
(𝑃𝐸𝐷𝑆𝑃 − 𝑃𝑆 )
VU = Vp/f(1 + 𝑃𝑆
∗ 𝛽)
The formula for the hedged value of the portfolio, VH
at expiry is given by
(Pf − PS )
VH = Vp/f(1 + ∗ 𝛽)
PS
i. Explain why the unhedged portfolio’s value is uncertain at expiry.
ii. Explain why the hedged portfolio’s value has certainty.
iii. Suppose a manager has a market-tracker portfolio worth £1m.
Complete the table below for the two cases of contango and backwardation.
Compare the two cases in terms of the efficiency of the hedge. (No calculations
required)

Spot Futures PEDSP Basis VU VH

Index, PS Index, Pf
6750 7000 6500

7000 6750 6500

Solution.
a) The Index values are a proxy for the market value. If the market value is expected to fall
then the Spot Index values and Index futures Prices are expected to fall also. By selling
the futures the fall in the futures price will provide a profit that can (partially or more
than) offset the loss in the value of the portfolio.
b) The beta, β is the scale factor by which the rate of return of the p/f is related to the
market’s rate.
c)
i. The Value of the unhedged p/folio at expiry is
(PEDSP − PS )
VU = Vp/f(1 + ∗ β)
PS
It shows the unhedged value is dependent on the Future’s settlement Price
at expiry which is not known on day 1.
ii. The Value of the Hedged p/folio at expiry is
(Pf − PS )
VH = Vp/f(1 + ∗ β)
PS
It shows the hedged value is not dependent on the Future’s settlement
Price, but the future’s Price and the Spot Index Price on day 1 which are
known.The value of the hedged portfolio is dependent on the actual
portfolio correlation with the market via the beta, which is not an accurate
value.
iii.
 Spot Futures PEDSP Basis VU VH
Index, PS Index, Pf
6750 7000 6500 Contango £0.963m £1.037m

7000 6750 6500 Backwardation £0.928m £0.964m

In both cases the hedge provided protection with the hedged values being above
the unhedged value although in the case of contango the hedged value exceeded
the initial value.

3. A Portfolio Manager has a large holding of Black Gold shares currently priced at
6500p. She is concerned that the price may fall and decides to protect her holding
using BLACK GOLD Puts.

(i) Does she buy or sell the Puts? Explain.

(ii) Explain the relative merits of using the In-the-Money Puts with the Out-of-the-Money
Puts.

The current share price is 6500p. The manager observes the following Put Prices:

Exercise Price Put

6600 116
6500 28
6400 12

(iii) For each Put what is the value of the holding when at expiry the price of Black Gold
shares has fallen to 6000.

Solution:

(i) Manager buys the Puts because if the share price falls the price of the Puts increases.

(ii) The 6600p Put will be In-the-money if the price of Black Gold falls below 6600p.
The 6400p Put will only be In-the-money if the price of Black Gold falls below 6400p.
So the 6600p Put provides more protection. However the price of the 6600p Puts is higher
than the price of the 6400p Puts. Higher protection comes at a higher cost.
(iii)
X-price Share Payoff from Cost of Put Unhedged Hedged
Long Put Value Value

6600p 6000p 600p 116p 6000p 6484p

6400p 6000p 400p 12p 6000p 6388p

4. The treasurer of an American company has a liability of £500 000 to a British Company to be
paid for in 60 days’ time. The treasurer wishes to hedge her position using the CME British
pound (STG) futures due to expire in 60 days time currently priced at $1.35.
(i) Does the treasurer buy or sell the futures? Explain. How many contracts are used?
(ii) What is the hedged cost (in $) of the liability locked-in by the futures?
(iii) At expiry the futures is settled at the EDSP of $1.30. Explain what transactions occur and how
the liability is met.
(iv) What was the unhedged and hedged cost of paying the liability? Was the hedge successful?

(i) The treasurer is concerned that sterling will appreciate ($/£ will rise) and so buys the futures.
The face value of one STG contract is £62 500.
Number of contracts = £500 000/£62 500 = 8 contracts.
(ii) The hedged cost is $500 000*1.35 = $675 000.
(iii) The treasurer receives £500,000 (British Pounds) as the physical delivery of the futures
transaction.
Invoice price of 5x62 500x$1.30 = $650 000 that the treasurer pays to the short.
The margin account contains a profit calculated as follows:
(PSell−PBuy )∗tick value
Psell = $1.30, PBuy = $1.35. Profit = tick size
∗ No. of contracts
(1.30−1.35)∗6.25∗8
=$ 0.0001
= −$25,000 (loss)
Total Cost = $(650 000 + 25 000) =$675 000.
(iv) The unhedged cost is 500 000*$1.30 = purpose of the hedge was to lock in a price of $675 000
which was achieved.