Chapter 26: Derivatives and Hedging Risk

26.1

1. Futures contracts are standardized and traded on exchanges, while forward contracts are
tailormade to suit the specific needs of two counterparties. The standardization of
contracts increases the liquidity of futures markets in comparison to forward markets and
also allows traders to enter into their positions with a certain degree of anonymity.
2. The holder of a futures contract is insulated from default risk due to clearing corporations and
margin requirements. The owner of a forward contract has no guarantee that his counterparty will not
default, and therefore forward holders must carefully evaluate each others credit risk before entering into
a contract.
3. Since futures positions are markedtomarket at the close of trading, gains and losses on futures
positions are realized daily, while gains or losses on a forward contract are not realized until the
delivery of the asset.
When you need tailor-made contracts, you may prefer forwards over futures.
If the firm is selling futures contracts on lumber to hedge, it must have lumber to sell in the future and
worry about future price drop.

26.2

a.

1. Since the futures price of wheat is $3.09 per bushel at the end of trading on March 18,
the delivery price on that date is $3.09 per bushel.

2. On the delivery date, the long and short positions in a futures contract transact with
the
clearing corporation at the current futures price. Therefore, you will pay the
current futures price of $3.09 per barrel in order to receive the wheat. The
difference
between the price that you pay at delivery and the price at which you
entered into the
contract is reconciled by daily markedtomarket gains and losses.

increases

of

3. On March 15, you entered into a long futures position in wheat at a price of $3.00 per
bushel. Since the closing futures price is $3.06 per bushel, your account receives a
cash inflow of $0.06 at the end of the day. Your position in wheat futures
to $3.06 per bushel (= $3.00 + $0.06).
On March 16, your opening long position in wheat futures is $3.06 per bushel. Since
the closing futures price is $3.11 per bushel, your account receives a cash inflow
$0.05 at the end of the day. Your position in wheat futures increases to $3.11 per
bushel (= $3.00 + $0.06+ $0.05).
On March 17, your opening long position in wheat futures is $3.11 per bushel. Since
the closing futures price is $3.16 per bushel, your account receives a cash inflow of
$0.05 at the end of the day. Your position in wheat futures increases to $3.16 per
bushel (= $3.00 + $0.06 + $0.05 + $0.05).
On March 18, your opening long position in wheat futures is $3.16 per bushel. Since
the closing futures price is $3.09 per bushel, your account experiences a cash
outflow of $0.07 at the end of the day. Your position in wheat futures decreases to
$3.09 per bushel (=$3.00 + $0.06 + $0.05 + $0.05 $0.07). Since you receive a

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notice of delivery on this date, you will pay the $3.09 futures price and receive 1
bushel of wheat.
4. The following is a summary of your futures position:
March
March
March
March
March
March

15
15
16
17
18
18

Enter into Long Futures Positon at $3.00 per bushel

Futures Price Increases to $3.06 per bushel
Futures Price Increases to $3.11 per bushel
Futures Price Increases to $3.16 per bushel
Futures Price Decreases to $3.09 per bushel
Pay Futures Price of $3.07 at Delivery
Total Net Cash Flow

None
$0.06
$0.05
$0.05
-$0.07
-$3.07
-$3.00

Therefore, the net amount that you pay for one bushel of wheat is $3.00 per bushel.
b.

1. Since the futures price wheat is $3.07 per bushel at the end of trading on March 19,
the delivery price on that date is $3.07 per bushel.
2. On the delivery date, the long and short positions in a futures contract transact with
the clearing corporation at the current futures price. Therefore, you will pay the
current futures price of $3.07 per barrel in order to receive the wheat. The
difference between the price that you pay at delivery and the price at which you
entered into the contract is reconciled by daily markedtomarket gains and

losses.

increases
of

3. On March 15, you entered into a long futures position in wheat at a price of $3.00 per
bushel. Since the closing futures price is $3.06 per bushel, your account receives a
cash inflow of $0.06 at the end of the day. Your position in wheat futures
to $3.06 per bushel (= $3.00 + $0.06).
On March 16, your opening long position in wheat futures is $3.06 per bushel. Since
the closing futures price is $3.11 per bushel, your account receives a cash inflow
$0.05 at the end of the day. Your position in wheat futures increases to $3.11 per
bushel (= $3.00 + $0.06+ $0.05).
On March 17, your opening long position in wheat futures is $3.11 per bushel. Since
the closing futures price is $3.16 per bushel, your account receives a cash inflow of
$0.05 at the end of the day. Your position in wheat futures increases to $3.16 per
bushel (= $3.00 + $0.06 + $0.05 + $0.05).
On March 18, your opening long position in wheat futures is $3.16 per bushel. Since
the closing futures price is $3.09 per bushel, your account experiences a cash
outflow of $0.07 at the end of the day. Your position in wheat futures decreases to
$3.09 per bushel (=$3.00 + $0.06 + $0.05 + $0.05 $0.07).

will

On March 19, your opening long position in wheat futures was $3.09 per bushel.
Since the closing futures price is $3.07 per bushel, you will experience a cash
outflow of $0.02 at the end of the day. Your position in wheat futures decreases to
$3.07 per bushel (= $3.00 + $0.06 + $0.05 + $0.05 $0.07 - $0.02). Since you
receive a notice of delivery on this date, you will pay the $3.07 futures price and

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127

receive 1 bushel of wheat. Notice that even though you only paid $3.07 for the
delivery of wheat, the net amount that you paid for it out of your pocket is $3.00
bushel, the futures price at which you originally entered into the position.

per

4. The following is a summary of your futures position:

Event
March
March
March
March
March
March
March

15
15
16
17
18
19
19

Enter into Long Futures Positon at $3.00 per bushel

Futures Price Increases to $3.06 per bushel
Futures Price Increases to $3.11 per bushel
Futures Price Increases to $3.16 per bushel
Futures Price Decreases to $3.09 per bushel
Futures Price Decreases to $3.07 per bushel
Pay Futures Price of $3.07 at Delivery
Total Net Cash Flow

Cash Flow
None
$0.06
$0.05
$0.05
-$0.07
-$0.02
-$3.07
-$3.00

Therefore, the net amount that you pay for one bushel of wheat is $3.00 per bushel.
26.3

a.
Since you will receive the bonds face value of $1,000 in 16 years and the 16 year spot
interest rate is currently 8.5 percent, the current price of the bond is:
Current bond price = $1,000 / (1.085)16
Current bond price = $271.10
Since the forward contract defers delivery of the bond for one year, the appropriate interest
rate to use in the forward pricing equation is the oneyear spot interest rate of 4.2

percent:
Forward price = $271.10 (1.042)
Forward price = $282.48
b.
Given these

If both the 1year and 16year spot interest rates unexpectedly shift downward by 2 percent,
the appropriate interest rates to use when pricing the bond is 6.5 percent, and the
appropriate interest rate to use in the forward pricing equation is 2.2 percent.
changes, the new price of the bond will be:
New bond price = $1,000 / (1.065)16
New bond price = $365.09
And the new forward price of the contract is:
Forward price = 365.09 (1.022)
Forward price = $373.13

26.4

The coupon payment is not specified in the question. Hence, the most reasonable assumption is to
use a zerocoupon bond.

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128

a.

Youll receive $1,000 in 18 months. Use 18-month spot rate to discount the cash flow back to
time 0 and then arrive at the future value of it at the end of month 6. The forward price is
therefore:
Forward Price = [$1,000 /1.0623 ] (1.055) = $880.80

b.
The

It is important to remember that 100 basis points equals 1% and one basis point equals
0.01%. Therefore, if all rates increase by 15 basis points, each rate increases by 0.0015.
new 18month spot rate is 0.0605 (= 0.0620 0.0015), and the new 6month spot rate
is 0.0535 (= 0.055 0.0015).
Bond price = [$1,000 / 1.06053 ](1.0535) = $883.28

26.5

If Jonathon Simpleton believes that the futures price of silver will fall over the next month, he should
take on a short position in silver futures contracts with approximately one month until expiration. By
selling futures contracts now, he will be locking in a sales price that is higher than what he
believes he will be able to purchase silver futures for in one months time.

26.8

When you purchase the contracts, the initial value is:

Initial value = 10(100)($680)
Initial value = $680,000
At the end of the first day, the value of you account is:
Day 1 account value = 10(100)($673)
Day 1 account value = $673,000
So, your cash flow is:
Day 1 cash flow = $673,000 $680,000
Day 1 cash flow = $7,000
The day 2 account value is:
Day 2 account value = 10(100)($679)
Day 2 account value = $679,000
So, your cash flow is:
Day 2 cash flow = $679,000 $673,000
Day 2 cash flow = $6,000
The day 3 account value is:
Day 3 account value = 10(100)($682)
Day 3 account value = $682,000

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So, your cash flow is:

Day 3 cash flow = $682,000 $679,000
Day 3 cash flow = $3,000
The day 4 account value is:
Day 4 account value = 10(100)($686)
Day 4 account value = $686,000
So, your cash flow is:
Day 4 cash flow = $686,000 $682,000
Day 4 cash flow = $4,000
You total profit for the transaction is:
Profit = $686,000 680,000
Profit = $6,000
Note that: (1) $6,000 is the last contract price initial contract price
(2) $6,000 is also the sum of all of the above daily gains/losses.
26.9

When you purchase the contracts, your cash outflow is:

Cash outflow = 25(42,000)($1.52)
Cash outflow = $1,596,000
At the end of the first day, the value of you account is:
Day 1 account value = 25(42,000)($1.46)
Day 1 account value = $1,533,000
Remember, on a short position you gain when the price declines, and lose when the price increase.
So, your cash flow is:
Day 1 cash flow = $1,596,000 $1,533,000
Day 1 cash flow = $63,000
The day 2 account value is:
Day 2 account value = 25(42,000)($1.55)
Day 2 account value = $1,627,500
So, your cash flow is:
Day 2 cash flow = $1,533,000 $1,627,500
Day 2 cash flow = $94,500
The day 3 account value is:
Day 3 account value = 25(42,000)($1.59)

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130

Day 3 account value = $1,669,500

So, your cash flow is:
Day 3 cash flow = $1,627,500 $1,669,500
Day 3 cash flow = $42,000
The day 4 account value is:
Day 4 account value = 25(42,000)($1.62)
Day 4 account value = $1,701,000
So, your cash flow is:
Day 4 cash flow = $1,669,500 $1,701,000
Day 4 cash flow = $31,500
You total profit for the transaction is:
Profit = $1,596,000 $1,701,000
Profit = $105,000

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131

26.12

The duration of a bond is the average time to payment of the bonds cash flows, weighted by the
ratio of the present value of each payment to the price of the bond. Since the bond is selling at par,
the market interest rate must equal 10 percent, the annual coupon rate on the bond. The price of a
bond selling at par is equal to its face value. Therefore, the price of this bond is $1,000. The relative
value of each payment is the present value of the payment divided by the price of the bond. The
contribution of each payment to the duration of the bond is the relative value of the payment
multiplied by the amount of time (in years) until the payment occurs. So, the duration of the bond
is:
Payment
$100
$100
$1,100

26.13

PV of
Payment
$90.91
$82.64
$826.45

Relative Value
0.0909
0.0826
0.8264

Time to Payment (in years)

1
2
3
Duration =

Duration
0.0909
0.1653
2.4793
2.7355 years

The duration of a portfolio of assets or liabilities is the weighted average of the duration of the
portfolios individual items, weighted by their relative market values. Fed. fund deposits, receivables,
loans (i.e., loans lent out) and mortgages (i.e., mortgage held) are assets, and deposits (deposits from
outside) and long-term financing are liabilities.
a.

The total market value of assets in millions is:

Market value of assets = $28 + $580 + $390 + $84 + $315
Market value of assets = $1,397
So, the market value weight of each asset is:
Federal funds deposits = $28 / $1,397 = 0.020
Accounts receivable = $580 / $1,397 = 0.415
Shortterm loans
= $390 / $1,397 = 0.279
Longterm loans
= $84 / $1,397 = 0.060
Mortgages
= $315 / $1,397 = 0.225
Since the duration of a group of assets is the weighted average of the durations of each
individual asset in the group, the duration of assets is:
Duration of assets = 0.020(0) + 0.415(0.20) + 0.279(0.65) + 0.060(5.25) + 0.225(14.25)
Duration of assets = 3.79 years

b.

The total market value of liabilities in millions is:

Market value of liabilities = $520 + $340 + $260
Market value of liabilities = $1,120
Note that equity is not included in this calculation since it is not a liability. So, the market value
weight of each asset is:
Checking and savings deposits = $520 / $1,120 = 0.464

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132

Certificates of deposit
Longterm financing

= $340 / $1,120 = 0.304

= $260 / $1,120 = 0.232

Since the duration of a group of liabilities is the weighted average of the durations of each
individual asset in the group, the duration of liabilities is:
Duration of liabilities = 0.464(0) + 0.304(1.60) + 0.232(9.80)
Duration of liabilities = 2.76 years
c.
26.14

Since the duration of assets does not equal the duration of its liabilities, the bank is not
immune from interest rate risk.

Since the cost is $30,000 at the beginning of

each year for four years, we can find the present value of each payment using the PV equation (you can,
of course, use the annuity formula. Note that if you use it, make sure you understand the formula is for the
regular annuity only):
PV = FV / (1 + r)t
So, the PV each year of college is:
Year 1
Year 2
Year 3
Year 4

PV = $30,000 / (1.10)3
PV = $30,000 / (1.10)4
PV = $30,000 / (1.10)5
PV = $30,000 / (1.10)6

= $22,539.44
= $20,490.40
= $18,627.64
= $16,934.22

So, the total PV of the college cost is:

PV of college = $22,539.44+ $20,490.40+ $18,627.64 + $16,934.22
PV of college = $78,591.71
Now, we can set up the following table to calculate the liabilitys duration. The relative value of each
payment is the present value of the payment divided by the present value of the entire liability. The
contribution of each payment to the duration of the entire liability is the relative value of the
payment multiplied by the amount of time (in years) until the payment occurs.

26.17

Year

PV of payment

Relative value

Payment weight

3
4
5
6

$22,539.44
$20,490.40
$18,627.64
$16,934.22

0.28679
0.26072
0.23702
0.21547

0.86037
1.04288
1.18509
1.29282

PV of college

$78,591.71

a.

Duration = 4.38117 years

The price of a bond equals the present value of its cash flows.
Since Bond One pays an annual coupon of 5%, the bonds owner will receive $50 (= 0.05 *
$1,000) at the end of each year in addition to the bonds $1,000 face value when the bond
matures at the end of year 7..

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133

7
Price of Bond One = $50 A0.0456 +1000/(1+0.0456)7
= $1025.87

The price of Bond One is $1025.87.

Since Bond Two pays an annual coupon of 3.5%, the bonds owner will receive $35 (= 0.035 *
$1,000) twice a year in addition to the bonds $1,000 face value when the bond
matures at the end of year 6. The effective discount rate for the 6-month period
is:
1 0.0456 1 0.0225
12
Price of Bond Two = $35 A0.0225 +1000/(1+0.0225)12
= $1,130.19

The price of Bond Two is $1,130.19.

Since Bond Three pays an annual coupon of 10%, the bonds owner will receive $100 (= 0.1 *
$1,000) at the end of each year in addition to the bonds $1,000 face value when the bond
matures at the end of year 9.
9
Price of Bond Three = $100 A0.0456 +1000/(1+0.0456)9
= $1394.35

The price of Bond Three is $1394.35.

The duration of a bond is the average time to payment of the bonds cash flows, weighted
by the ratio of the present value of each payment to the price of the bond.
The relative value of each payment is the present value of the payment divided by the price
of the bond. The contribution of each payment to the duration of the bond is the relative
value of the payment multiplied by the amount of time (in years) until the
payment occurs.
Bond One

Payment
$50
$50
$50
$50
$50
$50
$1,050

PV of
Payment
$47.82
$45.73
$43.74
$41.83
$40.01
$38.26
$768.48

Relative
Value
0.0466
0.0446
0.0426
0.0408
0.0390
0.0373
0.7491

Time to
Payment
(in years)
1
2
3
4
5
6
7

Duration
0.0466
0.0892
0.1279
0.1631
0.1950
0.2238
5.2437
6.0892

The duration of Bond One is 6.0892 years.

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134

Bond Two
Payment
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
1035.00

PV of
Payment
34.23
33.48
32.74
32.02
31.31
30.63
29.95
29.29
28.65
28.02
27.40
792.47

Relative
Value
0.0303
0.0296
0.0290
0.0283
0.0277
0.0271
0.0265
0.0259
0.0253
0.0248
0.0242
0.7012

Time to Payment
(in years)
1
2
3
4
5
6
7
8
9
10
11
12

Duration
0.0303
0.0592
0.0869
0.1133
0.1385
0.1626
0.1855
0.2073
0.2281
0.2479
0.2667
8.4142
10.14

The duration of Bond Two is 10.1406 6-month periods or 5.0703 years.

Bond Three

Payment
$100
$100
$100
$100
$100
$100
$100
$100
$1,100

PV of
Payment
$95.64
$91.47
$87.48
$83.66
$80.02
$76.53
$73.19
$70.00
$736.38

Relative
Value
0.0686
0.0656
0.0627
0.0600
0.0574
0.0549
0.0525
0.0502
0.5281

Time to
Payment
(in years)
1
2
3
4
5
6
7
8
9

Duration
0.0686
0.1312
0.1882
0.2400
0.2869
0.3293
0.3674
0.4016
4.7530
6.7663

The duration of Bond B is 6.7663 years.

b.

If the market interest rate increases to 6% per annum:

7
Price of Bond One = $50 A0.06 +1000/(1+0.06)7
= $944.17

The price of Bond One is $944.17.

The effective discount rate for the 6-month period is:
1 0.06 1 0.0296

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135

Price of Bond Two

12
= $35 A0.0296 +1000/(1+0.0296)12
= $1053.88

The price of Bond Two is $1053.88.

9

Price of Bond Three = $100 A0.06 +1000/(1+0.06)9

= $1,272.06
The price of Bond Three is $1,272.06.

percentage
d.

Bond Three should experience a greater percentage change in its price. Bond Three has a higher
duration than Bond One and Two. Bonds with higher durations will experience greater
changes in price for a given movement in the interest rate.
The percentage change in the price of each bond is:
Percentage Change in Bond Price = (New Price / Old Price) 1
Percentage Change in Bond One = ($944.17 / $1025.87) 1
= 0.0796 or 7.96%
Percentage Change in Bond Two = ($1053.88/ $1,130.19) 1
= 0.0675 or 6.75%
Percentage Change in Bond Three = ($1,272.06 / $1,394.35) 1
= 0.0877or 8.77%

e.

Hubcap should issue Bond Three since it has the biggest percentage change.

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