You hold 3000 shares of ABC Bank selling at Rs 300 on August 1. You plan to sell them on September 24.

You are concerned about a possible price decrease and you want to hedge this price risk using futures,
but there are no futures contract being traded on ABC Bank. However it is believed that there is a high
correlation between the price movements of ABC Bank and a few other bank shares, one of them being
India bank. Also Sep futures (expiring on Sep 24) on India Bank with a contract size of 200 are selling for
Rs 2500.

Suppose you decide to hedge your shares using India Bank futures.

a) What will be your hedging strategy?

Hedging strategy will be Short Hedge. Because by selling the futures of India Bank, the
loss can be covered even if the price is down.

b) Assume you are going to hedge with 3 India Bank futures contracts, then calculate your cash
flows assuming that on Sep 24, the market price of ABC Bank and India Bank are 310 and 2550
respectively?
No of india bank future contracts sold : 3
Date 1-Aug

Total value of shares ₹ 900,000.00

Market Price of future contract ₹ 2,500.00

Date 24-Sep

market price of ABC Bank share ₹ 310.00

Market Price of future contract ₹ 2,550.00
Total value of shares ₹ 930,000.00

Cash flow by selling ABC Bank share ₹ 930,000.00

Cashflow after squaring off future contract ₹ -30,000.00
Net cashflow ₹ 900,000.00

c) How does your answer change if instead the market price of ABC Bank and India Bank are 295
and 2475 respectively on Sep 24?

Date 24-Sep
market price of ABC Bank share ₹ 295.00
Market Price of future contract ₹ 2,475.00
Total value of shares ₹ 885,000.00

Cashflow by selling ABC Bank share ₹ 885,000.00

Cashflow after squaring off future contract ₹ 15,000.00
Net cashflow ₹ 900,000.00
 d) What would have happened if you had hedged with lesser or more number of India Bank futures
contracts? Give the cash flows under both the scenarios above, if the number of contracts used
for hedging were 1, 2 ,3, 4 or 5. Report your observations (in less than 3 sentences).

Net cashflow
No of contracts case a (stock goes up) case b (stock goes down)
1 ₹ 920,000.00 ₹ 890,000.00
2 ₹ 910,000.00 ₹ 895,000.00
3 ₹ 900,000.00 ₹ 900,000.00
4 ₹ 890,000.00 ₹ 905,000.00
5 ₹ 880,000.00 ₹ 910,000.00
in case of short hedge strategy lesser number of contracts would be beneficial when stock goes up
and more no of contracts would be beneficial when stock goes down
change in stock price ₹ 15.00
change in future price ₹ 75.00
so hedge ratio (correlation is 1) 0.2
so optimal no of contracts for hedging= 3

e) Suppose that futures contract with Sep 24 expiry is not available, and only futures contracts with
expiry either Sep 10 or Oct 10 is available. Which one will you use for your hedging
requirements? Why? (in less than 3 sentences)
September 10th contract will be the choice because:

(i) it would be more liquid and

(ii) (ii) price movement would tend to follow the underlying stock price more closely than Oct
10 contract.

Also after expiry of September contract I will then roll it over to October 10 contract.