Chapter 19 End-Chapter Essay Questions Solutions

Chapter 19 End-chapter essay questions solutions
On top of the selected homework questions, you can use the remaining questions as
an extra study resource to help you learn.
1 Oil Search notes in its annual reports that it is exposed to the risk of falling oil prices,
increasing interest rates, and changes in the exchange rates of various foreign
currencies. How can Oil Search use derivative products to manage these risks? (LO
19.1)
ANSWER
 A derivative is a financial product that is designed essentially to manage specific

risk exposures. As a financial instrument a derivative has a price.
 Derivative contracts are offered in the major international financial markets.
Derivatives enable the management of risks associated with interest rates, equity,
commodities and foreign currencies.
 The trading in derivatives for the purpose of risk management allows the transfer
of risk to another party, such as an individual, corporation, financial institution or
speculator, that holds a different view on the direction, or extent, of future price
changes, or faces a risk exposure that is the opposite of the one faced by the first
party.
 In the case of Oil Search, the company is exposed to fluctuations in the price of
oil, changes in interest rates and changes in FX rates. Derivatives products may
be an important part of an overall risk management strategy.
 Primarily, the firm is exposed to the risk that physical market prices, the price of
oil, will fall and, consequently, reduce its revenue.
 The firm can hedge against this risk by taking positions in commodities futures
markets. The company would enter short positions in the oil futures markets.
IRM to accompany Viney & Phillips Financial Institutions, Instruments and Markets, 9th edition
© 2019 McGraw-Hill Education (Australia)
 If the prices in the physical markets fall, the short futures position will become
more valuable. This would offset some of the losses that the company might
experience.
 Oil Search can also use derivatives to hedge the risk of interest rate movements
and FX movements. If the company borrows funds, it can hedge against the risk
of an increase in interest rates by using BAB futures, for example. Similarly,
futures on foreign currencies may be used to hedge FX risk. There are, of course,
many different products available to Oil Search that will enable it to hedge these
various risks.
Section 19.1
2 Explain why it is not usually possible to perfectly hedge a position using futures
contracts. (LO 19.2)
ANSWER
 A futures contract is a legally binding contract between two parties to buy or sell
a specified commodity or financial instrument at a specified future date at a price
determined today.
 Futures contracts are essentially designed to allow the management of certain
risks attached to commodities and financial instruments.
 Speculators also buy and sell futures contracts to benefit from price movements.
Speculators provide liquidity in the market.
 Because speculators and hedgers will anticipate some of the expected movements
in underlying prices and rates, the futures prices at any given time will usually
reflect some premium or discount to the current physical market. As such, a
hedger seeking to hedge a risk of a price increase or decrease in some commodity
or rate will find that it is not possible to perfectly hedge.
 For example, if the hedger wants to hedge against the risk of a falling oil price,
the current price per barrel might be USD50. If a futures position could be taken
at USD50, a perfect hedge could be constructed. However, if prices are expected
to fall, the futures price might already be USD48. There is a USD2 per barrel
amount that cannot be hedged.
Section 19.2
3 For investors and borrowers considering setting up a risk management strategy using
futures contracts, there is a basic rule that determines the timing of the various buy/sell
transactions. Specify and explain this rule, giving examples from an investor’s and a
borrower’s viewpoint. (LO 19.2)
ANSWER
 The basic rule to be followed in establishing a hedging strategy is to conduct a

transaction in the futures market today that corresponds with what you intend to
do in the physical market at a later date.
 If a borrower plans to sell its paper (for example, bills or corporate bonds) to
raise funds, then it will sell a futures contract today to cover the interest rate risk
exposure when it actually issues the paper. The hedger will close-out the open
futures position by buying an identical futures contract when it issues the paper.
 If an investor plans to buy some shares when surplus funds become available but
is concerned the share price will rise in the meantime, the investor can buy
futures contracts today. The open position will be closed-out when the actual
shares are bought by selling a corresponding futures contract.
Section 19.2
4 a. Outline the procedure involved in buying a futures contract.

ANSWER
 Futures contracts are traded on formal exchanges, such as the SFE.
 A market order will be placed with a broker to buy or sell a particular contract.
 Transactions are conducted by open outcry on the exchange floor (for example,
CBOT) or on the exchange’s electronic trading platform (for example, SFE).
 The majority of exchanges now use electronic trading systems, however the
largest exchanges (CBOT and CME) use open outcry.
 The electronic trading system automatically matches buy and sell orders.
 Details of the transaction are recorded by the SFE clearing-house.
 The clearing-house guarantees transactions through processes of novation and
margin calls.
 Novation—an agreement to replace one party to a contract with another party.
 The full futures contract price is not paid; rather an initial margin is deposited
with the clearing-house.
 The margin is sufficient to cover immediate adverse movements in contract
prices in case it is necessary for the clearing-house to close-out a position for a
client.
 The clearing-house will mark-to-market the contract daily.
 Maintenance margin calls may be made by the clearing-house requiring the
broker to top-up the initial margin. This is required when the contract price has
moved against the client and the initial margin is no longer adequate.
Section 19.2
b. Indicate the implications of being long in a futures contract.

ANSWER
 The trader who is long in a futures contract will be exposed to losses and margin
calls if the price of the underlying asset falls.
Section 19.2
c. Indicate the implications of being short in a futures contract.
ANSWER
 The trader who is short in a futures contract will be exposed to losses and margin
calls if the price of the underlying asset increases.
Section 19.2
d. What are the procedures for closing out these positions prior to delivery? (LO 19.2)
ANSWER
 The vast majority of open futures positions are closed-out by the

client before expiry date by taking an opposite contract
 A long position occurs when the underlying asset has been bought
forward, that is, a buy futures contract. A party to a long position will close-out
that open position by selling another futures contract with the same commodity
and expiry date.
 A short position occurs when the underlying asset has been sold
forward. The short position can be closed out by going long a futures contract
with same commodity and expiry date.
Section 19.2
5 On ASX Trade24 the quotation of the three-year Treasury bond futures contract is
such that traders can easily follow a ‘buy low sell high’ rule. Construct an example that
shows how this works. (LO 19.2)
ANSWER
 Futures contracts are quoted at 100 minus the yield; therefore a Commonwealth
Treasury bond futures contract quoted at 93.75 has a yield of 6.25% per annum.
 Futures contracts are quoted at an index figure of 100 minus the yield so that a
dealer can follow the basic principle of buy low and sell high; for example, if the
above contract is priced based on a 6.25% yield were to be sold at a later date at a
yield of 7.00%, then it at first seems that a profit would be made because the
contract was bought at 6.25% and sold at 7.00%. However, if we calculate the
actual prices of the two contracts we find that a loss would be made.
 By adopting the index quote convention, if the dealer buys at 93.75 and sells at
93.00 it is apparent that a loss has been made.
Section 19.2
6 ‘In 2017, the average daily turnover in the Australian bond futures markets was 207
000 contracts for the 3-year and 162 000 for the 10-year. This indicates an undesirably
high level of speculation in the bond futures markets in Australia.’ Discuss the validity
of this statement. (LO 19.2)
ANSWER
 The daily turnover in the bonds futures markets in Australia indicates the
substantial size and importance of the markets.
 Futures and other derivative contracts can be used for both hedging and
speculation. The turnover figures themselves do not tell us which of these forces
is dominating.
 As we have seen, speculation is a critical component of the futures markets and
their risk management function. Individuals and firms with exposure to various
physical market risks can enter positions in the futures markets designed to
manage, minimise or offset those risks. Individuals with the opposite exposures
may take the other side of the contract but often it is a speculator with no
physical market exposure who takes the opposite side of the contract.
 The speculator operates on the basis of an expectation about the future prices that
will prevail in the physical markets. Whereas a farmer may wish to lock in a
price for his wheat and protect himself against a fall in the wheat price, a
speculator may believe that wheat prices have a good chance of increasing over
the short or medium term. The farmer goes short, the speculator goes long.
 The statement is not a valid one because (1) we cannot tell how many speculative
trades are included in the daily turnover figures, and (2) speculation is an
essential component of well-functioning derivative markets, providing much
needed depth and liquidity for hedgers seeking to transfer risk.
Section 19.2
7 Distinguish between hedgers and speculators. Show how a hedger could use the 90-
day bank-accepted bill futures contracts to hedge interest rate uncertainty. Show how a
speculator may use the same futures contract in an attempt to make a profit. (LO 19.4)
ANSWER
 A hedger uses the futures market to manage an interest rate risk inherent in their
business dealings.
 A hedger may use 90-day bank accepted bills futures contracts to manage a
short-term interest rate risk exposure; for example, a borrower can lock-in the
cost of borrowing by selling futures contracts to obtain protection against the risk
of rising interest rates. Alternatively, an investor can lock-in the value of an
investment, and protect against the effects of falling interest rates, by buying
futures contracts.
 Speculators attempt to make a profit by purposely taking risks. Speculators enter
the market in the expectation that the market price will move in a favourable
direction for them.
 Futures contract transactions of speculators are not supported by an underlying
commercial transaction; for example, a speculator may sell bills future contacts
simply based on its expectation that bank bill prices are going to fall (yields rise);
that is, sell contracts at say 93.50 and subsequently buy opposite contracts at say
92.00
 Speculators who expect prices to rise would buy the contract now (go long);
those who expect prices to fall would sell the contract now (go short).
 Speculators may construct straddle or spread positions. In a straddle the
speculator may simultaneously buy a contract for delivery in a particular month,
and sell an identical contract with a later month delivery date. This strategy is
motivated by an expectation of a change in the price differential between the two
contracts.
 A spread position is similar to the straddle, but involves the simultaneous buying
and selling of related contracts (rather than identical contracts) in the anticipation
of a change in the price differential, or spread, between the two contracts. An
example would be the buying of 90-day bank accepted bill contracts and the
simultaneous selling of 3-year treasury bond contracts. The speculator is
anticipating a change in the yield curve.
 Speculators take on much of the risk that hedgers seek to avoid. Speculators
support trading volumes and liquidity in the market.
Section 19.4
8 A business plans to borrow approximately $40 million in short-term funding through

the issue of commercial paper in three months’ time. The business does not have a view
on what is likely to happen to interest rates over the next three months, but it would be
very satisfied if it could obtain its funding at the current yield.
a. Using the following data, show how 90-day bank-accepted bills futures contracts can
be used to hedge the interest rate risk to which the business is exposed. Show the
calculation and timing of all transactions and cash flows (ignore transaction costs and
margin requirements).
Today’s data:
i. current commercial paper yields 6.00 per cent per annum
ii. 90-day bank-accepted bills futures contract 93.75.
Data in three months:
iii. commercial paper yields 7.00 per cent per annum
iv. 90-day bank-accepted bills futures contract 93.25.
ANSWER
Cash or Physical Market Futures Market
Today: Today:
The company expects to borrow $40 Sell 40 90-day bank accepted
million in three months; it notes that bills futures contracts at 93.75
current yields are 6.00%, but is exposed (yield 6.25%)
if yields rise before the commercial Use discount securities formula
paper is issued 365× $ 40 million
P ¿ ¿=¿ $ 39392 917.37 ¿
365+(0.0625 ×90)
pay initial margin
Three months time:

Sell commercial paper with a face value Three months time:
of $40 million – yield 7.00% buy 40 contracts at 93.25
P = $39 321 303.53 P = $39 345 145.86
Hedge outcome: profit received from the futures

transactions is $47 771.51
cost of borrowing increased over
the profit is used to offset the
three-month period by $95 543.12
additional cost of borrowing in
profit received from futures the physical market when the
transactions is $47 771.51
borrower was not able to perfectly
hedge risk because of initial and final company issues commercial
basis risk paper
Section 19.5
b. What is the effective cost of funds achieved with this hedging strategy? What
would the cost of funds have been had the hedge not been put in place? Explain your
answer, showing your calculations. (LO 19.5)
ANSWER
net cost of funds 365 $ 678,696.47−$ 47,771.51
Effective cost of funds ¿ [ total amount of fund available
× ] [ 365
]
90 $ 39,321,303.53+ 47,771.51 × 90 ¿=¿
¿ ¿ ¿
If the hedging strategy had not been put in place then the cost of issuing the
commercial paper would have been 7.00 per cent per annum.
Section 19.5
9 A funds manager forecasts that it will need to invest $100 million in approximately
90 days. The manager wishes to receive a return as close as possible to the medium-
term interest rates currently available, but expects that rates will have fallen by the time
the funds are available for investment.
a. Outline what the manager would do today in the financial futures market in order to
secure a return that is close to current medium-term market rates.
ANSWER
 The funds manager will investigate different strategies available to hedge the
interest rate risk exposure. Assume the manager decides to implement a strategy
using futures contracts. The manager is interested in medium-term yields and
therefore will use a three-year Commonwealth Treasury bond futures contracts.
Since the funds manager will buy investments in three months, the initial
transaction in the futures strategy is to buy futures contracts.
Section 19.5
b. Calculate the price of a three-year Treasury bond futures contract quoted at 96.50.
ANSWER
 To calculate the price of the three-year Commonwealth treasury bond futures

contract the formula is:
 where: i = the nominal interest rate per period expressed as a decimaln = the
number of coupon periodsC = periodic coupon paymentsA = the face value of
the bond
 A Commonwealth Treasury bond futures contract is based on a 6.00% per annum
fixed interest bond with a face value of $100 million and paying half-yearly
coupons.
 Therefore:
i = 3.50% per annum / 2 = 1.75 = 0.0175
n = 3 year bond x half-yearly coupons = 6
C = 6.00% per annum bond; half-yearly coupons
= $100 million x 0.03 = $3 000 000
A = $100 000 000
Section 19.5
c. Outline how the funds manager would close out the futures market position.
ANSWER
 The funds manager will close-out the position by selling a three-year

Commonwealth Treasury bond contract. The net margin plus (minus) any profit
(loss) made on the two transactions will be returned by the clearing house. The
profit (loss) will be offset against the return received when investing the funds
for the client.
Section 19.5
d. Outline and explain the factors that will determine how successful this strategy will
be in securing an effective return that is close to today’s market rates. (LO 19.5)
ANSWER
 The funds manager will need to charge the cost of the futures strategy against the
client; that is, the opportunity cost of the margin calls. This will lower the net
yield received.
 The hedging strategy will be exposed to initial basis risk and final basis risk. This
risk may impact the effectiveness of the strategy, but will usually make it
impossible to achieve a perfect hedge.
 When the funds are eventually invested the funds manager will probably not
invest them in treasury bonds, but rather will choose some other investment
alternative. Therefore an element of cross-commodity risk will be evident.
Section 19.5
10 A funds manager currently manages a diversified Australian share portfolio valued

at $250 million. The manager decides to use the S&P/ASX 200 Index futures contract
to manage an exposure to a forecast decline in share prices. The S&P/ASX 200 Index is
currently at 5500. In three months’ time the S&P/ASX 200 is at 5150.
a. Today: set up a hedging strategy to manage the risk exposure.

ANSWER
 The price of the futures contract equals the S&P/ASX200 Index multiplied by
$25
 To establish the hedging strategy, the funds manager can sell 1800 S&P/ASX200
futures contracts
 Value = 1800 x 5500 x $25 = $247 500 000
 Note: the manager wishes to protect a selling position in the future so will sell
futures contracts today
 Pay initial margin.
Section 19.5
b. In three months’ time: close out the open position.

ANSWER
 To close an open position, take opposite contracts
 Buy 1800 S&P/ASX200 futures contracts
 Receive return of margin payments and futures strategy profits.
Section 19.5
c. Show the net valuation effect of the hedging strategy. (LO 19.5)
ANSWER
 Buy 1800 S&P/ASX200 futures contracts

 Value = 1800 x 5150 x $25 = $231 750 000
 Net profit = $15 750 000
 Net profit will be used to offset the fall in value of the share portfolio in the stock
market.
Section 19.5
11 A fund manager currently holds a well-diversified portfolio of Australian shares

valued at $250 000 000. The global political context is unstable and the fund manager
anticipates a period of unusually high market volatility. The S&P/ASX 200 VIX
currently stands at 22. The S&P/ASX 200 Index stands at 6500.
a. Explain how the manager can use VIX futures to hedge exposure to the anticipated
volatility.
ANSWER
(a) Assuming the losses on the ASX200 are matched by the fund manager’s
portfolio, the fund will suffer a loss of 14.54 per cent. That is, after the market
index declines to 4700, the portfolio will be valued at $213 650 000. To hedge a
$250 000 000 portfolio, the fund manager could take a long position in VIX
futures. A general rule of thumb is to enter into one contract for each $100 000 of
market exposure, or 2500 contracts. The position is initially worth 2500 x $1000 x
22 = $55 000 000.
Section 19.5
b. Determine the net valuation of the strategy if the position is closed out when the
S&P/ASX 200 Index stands at 5700 and the corresponding VIX stands at 38. (LO
19.5)
ANSWER
(b) When the VIX increases to 38, the position is worth $95 000 000. The futures
profit of $40 000 000 partially offsets the loss suffered by the physical portfolio.
Section 19.5
12 While financial futures contracts may be used to hedge the risk of fluctuations in the
prices of the underlying securities, the use of futures contracts often entails some risk.
What are the sources of risk arising from the use of futures contracts in risk
management? List, explain and demonstrate the implications of each type of risk. (LO
19.6)
ANSWER
Important risks associated with using futures contract are standard contract sizes,
margin risk, basis risk and cross-commodity hedging.
Standard contract size:
 Financial and commodity futures contracts are traded on a formal exchange and
therefore contract terms and conditions are standardised; for example, the short-
term interest rate futures contract is only based on the 90-day bank accepted bill,
each contract has a face value of $1 million and must be settled on specified
contract dates.
 Similarly, the main share index futures contract is based on the S&P/ASX200
Index multiplied by 25, expressed in dollars. Also, the individual listed share
contracts are based on an underlying 1000 shares.
 In order to exactly match the dollar amount of an interest rate risk exposure, the
exposure would need to be for $1 million (1 contract), $2 million (2 contracts)
etc.
 It is to be expected that the majority of risks will be for amounts lesser or greater
than the standard contract sizes, especially for smaller businesses.
Margin risk:
 The futures exchange clearing-house requires buyers and sellers of contracts to

pay an initial margin, or deposit. If the price of the contract moves against
contract holders, they will be required to make maintenance margin calls to top-
up the margin held by the clearing-house.
 If a margin call is not made the clearing-house will automatically close-out the
position.
 The funds held in the margin account will be used to offset any futures contract
losses.
 There is a need to assess the opportunity costs and liquidity risks associated with
making margin calls.
Basis risk:
 Basis risk is a situation where pricing differentials between markets are evident.
 The price of a futures contract is derived from the underlying physical market
commodity or financial instrument.
 Price differentials are often evident between the futures market contract price and
the physical market price. The longer the term to maturity of a futures contract,
the greater is the potential price differential.
 Differentials appear because futures contract pricing include a component
relating to forecast price movements. For example, current bill yields may be
5.80%, but the market expects they will rise; the futures contract will incorporate
the expected rise in the yield.
 Initial basis risk occurs at the commencement of a futures hedging strategy.
 Final basis risk may be evident when closing out an open position.
Cross-commodity hedging:
 Using a futures contract based on one commodity or financial instrument to

hedge a risk associated with a different commodity or financial instrument.
 Contract specification on futures contracts are standardised; for example, to
hedge a short-term interest rate exposure, using futures contracts, it is necessary
to use the 90-day bank accepted bill contract. The hedger may in fact be exposed
to changes in yields at the roll-over dates of promissory notes (commercial
paper).
 Another example is of a share market investor using share index futures contracts
to manage the exposure of an investment portfolio. The futures contract is based
on the S&P/ASX200 Index; however, the investor may well hold a portfolio of
only a small number of shares
 While price correlation will exist in the above example, they may not be
constant.
Section 19.6
13 a. Define the forms of basis risk and explain why it is important for a hedger to
understand this risk prior to dealing in derivative products. Use examples to explain
your responses.
ANSWER
 One of the basic principles of risk management hold that in managing one risk
exposure, you may in fact be creating another risk exposure. It is therefore
essential for a risk manager to understand completely the risk management
products and strategies that are available, and the implications of using these.
 Within the context of the futures market, basis risk describes the difference
between the price of a commodity or financial security in the physical market,
and the price of the related futures contract.
Initial basis risk:
 Occurs when pricing differentials appear between the physical market and the
futures market at the commencement of a hedging strategy
 Initial basis will be evident where the market generally has adopted the view that
prices in the physical market will change; for example, if a company with a loan
facility that is due to be rolled over in three months is concerned that interest
rates may rise in that time, then in all probability other market participants have
also come to the same view. The forecast rise in interest rates will be reflected in
a rise in yields in the futures market. It is then a question of how far yields are
expected to change that will be reflected in the futures contract pricing. In this
situation the interest rates quoted in the physical market will be the current rates,
whereas the rates quoted in the futures market will reflect the forecast change in
rates, thus creating initial basis risk.
Final basis risk:
 Occurs when pricing differentials between the physical market and the futures
market appear at the completion of a hedging strategy; for example, while a
company may use a 90-day bank-accepted bills futures contract to hedge a
borrowing exposure. Final basis risk will occur where the company is unable to
discount its bills in the physical market at exactly the same yield used to price the
futures contract. One reason that there will be a difference between the actual
cost of borrowing in the physical market and the price of the futures contracts
will be the level of risk attributed to the borrower. The discounter will add a
margin for the borrower’s credit risk and this will result in final basis risk
between the prices quoted in the futures market and the physical market.
 Typically, initial and final basis risk will be evident between the markets and this
means that it is generally not possible to set up a perfect hedging strategy.
Section 19.6
b. When hedging risk, what is cross-commodity risk? In your answer provide

examples to explain cross-commodity risk within the context of interest rate risk and
share price risk. (LO 19.6)
ANSWER
 Cross-commodity hedging refers to the use of a futures contract based on one

commodity or financial instrument to hedge a risk associated with another
commodity or financial instrument.
 The necessity for cross-commodity hedging arises because futures contracts are
available for only a relatively small number of commodities and financial
instruments.
 The cross-commodity hedge will use a futures contract that exhibit price
movements that are highly correlated with the price of the risk exposure to be
hedged; for example, a borrower that has issued securities into the money or
capital markets is exposed to interest rate movements. If the borrower intends to
use futures contracts to hedge that interest rate risk exposure it must decide
which type of futures contract to use. For example, within the Australian
markets the surrogate short-term interest futures contract is the 90-day bank
accepted bills contract; the medium-term contract is the 3-year Commonwealth
Treasury bond contract and the longer-term contract is the 10-year
Commonwealth Treasury bond contract. Therefore, a borrower may need to:
o use the 90-day bank-accepted bill futures contract to hedge a commercial paper
issue
o use the 3-year Commonwealth Treasury bond futures contract to hedge a loan
facility that could range from say 1 year to 5 years to maturity
o use the 10-year Commonwealth Treasury bond futures contracts to hedge a
longer-term debenture or unsecured note issue.
 While the prices of each of these pairings may be reasonably highly correlated,
the spread, or difference in prices, may not be constant through time. As a result
of changes in the spread, cross-commodity hedge risk is introduced. The
combination of basis risk and cross-commodity hedge risk means that a perfect
hedge can seldom be expected using futures contracts.
Section 19.6

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Chapter 19 End-chapter essay questions solutions

 A derivative is a financial product that is designed essentially to manage specific

 The basic rule to be followed in establishing a hedging strategy is to conduct a

4 a. Outline the procedure involved in buying a futures contract.

b. Indicate the implications of being long in a futures contract.

 The vast majority of open futures positions are closed-out by the

8 A business plans to borrow approximately $40 million in short-term funding through

Cash or Physical Market Futures Market

Three months time:

Hedge outcome: profit received from the futures

 To calculate the price of the three-year Commonwealth treasury bond futures

 The funds manager will close-out the position by selling a three-year

10 A funds manager currently manages a diversified Australian share portfolio valued

a. Today: set up a hedging strategy to manage the risk exposure.

b. In three months’ time: close out the open position.

 To close an open position, take opposite contracts

 Buy 1800 S&P/ASX200 futures contracts

11 A fund manager currently holds a well-diversified portfolio of Australian shares

 The futures exchange clearing-house requires buyers and sellers of contracts to

 Using a futures contract based on one commodity or financial instrument to

Initial basis risk:

Final basis risk:

b. When hedging risk, what is cross-commodity risk? In your answer provide

 Cross-commodity hedging refers to the use of a futures contract based on one

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