Chapter 11: Hedging

Exercises
1. Demonstrate that a synthetic forward on a stock can be constructed with a combination
of options on the stock, and that the prices of the two are equal. Assume that the stock
pays no dividends and use continuous time and discounting/compounding.
2. You are planning a large deal to sell Danish pastry during an upcoming sports event. It
requires a special type of wheat and you want to hedge the price risk of the wheat. You
performed a regression analysis of the changes in the spot prices of the special wheat
against the price changes of wheat futures on the Euronext exchange, and you have
found an optimal hedge ratio of 1. You plan to use 5000 kg of the special wheat and
Euronext future contracts are on 1000 kg of wheat.

(a) How many future contracts do you need for your hedge? Are they long or short?
(b) Does the optimal hedge ratio of 1 mean that you have a perfect hedge? Explain
why.

3. In the main text we have written the cash-and-carry relation for forward prices as F0 =
S0 (1 + rf )T . In continuous time this is written as F0 = S0 erT , or more generally
as Ft = St er(T t) where Ft is the price of a ’new’ forward contract written at any
time t before maturity T (so t < T ) using the corresponding stock price St and r is
the risk free interest rate. If the stock price follows the geometric Brownian motion
dSt = St dt + St dWt , what dynamic process does Ft follow over time? Use Itô’s
lemma.
4. You are a citizen of Euroland and in your …nancial newspaper you read the following
(spot) exchange rates in London and Frankfurt:

London Frankfurt
S£ $ = 0:619 Se$ = 0:757
S£ e = 0:818 Se£ = 1:223
S£ Y
= = 0:726 Se=
Y = 0:896

Dollars and pounds are quoted per 1, Japanese yen per 100. The notation is as in the
book, e.g. it takes e0.896 to buy Y
=100 in Frankfurt.

(a) Do these exchange rates o¤er any arbitrage opportunities between Frankfurt and
London?
(b) Brie‡y discuss the possibilities of foreign exchange arbitrage by private citizens.

5. You turn your attention to forwards and international money markets. The table below
summarizes information you collected about spot exchange rates, the one-year forward
exchange rates and the annual interest rates. The euro is your domestic currency.

1
 Currency Spot rate Forward rate Interest rate
US $ Se$ = 0:757 Fe$ = 0:7356 r$ = 6%
British pound Se£ = 1:223 Fe£ = 1:1891 r£ = 9%
Euro re = 3%

(a) Do the rates in the table o¤er any arbitrage opportunities?

(b) Explain how you would pro…t from the arbitrage opportunities you …nd, if any.
Show the transactions using an amount of e10 000 as an example.

6. You buy a forward on a share of ZX Co The share does not pay dividends. At the same
time, you buy a European put on a share of ZX Co The put matures on the same date
as the forward and its exercise price is equal to the forward price F .

(a) What does your position pay o¤ at maturity? Describe in terms of forward price F
and ST ; the share price at maturity.
(b) What other security gives exactly the same payo¤ at maturity?
(c) What does this say about the value today of that other security?
(d) What other way is there to derive the same relation between the put and that other
security?