Prof.

Roberto Steri Derivatives I - Problem Set 1 Spring 2019

Problem Set 1
Suggested Deadline: 08/03/2019

Forward and Futures Contracts:

Markets and Hedging Strategies

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

1. The investment fund Rusty Bear enters a short position to sell 10,000 shares of Microsoft for
50$ per share. The initial margin is 80% of the initial stock price and the maintenance margin
is 70% of the current stock price. Rusty Bear trades by putting the minimum amount of cash
on the margin account to satisfy the initial requirement.

a) What is the maximum possible pro…t the position Rusty Bear can get at maturity? What
is the maximum possible loss? Suppose that if the price falls below 20$, Rusty Bear will
be squeezed out and be forced to liquidate its position. What are the maximum pro…t
and loss in this case?
b) What is the minimum security price pM that will lead to a margin call? Would you
receive a margin call if the price is greater than pM ? Would your answer to the last
question change in the case of a long position in the very same stock?
c) What is the value of pM if the initial amount of cash in the account would be 500,000$
instead?
d) On the …rst two weeks the price of the futures goes down by 10%, and Rusty Bear
interprets this as a bearish sign for Microsoft and is willing to strengthen its position.
The requirements to short a contract are now a 75% maintenance margin, and a 85%
initial margin. What is the minimum amount of cash Rusty Bear needs to add to its
account to short additional 5,000 shares?

Solution

a) The maximum pro…t that Rusty Bear can obtain is in the case the price goes to zero,
that is 10; 000 50 = 500; 000$. The maximum loss is unbounded, since there is no
theoretical bound for price increases. If the company expects to be squeezed out at
20$, the maximum pro…t is 10; 000 (50 20) = 300; 000$. The maximum loss is still
unbounded.
b) A margin call for a short position occurs if
decrease in stock value max cash reduction
z }| { z }| {
10000 (p 50) 10000 0:8 50 10000 0:7 p

where p is the stock price at a given point in time. Solving with equality yields pM =

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

52:94$. The following picture illustrates the margin account balance:

Because the position is short, the value of the account decreases with the price, so every
price p > pM activates a margin call. Vice versa, with a long position, a margin call
occurs for every price p < pM .
c)
decrease in stock value max cash reduction
z }| { z }| {
10000 (p 50) 500000 10000 0:7 p

Solving with equality yields pM = 58:82$.

d) The price at the end of the …rst two weeks is p = 50 (1 0:1) = 45$. To short 5,000
additional shares, the new initial margin requirement must be satis…ed. Therefore the
minimum additional cash C to be added must be such that no margin call is triggered
on the two contracts, that is
Initial margin Excess cash wrt maintenance margin Extra cash from Pro…ts
z }| { z }| { z }| {
C = 5000 0:85 45 [10000 0:8 50 10000 0:7 45 + (50 45) 10000]

This yields C = 56; 250$.

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

2. A Soybean Futures Contract is traded in contracts with a size of 5,000 bushels. Prices are
quoted in cents per bushel, and the tick size is 0.25 cents per bushel.

a) Consider the following quote for December soybean

Suppose you have just purchased a long position on 10 SX14 contracts at the last price.
How much does the dollar value of your position increase if the price goes up by one
tick?
b) Suppose, for simplicity, that there are only three brokers (the Good, the Bad, and the
Ugly) in the clearing house. The brokers hold the following positions in SX14

Participant Long Short

the Good 10 3
the Bad 5 8
the Ugly 3 7

What is the open interest in the market?

c) Suppose the following orders are submitted to the brokers by their customers (and that
there are no existing orders):
1) customer A submits a limit order to buy one contract at 1005 cents to the Good,
and customer B submits a market order to sell one contract to the Ugly;
2) customer C submits a limit order to buy …ve contracts at 1006 cents to the Ugly,
and customer D submits a limit order to sell three contracts at 1006 cents to the
Bad;
3) customer E submits a market order to sell two contracts to the Good;
4) customer A submits a limit order to sell at 1005 cents to the Good, and customer D
submits a limit order to buy at 1005 cents three contracts to the Bad;
5) customer F submits a market order to sell two contracts to the Ugly;
6) customer A submits a limit order to buy at 1004 cents to the Good, and customer
F submits a limit order to sell at 1005 cents to the Bad.
Suppose the trading volume for the day before the orders were submitted was 18. What
is the …nal open interest? And the …nal trading volume? And the last price?

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

d) Consider the following quote

and match the following scenarios for the previous week (with respect to the quote above)
to the interpretations in the column at the right:

Solution

a)
$ $
10contracts 1004:25 1004 5000bushels = 125$
bushel bushel
b) The open interest is the sum of all long (or equivalently) short open positions. Therefore,
the answer is 18.
c) The following table summarizes the evolution of trading activity, open interest, trading
volume, and prices

Hence, the …nal open interest is 23, the …nal volume is 27, and the last price is 1005.

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

d)

In general:

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

3. PoorGold, a jewelry manufacturer, will require 1000 troy ounces (t. oz) of platinum on April
2015. The price for April 2015 delivery is 1415 $/t. oz. Futures contracts are sold on the
New York Mercantile Exchange (NYMEX) and are for the delivery of 50 t. oz of platinum.
While the spot price today (September 2014) is 1400 $/t. oz, PoorGold prefers to trade
futures instead of incurring insurance costs of storing platinum to hedge its price. For logistic
reasons, PoorGold will not have the platinum delivered through the futures contract, but will
close its futures position on the April 2015 spot market and buy platinum at the spot price.

a) How many contracts should PoorGold buy or sell to minimize its exposure to platinum
price? What is the e¤ective cost of purchasing platinum if April 2015 price would be
1450 $/t. oz, with and without the hedge you propose? What if April 2015 price would
be 1350 $/t. oz instead?
b) PoorGold has mandated a market research company to study the possible scenarios for
the platinum market in April 2015. After reading their report, PoorGold’s management
believes in the following scenario:

April Platinum
Strong Weak
Probability pS pW
Spot Price 1440 1350

where pS and pW are the probability the …rm attaches to the strong and weak market
conditions and the management is trying to evaluate. The company needs to decide how
much of the 1000 t. oz. requirement to purchase on the spot market in April 2015, and
how much with the April 2015 futures. Suppose the …rm is risk neutral. What is your
recommendation?
c) PoorGold has recently changed its product o¤er. For this reason the company would
like to sell its 250,000 t. oz. excess inventory in two batches: B1 t. oz. in January
2015, and B2 t. oz. in May 2015, by shorting the corresponding silver futures on the
COMEX division of NYMEX. Prices for January and May delivery are 19 $/t. oz. and
19.5 $/t. oz respectively. The size of both contracts is 5,000 t. oz. To ful…ll unexpected
production needs, PoorGold does not want to sell more than 150,000 t. oz. in January
2015. For each t. oz. stored from January to May, there is a marginally increasing cost
c given by
c= Q

where Q is the residual inventory after January’s sale, = 1:5, = 9:622 5 10 4 . What
are B1 and B2 that maximize total revenues from silver sales? How many contracts will
you respectively sell in January and May?

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

Since convenience yields and interest rates are expected to be approximately the same,
the time value of money is negligible and can be ignored.

Solution

a) The company can hedge the platinum price perfectly by entering a long hedge for N = 20
contracts. Denote as pAP R the spot price of platinum in April 2015. The e¤ective cost
of purchasing is:
purchase costs pro…ts from futures
z }| { z }| {
1000 pAP R 20 50 (pAP R 1415) = 1; 415; 000$

which is invariant with respect to April 2015 spot price.

b) Denote as N the number of futures contracts to be purchased. The expected purchasing
cost in April 2015 is
2 pro…ts from futures
3
purchase costs
z }| { z }| {
pS 41440 1000 N 50 (1440 1415)5 +

2 pro…ts from futures

3
purchase costs
z }| { z }| {
pW 41350 1000 N 50 (1350 1415)5

The coe¢ cient on N is negative (i.e. buying more contracts decreases costs) if

50 [pS (1440 1415) + (1 pS ) (1350 1415)] > 0

which implies
expected spot price futures price
z }| { z}|{
pS 1440 + (1 pS ) 1350 > 1415

Intuitively, when the expected spot price is higher than the futures prices, increasing N
reduces costs and PoorGold expects to be better o¤ with hedging. Solving for pS yields:

pS > 0:722

Therefore, if the management is con…dent that the strong market will happen with a
probability greater than 0:722 they should hedge by buying N = 20 contracts, otherwise
they should buy platinum on the spot in April 2015.

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

c) The revenues from sales are

= B1 19 + B2 19:5 B2

with B2 = 250; 000 B1 and B1 150; 000. Substituting the equality constraint and
maximizing revenues with respect to B2 yields the following optimality condition for a
maximum (warning: check this is a maximum and not a minimum!):
1
0:5 B2 =0

which yields
1
0:5 1
B2 = = 120; 000

The solution satis…es the inequality constraint on B1 . Therefore:

B1 = 130; 000 t. oz
B2 = 120; 000 t. oz

Thus, PoorGold needs to short 26 contracts in January and 24 contracts in May.

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

4. HappyPork, a farm based in Lamar (Missouri), is concerned about ‡uctuations of the price of
grain sorghum (milo), which is used to as a feed grain for their livestock. HappyPork needs to
buy 10,000 hundredweights (cwt) of milo in May 2015 and would like to minimize the variance
of this position by going long in futures contracts. However, there are no futures with milo as
the underlying asset.

a) Suppose HappyPork decides to use corn futures to achieve its goal. Corn futures have a
contract size of 5,000 bushels (bu.). A regression of May milo prices on May weekly corn
futures prices for the last 30 years delivers the following result.

Intercept Slope R2
0.60 1.5 92%

How many corn futures should HappyPork purchase?

b) Chuck Sornir, HappyPork’s owner, heard through the grapevine that his competitor -
the farm SoggyPig based in Hannibal (Missouri) - bought 10 May futures contracts on
the Chicago Mercantile Exchange (CME) to hedge May 2015 milo. Historically, the two
farms have had approximately the same size. Chuck asks to his sta¤: "Why is SoggyPig
buying so many contracts? Are they trying to expand?". One sta¤ member replies: "This
is impossible, my sister lives in Hannibal, and they sold many of their cows recently. I
am totally sure they need less milo than we do in May. I suspect this is because of
geographical di¤erences in milo prices. They often have hailstorms over here".
The sta¤ then obtains the following regression table for May corn in Hannibal:

Intercept Slope R2
-0.1 1.6 95%

Supposing all the information about SoggyPig is accurate, what is a plausible explana-
tion?
c) The weekly standard deviations of milo and corn prices are respectively and 0.05 and
0.03. What is the percent reduction of the variance of the e¤ective purchasing costs at
point a) that HappyPork can obtain in comparison to buying milo on the spot market
in May 2015?

Solution

a) The minimum variance hedge ratio h is the slope of the regression, that is 1.5. The
number N of contracts is therefore
QA 10000
N =h = 1:5 =3
QF 5000

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

b) The number of contracts used by SoggyPig is N SP = 10, and is given by

SP SP QSP
A
N =h
QSP
F

SP
From the information above, we know that h = 1:6, so we obtain:
QSP
A N SP 10
SP
= SP
= = 6:25
QF h 1:6

We also know that QSP

A < QA = 10000. Therefore

10000
> 6:25
QSP
F

which yields:
10000
QSP
F < = 1600
6:25
Therefore, SoggyPig must be necessarily using di¤erent contracts, namely mini-corn
futures. For example, there is a mini-corn futures traded on the CME with contract a
size of 1,000 bushels. In that case, the size of the milo position to hedge would be
QSP
F
QSP
A = N
SP
= 6250 cwt
h SP
consistent with all the information provided.
c) Denote as St and ST the spot prices of milo today and in May 2015 respectively, as Ft
and FT the corn futures price today and in May 2015 respectively, and as QA and QF the
quantities of the milo to hedge and of corn underlying the futures contract to purchase.
The total expense CT in May 2015 is
purchase costs pro…ts from futures
z }| { z }| {
CT = ST QA (FT Ft ) QF

De…ning the (non-necessarily "optimal") hedge ratio as

QF
h
QA

CT can be written as
CT = QA (ST (FT Ft ) h)

whose variance is

V ar(CT ) = Q2A ( 2
S + h2 2
F 2h S;F F S)

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

where F is the standard deviation of corn futures prices, S is the standard deviation of
milo prices, and S;F is the correlation coe¢ cient between corn futures and milo prices.
The necessary and coe¢ cient stationary condition for a minimum (check!) is

@V ar(CT )
=0
@h
which indeed yields
S
h = S;F
F

The minimized variance is therefore:

V ar(CT ) = Q2A ( 2
S + (h )2 2
F 2h S;F F S) = 47; 500

because the values h = 1:5, S = 0:05 and F = 0:03 imply S;F = 0:9.
QF
With no hedging, we would have h = QA
= 0, with a variance of

V ar(CT ) = Q2A 2
S = 100002 0:052 = 250; 000

250;000 47;500
The percent reduction is therefore 250;000
= 81%.

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

5. Liquid Stone Sons & Co. is a fund with $150 million of assets under management. The of
the fund’s portfolio is 0.5.

a) Suppose the manager is concerned about the performance of the market over the next
six weeks and wants to hedge her portfolio by using 3-month futures contract on the
S&P 500 index. The size of one contract is 250$ times the index. The current level of
the index is 2000, and so is the 3-month futures price. How many contracts should the
manager short to reduce the portfolio to 0.25?
b) In the portfolio there is a signi…cant position of 25,000 shares of Apple, worth 100$ per
share. The manager is considering hedging only this position. He believes Apple will
outperform the market over the next three months, but is also concerned about a possible
bear market. The of Apple is 1.3. The manager …nally decides to short 2 three-month
contracts on the S&P 500 index. What is the actual of the position after the hedge?
Do you think this is an e¤ective hedge against the fund’s exposure to Apple’s share price?
c) Suppose that in three months the market index is 1950, and the 3-month riskfree rate is
1%. The value of the fund’s expected overall position in three months in this scenario,
including the gains from hedging, is $151.5 million. What is the three-month dividend
yield on the index?

Solution

a) The number of contracts is:

value of porfolio
beta reduction z }| {
z }| { 150 106
N = (0:5 0:25) = 75
250
| {z2000}
value of underlying
a futures contract

b) If the fund shorts 2 contracts the following must hold:

value of shares
number of contracts beta reduction z }| {
z}|{ z }| { 25000 100
2 = (1:3 )
250
| {z2000}
value of underlying
a futures contract

where is the desired e¤ective . Solving for yields a value of 0.9. In practice,
hedging individual stocks through their exposure to the index is not as performing as
hedging entire porfolios, because the exposure to the market is only a relatively small
proportion of the total risks in the price of individual stocks.

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Prof. Roberto Steri Derivatives I - Problem Set 1 Spring 2019

c) If the index goes down to 1950, the gain from futures is

75 (2000 1950) 250$ = 937; 500$

The three-month expected return on the original porfolio E[R], by the CAPM, is

E[R] = Rf + (RM Rf )

where Rf is the riskfree rate, and RM is the return on the index. The ex-dividend loss
on the index is 200020001950 = 2:5%, so that

RM = 0:025 + d

and
E[R] = 0:01 + 0:5 (d 0:035)

where d is the dividend yield. The expected value of the overall position is therefore

150 106 (1 + E[R]) + 937500 = 151:5 106

Solving for d gives a three-month dividend yield of 2:25%.

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