Exam 20: Futures Contracts

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The item being traded is not transferred at the time of the futures contract, so the margin is not a down payment. Instead, it is a performance bond. It is common for the margin to be in the range of two to ten percent of the value of the contract.

Correct Answer:

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Solution: (a) Since the manager is long in the cash market, the correct hedge is a short futures position.
This problem ignores weighted hedges. The $\$ 2$ million face value represents $\$ 2,000,000 / \$ 1000=2000$ bonds, which at a current price of 77 is worth $\$ 1,540,000$ .
The manager sells 20 contracts at a current price of 67 , for a total transaction value of $20(\$ 67,000)=\$ 1,340,000$ . Repurchasing the futures three months later at a price of 60 results in a total cost of $20(\$ 60,000)=\$ 1,200,000$ .

$\begin{array}{llll}\text { Beginning sale } \quad \$ 67,000 \times 20 & = & \$ 1,340,000 \\\text { Ending purchase } \quad \$ 60,000 \times 20 & = & \underline{1,200,000} \\\text { Gain from short futures } & = & \$ 140,000\end{array}$


(b) As noted in (a), there are 2000 bonds. If the bonds are priced at 68 three months later, the cash market position is:

$\begin{array}{llll}\text { Beginning: } & \$ 770 \times 2000 & = & \$ 1,540,000 \\\text { Ending: } & \$ 680 \times 2000 & = & \underline{\$ 1,360,000} \\\text { Loss from long bonds }& & = & \$ 180,000\end{array}$

$\text { (c) The net effect of this hedge is a loss of } \$ 40,000 \text {. }$

$\begin{array}{lll}\text { Gain from short futures } & = & \$ 140,000 \text { from part (a) } \\\text { Loss from long bonds } & = & \underline{180,000 \text { from part (b) }}\\\text { Net loss }&&{\$ 40,000}\end{array}$