Posted: August 15th, 2015

Future Hedging and Interest rates

For each question, there should be a brief introduction, the body of the answer and a conclusion section. Students are expected to write clearly and concisely, with appropriate in-text citation and references provided (Harvard system).

This assignment is designed to test students on Topic 1 (Futures hedging) and topic2 (interest rates)

Question 1 (10 marks)

A company uses an alternative energy source called Liquid X. The recent movements on the price of oil have caused volatility in the price of Liquid X and so the company wishes to hedge its exposure to Liquid X. The price changes of liquid X have a 0.7 correlation with gasoline futures price changes.
The company will lose $500,000 for each 1 cent increase in the price per gallon of Liquid X over the next two months. Liquid X has a standard deviation that is 50% greater than price changes in gasoline futures prices. Futures contracts on Liquid X are non-existent and the company uses gasoline futures to hedge its exposure to Liquid X. Assume each gasoline futures contract is on 40,000 gallons.
Two months later, the price of Liquid X rose by 2 percent from US$2.50 per gallon.
a. What should be the hedge ratio in the use of gasoline futures to hedge its exposure?
b. What is the company’s exposure measured in gallons of Liquid X?
c. What position measured in gallons, what is the type of position should the company take in gasoline futures to hedge its exposure?
d. How many gasoline futures contracts should be traded in this hedging strategy?
e. After two months, what is the gain/loss in the spot market and the trading gain/loss on the futures contracts in part d?

Question 2 (10 marks)

Global investors are not waiting for the Federal Reserve (Fed) to raise interest rates this year. They are already betting that interest rates are going to increase in the U.S. this year, the first in nearly a decade. According to CME Fed Watch (on 19 March 2015), the Fed’s funds futures contracts suggest a 12 percent probability of a June rate hike, a 49 percent probability of an increase in September, a 70 percent probability of a rate hike in October, and an 79 percent of December rate hike. The history of the past three tightening cycles showed that the US dollar gains in the six to nine months preceding the first interest rate hike over the cycle.

Discuss the impact of the market’s expectations of US interest rates on capital movements, Asian currencies and global economic growth.

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