Hello unbeliever73!
Here are the answers to your questions.
Question 1
Let's recall first the definition of futures contract:
"Futures [...] represent agreements to buy/sell some underlying asset
in the future for a specified price"
http://www.riskglossary.com/articles/future.htm
Also, recall that there is a negative relationship between bond prices
and the interest rates: as bond prices go up, interest rates go down,
and viceversa.
In this question, the investor is currently holding $1 million in
Treasury bonds. Thus, he or she will realize a gain if bond prices go
up (interest rates fall), and a loss if bond prices go down (interest
rates rise).
In order to hedge against this uncertainty in future interest rates
(and thus future bond prices), the investor should try to lock the
price at which he will be able to sell his bonds in the future. This
can be done by SHORTING Treasury bond futures, preferably of the same
type as the one he or she is holding.
Let's see what happens when price changes. If interest rates go up
(bond price falls), the investor would realize a loss if he or she did
not take the hedge. However, since he or she shorted Treasury bond
futures, when bond prices fall, a gain is realized on the futures
contracts position, because Treasury bond futures prices will also go
down as bond prices fall. Therefore, the loss suffered in the bonds
the investor holds will be offset (partially or fully, depending on
the size of the hedge) by the gain realized by shorting futures
contract.
Basically, by shorting futures, the investor locks in the future value
of his or her bond holdings, thus reducing or eliminating the risk in
his position.
Question 2
This question is very similar to the previous one. As in the previous
case, the treasurer worries about rising interest rates, as this means
that the cost of raising funds through the issuance of bonds will
become higher. So the treasurer needs to hedge against rising interest
rates, i.e. against falling bond prices, as in the previous question.
Therefore, the treasurer should SHORT Treasury bond futures with
delivery date three months from now. Thus, as before, if interest
rates rise, the higher cost for the firm to raise funds will be offset
by the gains in the futures contracts position.
It's interesting to notice that the hedge won't be as good as in the
previous question. Previously, the investor was hedging Treasury bond
positions with Treasury bond futures. In this case, the treasurer is
actually hedging corporate bonds position (taken in 3 months) with
Treasury bonds. Clearly, the interest rates on Treasury bonds may move
differently as the interest rates on corporate bonds, so that the
hedge could actually fail. For example, it may very well happen that
investing (buying bonds from) this corporation becomes more risky due
to a sector-specific shock (this firm may be a dot com just before the
dot com bust) so that the interest rates for its corporate bonds rise;
while the Treasury bonds may remain almost unchanged. In this case,
hedging would not eliminate the risk for this firm.
You may want to visit the following link (item 10.2) for another
example of hedging risk in a firm issuing bonds.
WWWFinance
http://www.duke.edu/~charvey/Classes/ba350/futures/futures.htm
Question 3
At the beginning of the page in the previous link, you will find a
list of commodity futures that are traded on futures exchanges.
Although there are quite a few in that list, there are many more
exchange-traded commodity futures, but it would be difficult to list
them all. The main categories of commodity futures are Agricultural
and Food, Metals, and Petroleum.
In all cases, firms that could usefully reduce risk by buying these
contracts are firms that use those commodities as inputs for its
production. For example, let's say we have a firm that produces
chocolate and candies, which will need to buy large quantities of
sugar and cocoa some time in the future. In order to hedge against
rising sugar and cocoa prices, the firm would need to buy sugar and
cocoa futures contracts, thus locking in the price at which the firm
will be able to buy these goods. Similarly, a car factory would be
interested in buying Steel futures. Energy-intensive firms may want to
hedge against rising oil prices by buying Oil futures contracts.
Who might wish to sell these contracts? As in any case, speculators
are always interested in buying and selling futures contracts, based
on their own prediction of whether the price will go up or down. But
they would be not hedging against anything. Firms that might wish to
sell these futures in order to usefully reduce risk would simply be
the firms that produce these commodities. Producers of commodities,
opposite to the firms in the previous paragraph, suffer losses when
the commodities prices fall. Therefore, they're interested in selling
futures in order to hedge, so as to lock in the price at which they
will be able to sell their goods. For example, farmers might wish to
sell wheat or corn contracts; oil-extracting firms might wish to sell
oil futures; etc. If they do, they should not worry about falling
commodities prices, because they would have already locked the price
at which they will sell their production.
Question 4
Is this a fair comment? Yes and no. It is true, in the sense that he
will have a loss if he sold futures at $3.40 but price stayed above
$3.40. Hadn't he sold the futures, he would be able to sell the wheat
at a higher price, thus he had a loss by selling them. However, this
is true by the time we know what happened to wheat prices. If the
farmer will only be able to sell his wheat 6 months from now, he
presently has no idea of what the price will be by then. So, by
selling futures, he's hedging against the possibility that wheat price
falls in the future.
Google search terms
"futures contract"
://www.google.com/search?hl=en&q=%22futures+contract%22
"corporate bond" hedge "treasury bills" futures
://www.google.com/search?hl=en&q=%22corporate+bond%22+hedge+%22treasury+bills%22+futures&spell=1
I hope this helps! If you have any questions regarding my answer,
please don't hesitate to request a clarification. Otherwise I await
your rating and final comments.
Best wishes!
elmarto |
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