LSE FM423 Asset Markets

Lou

Problem Solutions for Lecture 13

1. There is little hedging or speculative demand for cement futures, since cement prices
are fairly stable and predictable. The trading activity necessary to support the futures
market would not materialize.

2. (a) On one hand, the hotel chain faces the risk that the price at which it purchases
coffee will rise. On the other hand, the hotel chain can pass along these costs to
the consumers of the coffee, so it is not clear to what extent the hotel chain will
be affected by an increase in coffee prices.
The hotel chain’s ability to pass along rising costs to its customers is a type of
natural hedge. A company’s failure to recognize its natural hedges can lead to
“hedges” that actually increase risk (e.g. a hotel chain that locks in its costs by
buying forward coffee might be at a competitive disadvantage if coffee prices fall).
(b) The coffee farmer has no natural hedge and is at risk if the price of coffee falls.
The coffee farmer may wish to sell forward coffee.
(c) See (a) and (b).
(d) When entering into the contract, the coffee farmer presumably understood the
risk that a hedge would lock in a lower selling price if coffee prices rose above
the futures price. The fact that the farmer lost the upside while protecting the
downside does not indicate that there were “losses” or that the farmer was wrong.

3. (a) The March future price is 1491.80. One unit of the contract is worth $250 times
the S&P500 index. If margin is 10%, you must deposit .1*250*1491.80 or $37,295.
(b) The futures price increases by: 1,498.00 1,491.80 = 6.20 The credit to your margin
account would be: 6.20 $250 = $1,550. This is a percent gain of: $1,550/$37,295
= 0.041561 = 4.16% Note that the futures price itself increased by only 0.416%.
(c) Following the reasoning in part (b), any change in F is magnified by a ratio of
(l/margin requirement). This is the leverage effect. The return will be -10%.