Money and Banking - Study Guide - Chapter 13

Essays
1. Explain the difference between using the future markets for hedging and for speculating.
2. Explain why futures markets are insurance markets.
3. Explain how exporters and importers would use futures contracts.
4. Explain how borrowers and lenders would use futures contracts.
5. Evaluate the following statement: "Speculators destabilize markets."
6. Explain the differences between forward contracts and futures contracts.

Problems
1. Assume that you are a corn farmer in Iowa and you will have an expected harvest of 100,000 bushels of corn in six months. Cost of production is estimated at $2.50/bushel. The farmer is considering hedging with corn futures. What is the farmer's net profit or loss under the following situations:
a. the farmer doesn't hedge and corn sells at $2.85 in the spot market at harvest.
b. the farmer doesn't hedge and corn sells at $2.10 at harvest.
(Note: for c-f, assume that the farmer settles the futures contract in cash and sells his/her corn in the spot market. Solve each part separately and then calculate the net profit/loss.)
c. the farmer hedges by selling 100,000 bushels of corn futures short at $2.60 and corn in the spot market sells at $2.80/bu. at harvest.
d. the farmer hedges by selling 100,000 bushels of corn futures short at $2.60 and corn is selling at $2.00/bu at harvest.
e. the farmer hedges by selling 50,000 bushels of corn futures short at $2.60 and corn in the spot market sells at $2.80/bu. at harvest.
f. the farmer hedges by selling 50,000 bushels of corn futures short at $2.60 and corn is selling at $2.00/bu at harvest.

2. Assume that you have inside information that in several months the Russian government is going to make massive purchases of wheat.
a) Explain how you would use this information to speculate in the futures market of wheat. Wheat futures are trading at $6/bu.
b) If the actual spot rate in three months was $6.10, and you have one contract (5000 bu) did you make or lose money? How much?
c) If the actual spot rate in three months was $5.95, and you have one contract (5000 bu) did you make or lose money? How much?
d) If your total investment in the contract was $1000, calculate your rate of return in parts b and c.

3. An investor will have $5m to invest in the bond market in six months. Explain why and how they could use T-bond futures to hedge against interest rate risk. What type of person would take the opposite position of the investor?

4. A real estate developer is building a shopping mall with a construction loan. The project will be finished in a year and the developer will then seek permanent financing for the real estate in the form of a 30 year mortgage. How and why would the developer use Tbond futures to hedge against interest rate risk.

5. Royal Caribbean Cruise Lines is considering using commodity futures to hedge against price risk. Currently, April 1997 oil futures contracts are selling at $18/bbl. Assume RCCL buys 100,000 barrels every April for the cruise season. Additional costs of operation are fixed at $1.5m. Revenues are expected to be $4m. Assume that RCCL settles the futures contract in cash and buys oil at the spot rate. What would RCCL's annual profit be under the following situations?
a. no hedging and oil ends up at $32/bbl in the spot market next April.
b. no hedging and oil ends up at $16/bbl in the spot market next April.
c. RCCL hedges 100,000 barrels at $18/bbl and oil ends up at $32/bbl in the spot market.
d. RCCL hedges 100,000 barrels at $18/bbl and oil ends up at $16/bbl in the spot market.
e. RCCL hedges 50,000 barrels at $18/bbl and oil ends up at $30/bbl in the spot market.

6. Suppose that you plan to take an early retirement buyout next year, move to the country and build a log cabin. The early retirement plan includes a lump sum payment of $100,000, which you plan to invest in Tbonds. What type of risk do you face and how could you use lumber futures and Tbond futures to minimize your risk? (specify the positions that you would take - going long or going short).

7. Explain the type of interest rate risk that S&Ls face. How could they use futures contracts to hedge this risk.

8. Explain how you could use S&P 500 Stock Index futures to hedge your stock portfolio and provide portfolio insurance.