Why hedging with futures contracts may not be perfect

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Reference no: EM131858009

Financial Derivatives and Risk Management

Problem 1. In February, a gold mining company expects to sell 10,000 ounces of gold inMay this year. Unwilling to take any risk, it has decided to hedge this position by using the June gold futures contracts traded on the New York Mercantile Exchange. One contract has a standardized size of 100 ounces. The current spot price is $1,260/oz and the price of the June futures contracts is $1,270/oz.

Please answer the following questions:

(1) Should the company take a long or short position in the futures market? Explain.

(2) How many contracts are needed?

(3) Assume that in May, the spot price drops to $1,240 and the futures price becomes $1,255/oz. Evaluate the hedging result. In other words, how much can the company actually receive from the sale of 10,000 ounces of gold and the futures position?

(4) Why hedging with futures contracts may not be perfect?

Problem 2. It is September 1. A company knows that it will need to purchase 20,000 barrels of crude oil sometime in November. It has decided to use December oil futures to hedge the purchase price risk. Crude oil futures are traded on the NYMEX, and each contract has 1,000 barrels. Right now, the spot price of crude oil is $55 per barrel and the December futures price is $60.

Please answer the following questions:

(1) Should the company take a long or short position in the futures market? Please explain.

(2) How many contracts are needed?

(3) Assume that when the company buys the crude oil in November, the spot price of crude oil rises to $61, and the December futures price becomes $65. Evaluate the hedging result. In other words, how much is the total purchase cost for 20,000 barrels of crude oil?

(4) Why hedging with futures contracts may not be perfect? Please explain.

Reference no: EM131858009

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