Hedging Risks

Derivatives (3 credits)

Professor Michel Robe

Practice Set #5: Hedging with forwards vs. futures

What to do with this practice set? To help students with the material, eight practice sets with solutions shall be handed out. These sets contain mostly problems of my own design as well as a few carefully chosen, workedout end-of-chapter problems from Hull. None of these Practice Sets will be graded: the number of "points" for a question solely indicates its difficulty in terms of the number of minutes needed to provide an answer. Students are strongly encouraged to try hard to solve the practice sets and to use office hours to discuss any problems they may have doing so. The best self-test for a student of her/his command of the material is whether s/he can handle the questions of the relevant practice sets. The questions on the mid-term and final exams will cover the material covered in class. Their format, in particular, shall in large part reflect questions such as the numerical exercises solved in class and/or the questions in the practice sets.

Question 1 (15 points) We are on February 1st, 2010. Your employer, General Motors Corp. (Ann Arbor, Michigan), plans to import a first batch of 500 Opel Insignias from its plant in Rüsselheim, Germany, to rebadge them as “Regals” and to sell them in the U.S. via Buick dealerships. The German subsidiary of the company, Adam Opel A.G., has agreed to sell these cars to the US parent for a total of 10 million Euros, payable on April 9th, 2010. a. Explain how GM (U.S.) can use currency futures to hedge its exchange risk. Approximately how many futures contracts will GM need for the first monthly payment? (Recall that, on the CME, a Euro futures calls for delivery of Euro 125,000). (Hint #1: since April 9th falls in between the delivery date for the March contract (03-17-2010) and the delivery date for the June contract (06-16-2010), you must argue whether GM would be better off with a March or with a June contract.)...