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Hedging with derivatives

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Because of your impending MBA, you are the chair of the pension committee at the hospital where you work. Itââ?¬â?¢s a small, young hospital with a $40 million pension account-50% invested in an international bond index fund, and 50% invested in a S & P 500 index fund. Your economics/financial consultant expects a rise in interest rates and constant stock prices during the next two years.
a. Cite a strategy using derivatives to hedge against the possible rise in interest rates.
b. Explain how covered calls (long calls) can be used to create additional income on the equity portfolio during periods when the market is flat, i.e., cyclically constant stock prices.

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A forward rate agreement (FRA) could be used to hedge against interest rate hikes. If the pension fund foresees a need to borrow in the future, in order to meet its obligations, it would want to fix the interest rate at today's lower rate rather than borrow the money later at the higher rate. The hospital's pension fund would enter into an agreement with a FRA dealer that specifies a fixed interest rate. If at the ...

Solution Summary

using derivatives to hedge against the possible rise in interest rates; use of covered calls to generate additional income

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See Also This Related BrainMass Solution

10 Multiple choice questions on derivatives: short hedge, basis, anticipatory hedge, spot, asset, underlying, futures, cross hedge, minimum variance hedge ratio, profit at expiration, profit on a hedge, bonds, optimal stock index futures hedge ratio, portfolio, beta, S&P 500 futures, multiplier, ordinary hedge, risk

Please see attached.

1.
A short hedge is one in which
a. the margin requirement is waived
b. the futures price is lower than the spot price
c. the hedger is short futures
d. none are correct
e. the hedger is short in the spot market

2.
What happens to the basis through the contract's life?
a. it initially increases, then decreases
b. it moves toward zero
c. it initially decreases, then increases
d. it remains relatively steady
e. none are correct

3.
An anticipatory hedge is one in which
a. none are correct
b. the spot position will be taken in the future
c. all are correct
d. the basis is expected to fall
e. the hedger expects to make a profit on the futures

4.
A hedge in which the asset underlying the futures is not the asset being hedged is
a. none are correct
b. a cross hedge
c. a basis hedge
d. a minimum variance hedge
e. an optimal hedge

5.
Which technique can be used to compute the minimum variance hedge ratio?
a. regression
b. all are correct
c. duration analysis
d. none are correct
e. present value

6.
Suppose you buy an asset at $50 and sell a futures contract at $53. What is your profit at expiration if the asset price goes to $49?
a. -$1
b. $4
c. none are correct
d. -$4
e. $3

7.
Which of the following is not a reason for firms to hedge?
a. Hedging by corporations can have tax advantages
b. Shareholders are not always aware of their firms' risks
c. Firms can hedge less expensively than can their shareholders
d. none are correct
e. Shareholders cannot tolerate mark-to-market losses

8.
What is the profit on a hedge if bonds are purchased at $150,000, two futures contracts are sold at $72,500 each, then the bonds are sold at $147,500 and the futures are repurchased at $74,000 each?
a. -$500
b. -$5,500
c. -$2,500
d. -$3,000
e. none are correct

9.
Find the optimal stock index futures hedge ratio if the portfolio is worth $2,400,000, the beta is 1.15 and the S&P 500 futures price is 450.70 with a multiplier of 500.
a. 10.65
b. 5325.05
c. none are correct
d. 6123.80
e. 12.25

10.
Though a cross hedge has somewhat higher risk than an ordinary hedge, it will reduce risk if which of the following occurs?
a. futures prices are more volatile than spot prices
b. futures prices are less volatile than spot prices
c. spot and futures prices are positively correlated
d. the spot and futures contracts are correctly priced at the onset
e. none are correct

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