Question

On October, you own 10,000 shares of Don’t Worry Be Happy Inc. The spot price is $90 per share. You plan to sell the shares in November to pay for a house you have just bought. You are concerned that share prices will FALL substantially by November. There is a December futures contract on 100 shares of Don’t Worry Be Happy Inc. The futures price is $91 per share. You estimate the following regression for the hedging period:

Design an optimal hedging strategy.

(b) Assume that by November the spot price fell by $4.5 to $85.5 per share, and the futures price changed as estimated by the regression. What is the total gain/loss from the spot position? What is the total gain/loss from the futures position? How much money do you get from selling the shares and closing the hedge?

(c) Assume that by November the spot price rose by $4.5 to $94.5 per share, and the futures price changed as estimated by the regression. What is the total gain/loss on the spot position? What is the total gain/loss on the futures position? How much money did you get from selling the shares and closing the hedge?

Answer 1

Ans:

Number of Shares purcahsed : 10,000

Spot Price: $90

Future Price : $91

Part (b).

Spot Fell by november : $85.50

As per regression Method :

Future price by november: $91/$90*$85.50 = $86.45

1. Loss form Spot position: 10,000 * ($90 - $85.50) = $45,000

2. Gain form Future position: 10,000 * ($91 - $86.45) = $45,500

3. Money you will get from selling the shares and closing the Hedge : 10,000 Shares @91 = $91,000

Part (c).

Spot rose to november : $94.50

As per regression Method :

Future price by november: $91/$90*$94.50 = $95.55

1. Gain form Spot position: 10,000 * ($94.50 - $90.00) = $45,000

2. Loss form Future position: 10,000 * ($95.50 - $91.00) = $45,500

3. Money you will get from selling the shares and closing the Hedge : 10,000 Shares @91 = $91,000

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