Question

It is July 16. A company has a portfolio of stocks worth £30 million. The beta of the portfolio is 1.0. The company would like to use the December futures contract on a stock index to change beta of the portfolio to zero during the period July 16 to November 16. The index is currently 1,250, and each contract is on £250 times the index.

1. (a) What position should the company take? [6 marks]

2. (b) If the company instead wants to increase its portfolio beta from 1 to 2, what

   position in futures contracts should it take? [6 marks]

3. (c) Do the positions in (a) and (b) contain basis risk? [8 marks]

Answer 1

a) The company should take a short position in

=   

= 96 contracts

b) If the company wants to increase beta from 1 to 2, it will take a long position in

=

= 96 contracts

c)  Basis risk is considered a systematic, or market, risk. It is the risk arising from the inherent uncertainty of the markets. Between the time a futures position is initiated and closed out, the spread between the futures price and the spot price may widen or narrow. As the futures contract nears expiration, the futures price usually converges toward the spot price.

Different types of basis risk

1) Price basis risk

2) Location basis risk

3) Calendar basis risk

Both the long and short position contain basis risk.