Portfolio Hedging and Risk Management: Futures, Swaps, and Strategies

This assignment delves into various aspects of financial risk management, focusing on hedging strategies using futures contracts and swap valuation. It explains open interest and the convergence of future prices to spot prices, along with the computation of hedge ratios and contract sizes for managing inventory risk. The assignment further calculates the amount of a portfolio that should be hedged using Fisher's formula, considering factors like beta and withdrawal amounts. Lastly, it explains the construction of swaps using floating and fixed-rate bonds, providing a detailed valuation of an interest rate swap. Desklib provides a platform where students can access this solution and many other solved assignments for their academic needs.

EXPLANATION AND
REASONING

TABLE OF CONTENTS
QUESTION 1...................................................................................................................................3
A. Explanation on open interest .................................................................................................3
B. Reason of convergence of future price to its spot price.........................................................3
QUESTION 2...................................................................................................................................3
Determining hedge ratio and contract size..................................................................................3
QUESTION 3...................................................................................................................................4
Calculating amount of portfolio which should be hedge through Fisher....................................4
QUESTION 4...................................................................................................................................4
A. Explaining construction of swap with application of floating rate bond and fixed rate bond
.....................................................................................................................................................4
B. Value of Swap........................................................................................................................5
REFERENCES................................................................................................................................7

QUESTION 1
A. Explanation on open interest
Open interest is refereed as total number of open contracts on basis of security which are
applied at initial position in future market. If there is increase in open interest with its price then
it is reflected as upward trend. In the similar aspect, if open interest raises with decrement in
price gives downward trend. These movements in prices at flat open interest rate might decline
and indicates possible reversal trend (Xiao and et.al., 2018).
In the similar aspect, if prices are increasing along with open interest and volume are up
indicates that market are strong. Further, if prices are again increasing but open interest and
volume is down then there is presence of weak market. If there is decline in prices and volume
and open interest is down then strength has been gained through market.
B. Reason of convergence of future price to its spot price
The future price would be inched towards and becomes equal to its price of spot at the
month of progress. It is considered as very strong trend which had been occurred at underlying
asset with its contract (Zhang, J. and et.al., 2018). This convergence is explained as arbitrage
along with law of demand and supply. The impact of arbitrageurs would be directly shorting
specific future contract which creates fall in these as it raises supply of contracts for availability
of trade. The purchase of underlying asset creates rise in whole demand for asset along with its
spot price as outcome.
It would be continued through arbitragers as spot and future price will be converged until
they are less or more equal. The similar effect would occur with higher spot prices as compared
to fixture. The main exception is during arbitrageurs short sell asset and future contracts are long
(Białkowski and Koeman, 2018).
QUESTION 2
Determining hedge ratio and contract size
Computation of hedge ratio and contract size
Particulars Formula Figures
Current inventory goods 1250 tonnes
Standard deviation 0.22
Contact size 10

Volatility of future 0.44
Correlation future and spot cocoa 0.88
Contract size 10 tonnes
Hedge ratio
Correlation*(standard
deviation/Volatility) 0.44
Contract
(hedge ratio*current
inventory goods)/Contract
size
55
Interpretation: In the above scenario, hedge ratio has been extracted with correlation,
standard deviation and volatility. It has presence positive correlation of 0.44 through it must
trade 55 contracts (buy).
QUESTION 3
Calculating amount of portfolio which should be hedge through Fisher
Particulars Figures Particulars Figures
Beta 1.6
equity 60 million
Amount needs
to be hedged 50000000
withdrawal in 4 months
Withdrawal
amount 10 Million
Particulars Contract value Value Size Hedge
September 2088.5 250 8.354 9576250.89
December 2100 250 8.4 9523809.52
March 2110.5 250 8.442 9476427.38

Interpretation: The above table has stated amount of portfolio which should be hedged,
as it is extracted by q=(n/f)*beta. From September, December and march it has to hedge
9576250.89, 9523809.52 and 946427.38 respectively.
QUESTION 4
A. Explaining construction of swap with application of floating rate bond and fixed rate bond
The swap rate is fixed rate of interest which had been demanded by receiver's demand
exchange for having uncertainty to pay short term floating rate over time. With context of
agreement of swap along with whole value of swap's fixed rate flow is considered as expected
payments of floating rate which is implied through floating curve. There will be alteration so
fixed rate about demand of investors had been entered in new swaps. These swaps are quoted as
fixed rate (Aragon and Li, 2018).
B. Value of Swap
The data had been taken from example 22.2 that had been provided from your side
Floating Rate Loan $100 million
Floating Interest Rate @6%
Now in this case study we have to assume that payments are made half yearly so coupon rate will
6%/2=3%=.03
Time Maturity in Years Zero Coupon Bond Prices Bond Prices (0,T)
0.5 B(0,0.5) 0.99
1 B(0,1) 0.97
1.5 B(0,1.5) 0.95
2 B(0,2) 0.93
2.5 B(0,2.5) 0.91
3 B(0,3) 0.88

The Fixed Payment that has to be made at end of each period
C=Loan Amount * Interest Rates
C=100*.03(.06/2)
C=$3 Million
Fixed Payment that had to be made at end of each period is $3 Million.
Calculation of Present Value of Fixed rate loan is
PV of Fixed Loan= B(0,.5)*C+B(0,1)*C+B(0,1.5)*C+B(0,2)*C+B(0,2.5)*C+B(0,3)*Loan
Amount
PV of fixed loan= (.99+.97+.95+.93+.91+.88)*3+.88*100
=$104.89 Million
As floating rate loan is equal to par value at payment dates
So, PV of Floating Loan=$100 million
Value of Swap=Present Value of Floating Rate Loan- Present Value of Fixed Rate Loan
=$100-$104.89
=$-4.89 million
Interpretation
The Above calculation states that for entering into swap, company have to be paid $4.89
million today (Kaufman and Hopewell, 2017).

REFERENCES
Books and Journals
Aragon, G. O. and Li, L., 2018. The use of credit default swaps by bond mutual funds: Liquidity
provision and counterparty risk. Journal of Financial Economics.
Białkowski, J. and Koeman, J., 2018. Does the design of spot markets matter for the success of
futures markets? Evidence from dairy futures. Journal of Futures Markets, 38(3), pp.373-
389.
Kaufman, G. G. and Hopewell, M. H., 2017. Bond price volatility and term to maturity: A
generalized respecification. In Bond Duration and Immunization (pp. 64-68). Routledge.
Xiao, S. and et.al., 2018. Self-evolving trading strategy integrating internet of things and big
data. IEEE Internet of Things Journal, 5(4), pp.2518-2525.
Zhang, J., and et.al., A hybrid model using signal processing technology, econometric models
and neural network for carbon spot price forecasting. Journal of Cleaner Production.