Question

Define the following terms as they pertain to futures markets: speculator, hedger, long position, short position, spot market, margin, margin call. Suppose a bond dealer wants to hedge its inventory of Treasury bonds. The dealer is holding $15 million worth of T-bonds with a modified duration of 15 years. The futures contract, currently priced at 161, has a modified duration of 18 years. Compute the number of contracts required to hedge the position, indicate whether you would go long or short, and explain how the hedge works

Answer 1

Ans. Definition of Following terms as per the futures market:-

1. Speculator:- A Speculator can be any individual or firm that accepts risk in order to make a profit. They are the primary participants in the futures market. Speculators achieve their profits by buying low and selling high. But in the case of futures market, the scenario is bit different as they sell first and later buy at a lower price.
2. Hedger:- Hedger is any individual or firm that buys or sells the real physical commodity. They are the primary participants in the futures market.Hedgers can be producers,wholesalers, manufacturers or retailers they are affected by the changes in commodity prices, interest rates and exchange rates. To minimize the effects of these changes, ages will utilize futures contracts. Speculators accepts market risk for profit, whereas Hedgers use the futures market to manage and offset risk.
3. Long Position:-Having a long position means that you own the security. Investors maintain long positions in the anticipation of a future value increase in the stock. A long position is opposite of a short position.
4. Short Position:-In general, a "short" position is the sale of a stock that you do not own. Investors selling short believe the stock price will decline in value. If the price falls, at the lower price you can buy the stock and make a profit. If the stock price rises and you buy it back at the higher price later, you will lose it.
5. Spot Market:-Spot market is a public financial market in which financial instruments of commodities are traded for immediate delivery. It is a total contrast of a futures market, where delivery is due at a later date. In a spot market, settlement usually takes place in T+2 days, that means, delivery of a financial instrument is done after 2 working days of the trade date. Spot market can be through both the medium, an exchange or over the counter(OTC).
6. Margin:-Margin refers to purchasing of stocks and shares or any other securities with the combination of investor's funds and borrowed funds.
7. Margin Call:- Margin Call refers to to the demand request made by the brokerage firm to a customer to bring the margin deposits up to the the initial margin levels so as to maintain the existing position. The occurrence of Margin Call takes place, when adverse move against the customer's position transpires.

Solution:- Dealer is holding $15 million worth of T-bonds with a modified duration of 15 years. The futures contract, currently priced at 161, has a modified duration of 18 years. Compute the number of contracts required to hedge the position.

Assume "x" be the number of contracts required to hedge the position.The equation becomes:-

Contracts.

We should go short position so as to hedge the risk.

Hedging against investment risk means using market instruments strategically to offset the risk of any adverse movements in prices.In this case, we have to take short position in the futures market, as the futures contract currently priced at 161 with 77639 contracts so as to Hedge the risk arise due to long position why the dealer in case of T- bonds.