4w FinEcon 2024fall v2

Summary

The video script discusses the concept of basis risk in the context of futures and spot prices. It explains how basis risk arises due to uncertainty between the spot and future prices when closing out a hedge. The script uses examples to illustrate how gains or losses occur when taking long or short positions in futures contracts, such as with Samsung stock. It further explores cross hedging, where the underlying asset of the future contract differs from the asset being hedged, and introduces the concept of beta to explain the relationship and optimal hedge ratio between different assets.

Takeaways

• 📈 Basis risk arises from the uncertainty about the difference between the spot and future prices, known as the basis.
• 🔄 The basis is the difference between the spot price and the future price of an asset.
• 💼 To lock in a future price, one might take a short position in a forward contract, which can result in gain or loss depending on the final spot price.
• 💹 The gain or loss from a forward contract is calculated as the difference between the future price (strike price) and the spot price at maturity.
• 📉 If the spot price at maturity is higher than the forward price, a short position results in a loss, and vice versa for a long position.
• 💼 The net amount received from selling an asset and settling a forward contract depends on the initial and final spot prices and the forward price.
• 🌐 Basis risk can be mitigated by understanding the relationship between the asset and the future contract used for hedging, often represented by the beta coefficient.
• 📊 The beta coefficient indicates the sensitivity of the asset's price movement to the movement of another asset or index used as a hedge.
• 🔢 Cross hedging involves using a different but related asset or index future to hedge the price risk of the asset of interest.
• 🌐 In cross hedging, the optimal hedge ratio is crucial to minimize basis risk and is often determined by the beta coefficient.
• 📉 An increase in the basis, or the difference between the spot and future prices, can lead to unexpected losses even when the hedge is theoretically sound.

Q & A

What is basis risk?

Basis risk refers to the risk that arises from the uncertainty about the difference, or 'basis', between the spot price and the future price of an asset when a hedge is closed out.

Why does basis risk rise?

Basis risk rises due to the uncertainty about the basis when the hedge is closed out, which can lead to unexpected gains or losses.

Can you provide an example of how basis risk works with a stock like Samsung?

Yes, if you take a short position in a forward contract on Samsung with a strike price of 60,000 and the spot price at maturity is 70,000, you would have a gain of 10,000 if you had taken a long position. However, since you took a short position, you would incur a loss of 10,000.

What is the difference between a long and short position in a forward contract?

A long position means you expect the price to rise and you benefit from the increase. A short position means you expect the price to fall and you benefit from the decrease.

How does the spot price at maturity affect the outcome of a short position in a forward contract?

If the spot price at maturity is higher than the strike price of the forward contract, the holder of a short position will incur a loss equal to the difference between the spot price and the strike price.

What is meant by 'basis' in the context of futures and spot prices?

In the context of futures and spot prices, 'basis' refers to the difference between the spot price of an asset and its future price at a specific point in time.

Why might the basis change between the spot and future prices?

The basis can change due to various factors such as changes in supply and demand, storage costs, interest rates, and other market conditions that affect the spot and future prices differently.

What is the significance of the basis at maturity in a futures contract?

At maturity, the basis should theoretically be zero because the future price converges with the spot price. Any difference at this point represents basis risk.

What is a cross-hedge and why is it used?

A cross-hedge is a hedging strategy where a futures contract on one asset is used to hedge the price risk of another, related asset. It is used when there is no futures contract available for the exact asset you want to hedge.

How does beta relate to cross-hedge?

Beta is a measure of how much the price of one asset, like a stock, is expected to move in relation to another asset, like an index. In cross-hedge, beta is used to determine the optimal hedge ratio to minimize basis risk.

What is the optimal hedge ratio and how is it found?

The optimal hedge ratio is the ratio of the size of the hedging position (like the number of futures contracts) to the size of the exposure being hedged. It is found by analyzing the relationship between the asset being hedged and the hedging instrument, often using statistical methods like regression analysis.