The question for the two sets is as follows:

Case 1 - American Barrick Resources Corporation: Managing Gold Price

Risk
1. In the absence of a hedging programme using financial instruments, how
sensitive would Barrick stock be to gold price changes? For every 1%
change in gold prices, how might its stock be affected? How could the
firm manage its gold price exposure with the use of financial contracts?

In the absence of a hedging program, Barrick's stock would be highly sensitive to changes in
gold prices, as the firm’s profits, cash flows, and ultimately its stock price are closely tied to
the market price of gold. A 1% change in gold prices would have a direct impact on Barrick’s
revenue, and due to its leverage and high operational gearing typical in mining, the stock’s
price could experience amplified effects relative to this 1% change in gold.

Estimating the Impact of Gold Price Changes on Barrick’s Stock

To determine the stock's sensitivity to gold prices, consider the following factors:

1. Revenue Dependency: Nearly all of Barrick's revenue comes from gold sales, so a
change in gold prices directly affects the firm's income.
2. Profit Margins: If the average realized price of gold moves up or down by 1%, the
effect on profit margins could be more significant, especially given Barrick’s
relatively high cash cost per ounce in some years.
3. Leverage: Any income change due to gold price movement is amplified by Barrick’s
financial structure, with both debt and equity financing affecting the stock price
volatility.

A simplified approach would be to assess the historical correlation between gold prices and
Barrick's stock returns, which could provide an approximate beta relative to gold prices.
However, without hedging, a 1% decrease in gold prices could likely lead to an equivalent or
greater drop in stock price, depending on the degree of operational leverage and market
sentiment.

Managing Gold Price Exposure with Financial Contracts

Barrick can utilize financial instruments to manage this sensitivity to gold price fluctuations.
Here’s how:

1. Forward Sales: Barrick could enter into forward contracts to sell a portion of its
expected gold production at pre-set prices, ensuring a minimum revenue level
regardless of market price changes. This approach would provide stability in cash
flows and earnings.
2. Options: Through options (e.g., puts and collars), Barrick could protect against
downside risks while retaining some upside potential. A collar strategy—in which
Barrick buys put options to set a floor price and sells call options to cap the upside—
offers price stability with moderate cost, aligning with its goal of stable cash flow.
3. Spot Deferred Contracts: These allow Barrick to defer delivery to take advantage of
favorable prices in the future while locking in a minimum selling price at initiation.
 This tool provides flexibility in deciding when to deliver gold, depending on market
conditions.

2. What is the stated intent of ABX’s hedging programme? What should be

the goal of a gold mine’s price risk management programme?

The stated intent of American Barrick Resources Corp (ABX)’s hedging program is to ensure
financial stability by protecting the company from dips in the gold price, allowing it to plan
cash flows confidently. The hedging program aims to provide a predictable earnings profile,
enabling Barrick to shield itself from short-term market volatility while maintaining a portion
of upside potential. As Peter Munk, ABX’s founder, emphasized, this stability helps attract a
broader investor base that may typically avoid the high volatility of unhedged gold mining
stocks(C2_American Barrick Res…).

Goals of a Gold Mine’s Price Risk Management Program

A gold mine’s price risk management program should aim to achieve the following
objectives:

1. Stabilize Cash Flows: By moderating exposure to gold price fluctuations, the mine
can maintain a steady revenue stream, which is crucial for covering operational
expenses, debt obligations, and capital investments. Predictable cash flows enable
better budgeting and financial planning, especially in capital-intensive industries like
mining.
2. Protect Against Downside Risk: Hedging allows the firm to set a floor price,
ensuring a minimum acceptable price for its gold production. This minimizes losses
during periods of low gold prices and safeguards profitability, supporting shareholder
value.
3. Provide Predictable Returns to Investors: A risk management program reduces
earnings volatility, making the company more appealing to a diverse range of
investors who might shy away from the cyclical nature of the gold market. Investors
benefit from reduced risk without sacrificing exposure to the gold industry.
4. Retain Upside Potential: Effective hedging strategies allow for a level of upside
participation. For instance, strategies like collars or selective forward contracts enable
the company to benefit from price increases above certain thresholds while limiting
losses below certain levels.
5. Enhance Financial Flexibility: Reducing price risk provides the company with
flexibility to pursue strategic projects and expansions, like Barrick’s Meikle Mine
development, without excessive financial risk. This flexibility also positions the
company to take advantage of growth opportunities during downturns when
competitors may be more constrained.

3. What would convince you that a price risk management programme

created value for its shareholder ex ante?

To determine if a price risk management program creates value for shareholders ex ante (i.e.,
before outcomes are realized), I would look for the following key indicators:

1. Alignment with Strategic Objectives

  Stability of Cash Flows: Evidence that the program aligns with the company’s need
for stable cash flows to meet operational and debt obligations, even in adverse market
conditions. For ABX, for example, the ability to ensure cash flow stability would
support long-term investment and operational continuity.
 Investor Attractiveness: The program should make the company more attractive to a
diverse range of investors, particularly those who typically avoid the high volatility of
commodity-based stocks. If the program expands ABX’s investor base to include
more institutional investors or risk-averse individuals, it adds shareholder value.

2. Reduction of Earnings Volatility

 Projected Reduction in Earnings Volatility: Simulations or scenario analysis should

demonstrate that the program reduces expected earnings volatility. If hedging can
reduce the potential fluctuations in income and cash flow, the company is likely more
attractive to investors, potentially leading to a higher price-to-earnings (P/E) multiple
and increased stock valuation.
 Improved Predictability of Dividends: A risk management program that supports
predictable earnings may allow the company to maintain or increase dividends,
enhancing shareholder returns.

3. Cost-Benefit Analysis

 Efficient Use of Capital: The cost of implementing the program (e.g., the premiums
paid for options or the opportunity cost of forward contracts) should be justified by
the expected benefits in terms of reduced risk exposure. Transparent cost projections
should show that the financial contracts or derivatives used do not erode profitability
excessively.
 Cost Savings from Lower Financing Costs: A company with stable cash flows and
lower earnings volatility might secure debt at lower interest rates, reducing the
weighted average cost of capital (WACC). This would enhance the net present value
(NPV) of future cash flows and add to shareholder value.

4. Strategic Flexibility

 Ability to Capitalize on Market Opportunities: The program should include

flexible hedging instruments that allow the firm to take advantage of favorable market
conditions. For instance, if the program uses spot deferred contracts, ABX could defer
delivery during low-price periods and sell in the spot market when prices improve.
 Tailored to Operational Needs: A robust program should account for production
schedules, investment plans, and anticipated increases in production capacity (e.g.,
ABX’s Meikle Mine). By ensuring that the hedging activities match the company’s
operational profile, ABX can maintain production and expansion plans confidently,
which supports future earnings growth.

5. Market Perception and Share Price Premium

 Share Price Stability or Premium: If investors perceive the program as adding value
by reducing risk, ABX could enjoy a share price premium over competitors without
similar risk management. Analysts and investors may assign a higher valuation
 multiple to ABX’s stock relative to peers, reflecting the perceived value of reduced
price volatility.
 Positive Market Reaction: A strong price risk management program could lead to
positive analyst recommendations and market reactions if communicated effectively.
For example, if ABX’s program is well-publicized and analysts view it as a
competitive advantage, the market’s confidence in ABX’s future cash flows could
increase its stock price.

4. How would you characterize the evolution of Barrick’s price risk

management activities? Are they consistent with the stated policy goals?

 Barrick Gold Corporation's approach to managing gold price risk has evolved
significantly over the years, reflecting shifts in market conditions and strategic
objectives.

Early Hedging Strategy:

 In its formative years, Barrick implemented an extensive hedging program to mitigate

gold price volatility. This strategy involved forward sales and spot deferred contracts,
allowing the company to lock in favorable prices for future production. Such
measures provided revenue stability and facilitated growth during periods of declining
gold prices. For instance, in 1997, Barrick's hedging program generated a premium of
$88 per ounce over the spot price, contributing an additional $269 million in revenue.
 London Bullion Market Association

Shift in Strategy:

 As gold prices began to rise in the 2000s, the benefits of hedging diminished.
Investors expressed concerns that hedging limited Barrick's ability to capitalize on
higher gold prices. In response, Barrick announced in September 2009 its plan to
eliminate all fixed-price gold hedges within 12 months, aiming to gain full leverage to
the gold price on all future production.
 Barrick Gold Corporation

Elimination of Hedging:

 By December 2009, Barrick had completed the elimination of all its gold hedges,
thereby fully exposing its production to market gold prices. This move aligned with
the company's positive outlook on gold prices and addressed investor concerns
regarding hedging practices.
 Barrick Gold Corporation

Consistency with Policy Goals:

 Barrick's initial hedging activities were consistent with its policy goals of ensuring
revenue stability and supporting growth during times of low gold prices. However, as
market conditions changed, the company adapted its strategy to align with its goal of
maximizing shareholder value by fully participating in rising gold prices. This
 evolution demonstrates Barrick's responsiveness to market dynamics and commitment
to aligning its risk management practices with its overarching policy objectives.

6. What is a ”spot deferred contract”? Is it an option or a forward contract? Why

has ABX chosen to rely on spot deferred contracts relative to other derivatives?

A spot deferred contract (SDC) is a type of forward contract, not an option. In a standard
forward contract, the delivery date and price are set at the start, and the seller is obligated to
deliver the asset (in this case, gold) on the specified date. A spot deferred contract, however,
allows for multiple delivery dates over an extended period (often 5 to 10 years), giving the
seller (like ABX) flexibility in choosing when to deliver within that timeframe.

Characteristics of a Spot Deferred Contract

1. Deferred Delivery: The seller has the flexibility to defer delivery of the asset to any
of the predefined rollover dates during the contract’s life, rather than a single fixed
date.
2. Contango Adjustment: The contract price for deferred delivery is adjusted based on
contango (the difference between the dollar interest rate and the gold lease rate). At
each rollover date, the delivery price is updated with the prevailing contango rate,
allowing ABX to wait for favorable market conditions.
3. Long-Term Structure: SDCs are designed for longer horizons than standard forward
contracts, often spanning several years, which aligns well with the long-term nature of
mining operations and production cycles.

Why ABX Relied on Spot Deferred Contracts

ABX chose to rely on SDCs over other derivatives like simple forward contracts, futures, or
options due to their unique advantages in managing long-term gold price risk. Here’s why
SDCs suited ABX's strategy:

1. Flexibility to Capture Upside Potential: SDCs allow ABX to defer delivery if

market prices are unfavorable. This means ABX can wait for potentially higher prices,
rather than being locked into a specific date, as would be the case with standard
forwards or futures.
2. Risk Management Aligned with Production Cycles: Mining projects have variable
production rates and long lead times. SDCs give ABX the flexibility to hedge future
production without rigid timing constraints, aligning well with the company's ongoing
production adjustments.
3. Preservation of Cash Flow Stability: By deferring delivery during low-price
periods, ABX can manage cash flows more predictably, reducing the impact of gold
price volatility on its revenues and enhancing financial stability.
4. Cost-Effective Protection: Unlike options, which require premium payments, SDCs
do not involve upfront costs. This makes them a cost-effective method of achieving
risk management while retaining flexibility.
5. Compatibility with Reserve Base and Financial Strength: Due to its strong
reserves and financial position, ABX could negotiate favorable SDC terms, which
allowed the company to manage price risk efficiently and avoid the requirement for
 frequent contract rollovers or margin payments associated with shorter-term
derivatives.

6. How should a gold mine that wants to moderate its gold price risk compare hedging
strategies (using forwards or options or spot deferred contracts) with insurance
strategies (using options)? On what basis should these decisions be made? Once a
firm has decided on either a hedging or an insurance strategy, how should it choose
from among specific alternatives?

To moderate gold price risk, a gold mine should compare hedging strategies (using
forwards, spot deferred contracts, or a mix of both) with insurance strategies (primarily
using options) based on several key factors:

Basis for Comparing Hedging and Insurance Strategies

1. Risk Tolerance and Objectives:

o Hedging (e.g., forwards or spot deferred contracts) stabilizes cash flows and
protects against downside risk by locking in prices, though it limits upside
potential.
o Insurance (options) protects against price declines while allowing the mine to
benefit from price increases. This strategy is generally more flexible but may
be more costly due to option premiums.

2. Cost Considerations:
o Forwards and spot deferred contracts are typically less costly because they
don’t require an upfront premium, as options do.
o Options involve a premium, which is a fixed cost, offering insurance-like
protection. Mines should weigh the premium cost against their cash flow
needs and risk appetite.

3. Market Conditions and Price Expectations:

o When gold prices are expected to be volatile or trend upwards, options may be
preferable as they provide downside protection without capping the upside.
o In stable or downward-trending markets, forwards or spot deferred
contracts can offer more predictable outcomes and reduce costs if the mine
aims for stable cash flows.

4. Operational Flexibility:
o Spot Deferred Contracts offer flexibility for production timing and delivery
and allow the mine to adjust delivery based on market conditions.
o Forwards are simpler but require fixed delivery dates, which may not align
with operational realities if production varies.

5. Financial Position and Access to Capital:

o Mines with strong cash reserves and a lower cost of capital may find options
viable due to the premium expense.
 o Mines with tighter budgets may prefer forwards or spot deferred contracts
to avoid premium costs.

Deciding Between Hedging and Insurance Strategies

Once a firm decides on either a hedging or insurance approach, it should assess specific
alternatives based on the following:

1. Forwards vs. Spot Deferred Contracts (if choosing Hedging):

o Forwards provide fixed price certainty and simplicity, ideal for firms with
predictable production schedules.
o Spot Deferred Contracts are better suited for firms needing flexibility in
timing, allowing delivery deferral until favorable pricing conditions arise.

2. Types of Options (if choosing Insurance):

o Puts provide a minimum price guarantee (similar to insurance), protecting the
mine from falling prices.
o Collars (buying a put and selling a call) lower the cost of insurance by
limiting upside gains in exchange for downside protection.
o Participating Options allow a firm to retain a portion of the upside beyond a
certain threshold, which can be advantageous if gold prices are expected to
rise significantly.

3. Strike Prices and Maturity Terms:

o For puts or collars, the strike price should align with the mine’s break-even or
desired minimum price threshold to ensure adequate protection.
o Maturity terms should align with the mine’s production timeline, ensuring that
price protection is available during peak production periods or major projects.

Practical Considerations for Choosing Among Alternatives

1. Scenario Analysis and Sensitivity Testing: The mine should simulate various
scenarios to estimate the cash flows and financial impact of each option under
different gold price conditions.
2. Market Liquidity and Counterparty Risk: If using over-the-counter (OTC)
instruments like forwards or spot deferred contracts, the mine should consider the
liquidity and creditworthiness of counterparties.
3. Regulatory and Tax Implications: Different financial instruments can have varied
impacts on accounting, regulatory requirements, and taxes, which the mine should
assess based on its jurisdiction.

Case - 2 Application of Financial Futures

1. People’s Federal Savings Bank
a. Should People’s Federal Savings Bank have hedged its September 1
savings certificate rollover?
b. What would you have advised Mr. Myers to do on August 6?
 c. How should Mr. Myers explain his futures losses to the board on
August 27?

1. People’s Federal Savings Bank

a. Should People’s Federal Savings Bank have hedged its September 1

savings certificate rollover?

Yes, hedging the rollover of the September 1 savings certificates was reasonable given the
significant exposure to interest rate fluctuations. By holding a large portfolio of fixed-rate
loans funded through short-term consumer deposits, the bank faced substantial interest rate
risk. Rising interest rates could increase the bank's funding costs, eroding profitability or even
threatening regulatory capital requirements. Therefore, a hedging strategy was justified to
mitigate this exposure.

However, the specific choice of using a short position in Treasury bill futures may have been
less effective given the market’s volatility, the absence of stop-loss mechanisms, and the
heavy reliance on predictions from a single analyst.

b. What would you have advised Mr. Myers to do on August 6?

On August 6, Mr. Myers had already observed significant margin calls totaling $690,000,
indicating that the futures position was not performing as anticipated due to declining rates.
At this point, I would have advised Mr. Myers to reconsider his position based on market
trends and risks, including:

1. Reducing the Position Size: Scaling back the futures contracts could have limited
potential future losses if the trend of falling rates continued.
2. Implementing Stop-Loss Orders or Alternative Strategies: Considering protective
measures, like stop-loss orders, could have minimized additional losses. Alternatively,
Myers might have explored more flexible instruments that allow partial hedging
adjustments, such as options.
3. Monitoring Market Trends Closely: Given that financial markets often experience
short-term rate fluctuations, I would advise a more vigilant approach to adjust
hedging positions dynamically, considering market signals and rate movements
closely.

c. How should Mr. Myers explain his futures losses to the board on August
27?

When explaining the futures losses to the board, Mr. Myers should focus on the context,
strategic reasoning, and learning outcomes from this hedging experience:

1. Context of the Decision: Emphasize that the decision to hedge with T-bill futures
was taken in response to significant interest rate risk threatening the bank’s regulatory
capital. The strategy was recommended by a major brokerage firm and was intended
to mitigate potential losses due to anticipated rate hikes.
2. Explanation of Losses: Clearly state that the drop in interest rates led to variation
margin calls, resulting in cash outflows. While the strategy was designed to protect
 against rate hikes, unforeseen declines in rates led to an unexpected adverse outcome,
with $2.5 million in losses incurred to maintain the position.
3. Risk Management Enhancements: Outline the lessons learned, such as the need for
flexible and dynamically managed hedging strategies. Propose measures to improve
future risk management, including continuous monitoring of hedged positions,
consideration of alternative hedging instruments, and potential stop-loss mechanisms
to prevent large losses.
4. Future Strategy Improvements: Myers could recommend enhancing the bank's
internal expertise in hedging and financial derivatives, potentially reducing reliance
on external advisors.

2. Southeast Corporation
a. How many September 1984 T – Bond futures contracts should Lori
Hiratani sell short to hedge Southeast’s interest rate exposure?
b. What rate will Hiratani “lock in” by initiating this hedge?
c. Does this hedging strategy eliminate Southeast’s exposure? If not,
what risks remain?

2. Southeast Corporation

a. How many September 1984 T-bond futures contracts should Lori

Hiratani sell short to hedge Southeast’s interest rate exposure?

To calculate the number of futures contracts Lori Hiratani should sell short, we use the
concept of hedge ratio based on the duration matching approach, which aligns the interest
rate sensitivity of the hedge with that of the underlying debt.

1. Determine the Dollar Duration of the Debt:

o The Southeast debt issuance is $60 million with a duration of 7.8 years.

Dollar duration of debt = Face Value × Duration

= $60,000,000 × 7.8
= $468,000,000

2. Determine the Dollar Duration of the Futures Contract:

o Each T-bond futures contract has a duration of 8.5 years and represents a bond
worth approximately $100,000 (standard contract value).

Dollar duration per contract = $100,000 × 8.5

= $850,000

3. Calculate the Hedge Ratio:

o Number of futures contracts = Dollar Duration of Debt / Dollar Duration per
Futures Contract
= $468,000,000 / $850,000
≈ 550 contracts
Thus, Lori Hiratani should sell approximately 550 T-bond futures contracts to hedge the
interest rate exposure on the $60 million debt issuance.

b. What rate will Hiratani “lock in” by initiating this hedge?

The hedge effectively “locks in” the interest rate for Southeast’s future debt by fixing the
yield environment for the debt issuance date in August 1984.

1. Current T-bond Futures Price: September 1984 T-bond futures are quoted at 69-08,
which represents a price of 69.25% of par.
2. Implied Yield: This price reflects a Treasury bond with a 12% coupon maturing in
August 2013, yielding 11.80% in the cash market.

By selling futures at this implied yield of 11.80%, Hiratani can "lock in" an approximate
effective rate near 11.80% for the Southeast Corporation’s debt issuance, assuming the hedge
closely tracks changes in interest rates.

c. Does this hedging strategy eliminate Southeast’s exposure? If not, what

risks remain?

While this hedging strategy significantly reduces Southeast’s exposure to interest rate
fluctuations, it does not completely eliminate all risks:

1. Basis Risk: Since the hedge uses T-bond futures, there is a potential mismatch
between the movements in Treasury bond yields and corporate bond yields. The
spread between corporate and Treasury yields could change, meaning that even if
Treasury rates remain stable or decrease, corporate borrowing costs might still rise.
2. Duration Mismatch: The futures contract has a duration of 8.5 years, while the debt
issuance has a duration of 7.8 years. This difference in duration could lead to
imperfect hedging, especially if there are substantial changes in interest rates.
3. Credit Spread Risk: Southeast’s credit rating could affect the interest rate it pays,
independent of the Treasury rate. If the company’s credit rating worsens, the cost of
borrowing could increase despite the hedge, which is based solely on Treasury rates.
4. Liquidity and Execution Risk: There is always the possibility that futures prices do
not move perfectly in line with Southeast’s debt requirements, especially in times of
market volatility. This could lead to small discrepancies between the hedge
performance and the actual funding costs.

3. Alpha Investors
a. What futures position should Jim take to hedge his portfolio?
b. What risks can Jim eliminate by shorting S & P 500 stock index
futures contracts? How effective do you expect the hedge to be? (Note
that you should try to quantify the effectiveness of Jim’s hedge using
the methodology described in the Salomon Brothers research report –
Appendix 3)
c. What return can Jim expect to earn during the third of 1985 assuming
he adopts your hedging strategy?
3. Alpha Investors

a. What futures position should Jim take to hedge his portfolio?

To hedge his portfolio, Jim should calculate the number of S&P 500 index futures contracts
to sell short, based on the beta of his portfolio, the portfolio's value, and the value of each
futures contract.

1. Portfolio Value: $36 million

2. Portfolio Beta (β): 1.18
3. S&P 500 Futures Contract Value: The futures contract multiplier for the S&P 500
is 500 times the index level.

The number of futures contracts to hedge the portfolio can be calculated with the following
formula:

b. What risks can Jim eliminate by shorting S&P 500 stock index futures
contracts? How effective do you expect the hedge to be?

By shorting S&P 500 futures, Jim can eliminate systematic (market) risk, which is the risk
associated with general market movements. Since his portfolio has a beta of 1.18, the hedge
will reduce exposure to fluctuations in the S&P 500 index, thereby protecting the portfolio's
value if the market declines.

To evaluate the hedge’s effectiveness, we can examine the R-squared (R²) value from the
regression analysis. The given R-squared is 0.690, which suggests that 69% of the portfolio’s
movements are explained by the S&P 500 index. Therefore, about 69% of the portfolio’s risk
due to general market movements is expected to be offset by the hedge.

However, this hedge won’t eliminate unsystematic risk (individual stock risks), nor will it
completely cover the tracking error due to the 31% of variance unexplained by the index.
Thus, the hedge will be effective to the extent that the portfolio’s performance aligns with the
S&P 500, but there may still be some residual risk from non-market factors.
c. What return can Jim expect to earn during the third quarter of 1985
assuming he adopts your hedging strategy?

To estimate the return Jim can expect, we need to consider the expected return on his
hedged position. Since Jim has hedged against market risk, his portfolio's return will
primarily depend on unsystematic performance and any remaining unhedged risk.

Given that:

 Average S&P 500 Weekly Return: +0.22%

 Average Weekly Return of Alpha Investors’ Portfolio: +0.39%

The portfolio is expected to outperform the S&P 500 by 0.39% - 0.22% = 0.17% per week
due to its higher beta and selection.

For the 13-week period in Q3:

1. Expected Excess Return (Unhedged): 0.17% per week × 13 weeks ≈ 2.21%

2. Expected Hedged Return: Since the hedge offsets market risk, Jim can expect the
portfolio to earn around 2.21% in Q3, primarily driven by unsystematic risk and
portfolio-specific factors.

Thus, with the hedge in place, Jim can expect an approximate return of 2.21% over the third
quarter of 1985, assuming the unsystematic performance aligns with historical trends.

4. Auto Star
a. If you were Rob Rough, what advice would you give to Edith Cooper?

4. Auto Star

a. If you were Rob Rough, what advice would you give to Edith Cooper?

If I were Rob Rough, I would advise Edith Cooper on a few critical aspects to manage Auto
Star's interest rate exposure, considering the company’s financial leverage, reliance on
variable-rate debt, and lack of direct futures contracts for prime rate instruments.

1. Use Cross-Hedging with T-bill or CD Futures: Since there are no direct futures
contracts available for the prime rate, Auto Star can cross-hedge using Treasury bill
(T-bill) or Certificate of Deposit (CD) futures, as these instruments generally have a
close correlation with the prime rate. Although an imperfect match, T-bill or CD
futures can still help reduce exposure to interest rate increases that would affect Auto
Star’s variable-rate debt.
2. Hedge Duration and Contract Quantity: Determine the hedge size based on the
amount of debt exposed to interest rate fluctuations and the expected duration of this
exposure. For an 18-month horizon, select T-bill or CD futures with durations that
best align with this period. This will involve calculating the number of contracts to
offset potential interest rate increases on Auto Star’s debt obligations, taking into
account the likely interest rate sensitivity of their debt.
 3. Prepare for Variation Margin Calls: Since margin calls are likely to occur in
response to rate fluctuations, Edith should ensure that Auto Star has sufficient
liquidity to meet these demands. Given the company’s recent difficulty securing
additional credit, it may be prudent to negotiate a dedicated line of credit or arrange
for cash reserves specifically for covering margin requirements.
4. Consider Alternative Hedging Instruments: If feasible, Edith might also explore
interest rate swaps as an alternative hedging instrument. By entering a swap
agreement, Auto Star could convert its variable-rate debt into a fixed-rate obligation,
providing greater certainty over interest costs without the need for continuous margin
maintenance.
5. Monitor and Adjust the Hedge Regularly: Given the imperfect correlation between
the prime rate and T-bill/CD futures, it’s essential to regularly monitor the hedge and
adjust it if necessary. Rate movements and shifts in the correlation between the prime
rate and the chosen futures contracts may require Edith to scale the hedge up or down.
6. Long-Term Financial Strategy: In the long term, I would advise Auto Star to
evaluate its overall debt structure and consider reducing reliance on variable-rate debt,
which exposes the company to high financial risk. Reducing leverage or shifting a
portion of debt to fixed-rate financing, if possible, would help stabilize interest
expenses and reduce the need for hedging in the future.

In summary, I would recommend Edith pursue a cross-hedge using T-bill or CD futures,

arrange liquidity to manage margin calls, consider an interest rate swap if viable, and review
Auto Star’s financing strategy to lower its exposure to variable rates over time.

5. Stock Index Futures Arbitrage

a. What is the theoretical price of the MMI March 86 futures contract?
b. Assume that Jim is subject a $5,000,000 position limit. What position
should he take to exploit the mispricing of the March 86 MMI futures?
c. What rate of return can Jim expect to earn on his position?
d. Who, in addition to securities dealers, would you expect to engage in
index futures arbitrage?
e. Why do index futures often trade at a premium or discount to its
theoretical values? How do you expect the pricing efficiency of
broader market index futures, like the S & P 500, to compare to the
pricing of MMI futures?
d. Who, in addition to securities dealers, would you expect to engage in index futures
arbitrage?

In addition to securities dealers, the following participants might engage in index futures
arbitrage:

1. Hedge Funds: Hedge funds often engage in arbitrage strategies to earn risk-free or
low-risk returns, and they have the capital and expertise to execute such trades
efficiently.
2. Institutional Investors: Large institutional investors, such as pension funds and
insurance companies, may use index futures arbitrage to manage risk and optimize
portfolio returns, especially if they hold large index-linked equity portfolios.
3. Market-Making Firms: Market makers in futures markets engage in arbitrage to
profit from discrepancies between the futures and cash markets, ensuring liquidity and
reducing price inefficiencies.
4. Proprietary Trading Firms: These firms specialize in arbitrage opportunities,
including index futures arbitrage, to generate profits through sophisticated trading
models and high-frequency trading capabilities.
5. Mutual Funds and Index Funds: Fund managers may use arbitrage as a tactic to
enhance returns, particularly if they track or benchmark to specific indices.

e. Why do index futures often trade at a premium or discount to their theoretical

values? How do you expect the pricing efficiency of broader market index futures, like
the S&P 500, to compare to the pricing of MMI futures?

Index futures can trade at a premium or discount to their theoretical values due to several
factors:
 1. Interest Rate and Dividend Variations: Fluctuations in interest rates or dividend
yields impact the cost-of-carry model, causing deviations from the theoretical price.
2. Market Demand and Supply Imbalances: Investor sentiment, liquidity constraints,
or speculative activity can drive the futures price above or below the theoretical value.
3. Transaction Costs and Execution Risk: Costs associated with trading and potential
price impacts can cause futures prices to differ from theoretical prices, especially in
less liquid markets.
4. Arbitrage Restrictions: If arbitrageurs face position limits, margin requirements, or
capital constraints, they may be unable to fully exploit pricing discrepancies, allowing
premiums or discounts to persist.
5. Time to Expiration and Basis Volatility: Closer to expiration, the futures price
converges to the spot price. However, the basis (difference between futures and spot
prices) can fluctuate widely in the interim, especially in volatile markets.

Efficiency Comparison between S&P 500 and MMI Futures

Broader market index futures like the S&P 500 generally exhibit higher pricing efficiency
than narrower indices like the MMI. This is because:

1. Higher Liquidity and Trading Volume: The S&P 500 futures market has
significantly greater liquidity and trading volume, which minimizes price
discrepancies and enables quicker arbitrage.
2. Lower Transaction Costs: Due to higher liquidity, the cost of executing arbitrage on
the S&P 500 is typically lower than on less widely traded indices like the MMI.
3. Diverse Arbitrage Participants: The S&P 500 attracts a broader range of
participants, including global institutions, which enhances pricing efficiency through
more frequent and smaller arbitrage trades.
4. Reduced Basis Volatility: The larger number of constituent stocks in the S&P 500
reduces volatility in the basis compared to the MMI, which can be more sensitive to
individual stock price changes.

In summary, S&P 500 futures are likely to trade closer to their theoretical values compared to
MMI futures, due to higher liquidity, greater market depth, and reduced impact from
individual stock price movements.