Finc derivatives hedging and risk

Q: What is a perfect hedge?

A: Eliminates all risk; rare in practice.

Q: What is a non-perfect hedge?

A: Only partially reduces risk.

Q: Why are some hedges non-perfect?

A: 1) Hedged asset ≠ futures asset; 2) Hedge closed out before maturity.

Q: What is basis?

A: Spot price minus futures price (S − F).

Q: What is basis risk?

A: Risk that basis ≠ 0 when hedge is closed or delivery occurs.

Q: When is basis zero?

A: At expiration if the hedged and futures assets are identical.

Q: Why do hedgers often close out contracts before maturity?

A: High delivery costs and erratic futures prices during delivery month (high basis risk).

Q: How can a hedger minimize basis risk?

A: Choose a futures contract with maturity close to but after hedge expiration.

Q: What is cross-hedging?

A: Hedging an asset with a futures contract on a different but correlated asset.

Q: What is the goal of equity portfolio hedging with index futures?

A: Remove almost all market risk, reducing portfolio beta to zero.

Q: Why hedge an equity portfolio instead of investing in risk-free assets?

A: 1) Retain abnormal returns (alpha) from mispriced stocks. 2) Get short-term protection without selling/rebuying entire portfolio.

Q: How can futures adjust portfolio beta?

A: Take short positions if β > β, long positions if β < β to reach desired β*.