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Power Associates is a one-year firm that wants to perfectly hedge its

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solution


Question

Power Associates is a one-year firm that wants to perfectly hedge its cash flows next year. That is, it wants to completely eliminate the riskiness of its cash flows by selling a certain number of futures contracts on a commodity index. The table below details the cash flows produced by Power Associates and the value of the commodity index in each possible state of the world next year;Assume that the expected return on Power Associates and the commodity index are 20 percent. Also assume a risk-free rate of 5 percent.;a) What is the value of Power Associates?;b) What is the one-year futures price on the commodity index?;c) How many index futures contracts would you have to sell to perfectly hedge the Power cash flows?;d) What is the expected cash flow next year from the futures position? This number should be negative ? explain why this is the case.;e) What is the value of Power Associates now that it has hedged its cash flows? Compare this value to the value you calculated in part (a).;Additional Requirements;Level of Detail: Show all work;Other Requirements: please show details.

 

Paper#24931 | Written in 18-Jul-2015

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