Question

. Today is the 4th of May 2020. Cobalt Co a cobalt producer is concerned about an increase in the price of cobalt over the next three months under the expectation of higher demand for electric batteries.  

BatteryCo is committed to sell 20000 tons of cobalt on the 15th of July. Cobalt prices have decreased by 20% since the break up of the Coronavirus crises due collapse in demand. For this reason, the BatteryCo proposes to use the August LME cobalt future contract to hedge against adverse movements in cobalt prices. The correlation coefficient between the LME cobalt future prices with cobalt spot prices is 0.85. The volatility of the cobalt spot price is 55% and the volatility of the three month LME cobalt future is 54.% Given the above data

a) Calculate the minimum variance hedge ratio (10)

b) Carefully  explain the strategy to be pursued by BatteryCo in order to hedge its cobalt price exposure. Note that each LME contract specifies delivery of 1 ton of cobalt. (10)

Answer 1

Correlation = 0.85

Volatility of cobalt spot price = 55%

Volatility of LME cobalt future = 54%

Minimum variance hedge ratio = correlation*(Volatility of cobalt spot price/Volatility of LME cobalt future)

Minimum variance hedge ratio = 0.85*55%/54% = 0.8657

(b) Since you are cobalt seller, you need to short the futures contract to hedge the futures contract. If the cobalt price decreases, the price of short futures increases, thus hedging the profits

No. of futures contract to short = (hedge ratio)*(order size)/(size of 1 future contract)

No. of futures contract to short = 0.8657*(20000tons)/(1ton) = 17314