Question

) SJU Hockey produces 15,000,000 hockey pucks a year and uses 5 ounces of rubber in each puck. From their analysis they determine ρ = 0.90, σpuck = 0.15 & σrubber = 0.25. Suppose rubber future contracts are for 160,000 ounces of rubber. How many future contracts should SJU Hockey use to hedge and should they long or short?

Answer 1

ρ = 0.90, σpuck = 0.15 & σrubber = 0.25

Since the company will need to buy the rubber in future, the company should buy or go long on the future contract.

Optimal hedge ratio = ρ x σpuck / σrubber = 0.9 x 0.15 / 0.25 = 0.54

Hence, nos. of contracts required to be hedged = optimal hedge ratio x Total quantity of rubber required / Quantity of rubber per contract = 0.54 x 15,000,000 x 5 / 160,000 = 253.125

The negative sign implies, SJU should long 253.125 future contracts.

This can be rounded upward to say, Long 254 future contracts or can be rounded downward to say Long 253 future contracts.