Question

Suppose that standard deviation of monthly changes and spot prices of silver is one. $1.25 per ounce of silver, and the standard deviation of monthly changes in futures prices of the relevant asset is $1.45 per unit. the coefficient of correlation between the two changes is 0.95. an investor is interested to trade 840 ounces of silver.with this information which one of the following is most true?

1.he should hedge almost 81.90 percent of his trading asset.

2.he should hedge almost 687.93 ounces of silver

3. It is a cross hedge situation

4. All of the above

Answer 1

(a) Optimal hedge ratio = Correltion of changes in spot & futures price () * Standard deviation of spot price ()/Standard deviation of spot price()

= 0.95*1.25/1.45

= 81.90%

(b) number of ounces = 0.8190*840 ounces

= 687.93 ounces

(c) According to defination of optimal hedge ratio, it is a cross hedge situation

Hence, Answer is option (4)