Question

1. Cross Hedging and Minimum Variance Hedge Ratio

A cryptocurrency trader owns 10,000 unit of Ethereum and decides to hedge the value of the position with futures contracts on Bitcoin. One futures contract is for delivery of 5 Bitcoins. In answering the following questions, please use the statistics that you obtained in Assignment 2 Question 2 regarding Cov (∆S, ∆F) and Var (∆F).

(a) What is the minimum variance hedge ratio?

(b) To minimize the variance of portfolio value, how many contracts does the trader need? Does the trader need to long or short?

Answer 1

Answer-(1)

(a)

Minimum Variance Hedge ratio is the optimal Numbre of the Future contract, that is required to hedge the Asset, so that there will be minimal loss or risk Or variance.

(b)

Optimal Futures Contract = (Size of value of the assets to be hedged* beta Of the Asset) / Size of One Futures Contract

Beta of the asset = Covariance of the Asset and market / Variance of market.

Cov (∆S, ∆F)= Covariance of asset and market

Var (∆F)= variance of market.

hence

Hence,

Optimal Number of Futures Contract needed=

V = Value of the asset =10000 unit of Ethereum

Sf1= size of one Future Contrsct = 5 Bitcoin