Question

A company wishes to hedge its exposure to a new fuel whose price changes have a 0.7 correlation with gasoline futures price changes. The company will lose $500,000 for each 1 percent increase in the price per gallon of the new fuel over the next three months. The new fuel's price change has a standard deviation that is 100% greater than price changes in gasoline futures prices.

How many gasoline futures contracts should be traded (one gasoline futures contract represents 42,000 gallons) without tailing the hedge? Please enter long contracts as a positive number and short contracts as a negative number.

Answer 1

Hedge ration should be 0.7*2=1.4

The company has exposure to the price of (500000/0.01)= 50 million gallon of new fuel.

So it should take a position of 50 million*1.4 = 70 million gasoline in future contract.

Since each future contract is of 42000 gallons = 70,000,000/42000 = 1666.67 contracts

It is assumed that the company is about to buy the fuel so the company should take long position of 1666.67 or 1667 contracts to avoid the losses due to the price hike.