Question

Calculate the optimal hedge ratio using the data provided. The producer has 3,000,000 MMBtu gas asset and need to hedge the exposure. Explain the producers’ position: should the producer long or short? How many futures contracts are needed? Show the calculations.

	HHC Price	Futures Price	Month	Year
3/25/14	5.468	5.4	3	2014
3/26/14	5.668	5.29	3	2014
3/29/14	5.447	5.29	3	2014
3/30/14	5.378	5.4	3	2014
3/31/14	5.389	5.47	3	2014
4/1/14	5.310	5.31	4	2014
4/2/14	5.516	5.39	4	2014
4/5/14	5.305	5.17	4	2014
4/6/14	5.236	5.04	4	2014
4/7/14	4.944	4.9	4	2014
4/8/14	4.923	4.78	4	2014
4/9/14	4.895	4.82	4	2014
4/12/14	4.861	4.77	4	2014
4/13/14	4.750	4.81	4	2014
4/14/14	4.661	4.68	4	2014
4/15/14	4.772	4.71	4	2014
4/16/14	4.707	4.76	4	2014
4/19/14	4.645	4.58	4	2014
4/20/14	4.656	4.59	4	2014
4/21/14	4.460	4.53	4	2014
4/22/14	4.441	4.52	4	2014
4/23/14	4.488	4.56	4	2014
4/26/14	4.388	4.44	4	2014
4/27/14	4.397	4.4	4	2014
4/28/14	4.313	4.39	4	2014
4/29/14	4.298	4.35	4	2014
4/30/14	4.414	4.3	4	2014

Answer 1

1) Producer to hedge the price, he should go for Short position. By this his price is fixed for the produced goods and need not be worried on price movement.

2) Optional Hedge ratio calculation is used to check the correlation between price of product with the exchange traded price. It checks the risk for the effectiveness of the hedge and useful for selecting best contract to enter with the price and quantity.

Since the underlying in this case is a commodity denominated in future and spot price, hedging it with futures which is volatile, you need to work out the optimal hedge ratio.

Formula ==> Optimal Hedge = Correlation X (Standard Deviation of HHC Price / Standard Deviation of Future Price)

Standard Deviation of HHC Price = 4.897 (Square Root of (x1 square + x2 square + ..) / 27 )

Standard Deviation of Future Price = 4.8528697 (Square Root of (y1 square + y2 square + ..) / 27 )

Correlation between both = 0.97213

Result = 0.97213 X 4.897 / 4.8528697

=  0.98097