Is the hedge ratio chosen in order to minimise the variance of a futures position? Why/why...

Is the hedge ratio chosen in order to minimise the variance of a futures position? Why/why not?

Expert Solution

YES ,hedge ratio chosen in order to minimise the variance of a futures position

The minimum variance hedge ratio is important when cross-hedging, which aims to minimize the variance of the position's value. The minimum variance hedge ratio, or optimal hedge ratio, is an important factor in determining the optimal number of futures contracts to purchase to hedge a position.

It is calculated as the product of the correlation coefficient between the changes in the spot and futures prices and the ratio of the standard deviation of the changes in the spot price to the standard deviation of the futures price. After calculating the optimal hedge ratio, the optimal number of contracts needed to hedge a position is calculated by dividing the product of the optimal hedge ratio and the units of the position being hedged by the size of one futures contract.

Example of the Hedge Ratio

Assume that an airline company fears that the price of jet fuel will rise after the crude oil market has been trading at depressed levels. The airline company expects to purchase 15 million gallons of jet fuel over the next year, and wishes to hedge its purchase price. Assume that the correlation between crude oil futures and the spot price of jet fuel is 0.95, which is a high degree of correlation.

Further assume the standard deviation of crude oil futures and spot jet fuel price is 6% and 3%, respectively. Therefore, the minimum variance hedge ratio is 0.475, or (0.95 * (3% / 6%)). The NYMEX Western Texas Intermediate (WTI) crude oil futures contract has a contract size of 1,000 barrels or 42,000 gallons. The optimal number of contracts is calculated to be 170 contracts, or (0.475 * 15 million) / 42,000. Therefore, the airline company would purchase 170 NYMEX WTI crude oil futures contracts.

please appreciate the work

jeff jeffy answered 1 year ago

Compare MM hedge and forward hedge. Compare forward hedge and futures hedge. Compare options and futures....

Compare MM hedge and forward hedge. Compare forward hedge and futures hedge. Compare options and futures. Which is easier to use? Which is riskier? Which has a higher initial cost?

Illustrate the notion of “minimum variance hedge ratio” by means of a numerical example

If the minimum-variance hedge ratio is -1, then which of the following statements is true? (a)...

If the minimum-variance hedge ratio is -1, then which of the following statements is true? (a) Changes in spot and futures prices are perfectly negatively correlated. (b) The standard deviations of spot and futures price changes are the same. (c) The minimum-variance hedge for a long spot exposure is a short futures exposure of the same size. (d) All of the above.

Prove that Optimal Hedge Ratio, h * , for hedging strategies using futures equals to F...

Prove that Optimal Hedge Ratio, h * , for hedging strategies using futures equals to F S h   =  * , where σS is the standard deviation of the change in the spot price during the hedging period, ΔS; σF is the standard deviation of the change in the futures price during the hedging period, ΔF; ρ is the coefficient of correlation between ΔS and ΔF.

The hedge ratio (delta) of an at-the-money call option on IBM is 0.29. The hedge ratio...

The hedge ratio (delta) of an at-the-money call option on IBM is 0.29. The hedge ratio of an at-the-money put option is −0.42. What is the hedge ratio of an at-the-money straddle position on IBM? (Negative value should be indicated by a minus sign. Round your answer to 2 decimal places.)

MNCs can use several methods to hedge transaction exposure (futures hedge, forward hedge, Money market hedge...

MNCs can use several methods to hedge transaction exposure (futures hedge, forward hedge, Money market hedge and currency option hedge). Give an example of how a particular company hedges the translation exposure (mention which one(s) of these techniques

Options contracts are an alternative to futures and forwards contracts to hedge FX risk. Why would...

Options contracts are an alternative to futures and forwards contracts to hedge FX risk. Why would investors prefer to use options rather than futures or forwards? Under which future outcomes do options provide an advantage relative to forwards or futures contracts? Why might managers choose not to enter into options contracts?

Explain how (not why) a company can use the futures market to hedge against rising interest...

Explain how (not why) a company can use the futures market to hedge against rising interest rates. What would they buy (or sell?) Explain how (not why) a company can use the futures market to hedge against rising raw materials prices. What would they buy (or sell?)

conditions for a perfect futures contract hedge. To illustrate the hedge, use an abattoir (consumer) who...

conditions for a perfect futures contract hedge. To illustrate the hedge, use an abattoir (consumer) who is required to purchase 20,000 kg of live cattle in December 2020. Futures contract on live cattle: Contract size: 10,000 Kg Contract maturity: Dec. 2020

Critically evaluate alternative derivatives including forwards, futures, options and swaps available in the market to minimise...

Critically evaluate alternative derivatives including forwards, futures, options and swaps available in the market to minimise risk when paying in international currencies.

Question